Rising Inflation Expectations: Why Macro Economists Can’t See It Coming

This is an example why macro-models used by mainstream experts don’t get it.

From the Wall Street Journal Blog (bold emphasis mine)

The Federal Reserve expects higher price pressures to be “transitory.” But other economic players aren’t so sure.

A new survey of finance professionals done by J.P. Morgan shows core inflation expectations are rising around the world.

In the U.S. specifically, the mean response is that core inflation, as measured by the consumer price index excluding food and energy, will be running 1.8% a year from now. That is up from 1.4% when the survey was last done in November and up from February’s actual reading of 1.1%. The survey polled about 750 respondents, with about 40% from North America.

The report notes the recent jump in oil prices and the longer-running increase in commodity prices may be skewing responses. But the report notes core inflation rates have already been rising in the U.S. and the U.K.

Duh?!

Core inflation expectations have long been rising around the world! Don’t these experts see that the REVOLTS in the Middle East have partly been triggered by record food prices??!!!

Chart from Business Insider

Next, price pressures are “transitory”???!!!

The IMF even says that people should get used to high food prices for all other reasons except macroeconomic government policies. The IMF is part of mainstream macro.

From the Bloomberg,

Consumers should get used to paying more for food, after prices rose to a record, because farmers will take years to expand production enough to meet demand and drive down costs, the International Monetary Fund said.

People in developing countries are becoming richer and eating more meat and dairy, meaning more grain for livestock feed and land for grazing animals, Thomas Helbling, an adviser for the IMF’s research department, and economist Shaun Roache wrote in an article. Rising demand for biofuels and bad weather also tightened supply, they said.

“Rising food prices may be here to stay,” Helbling and Roache wrote in the article published in the agency’s Finance & Development magazine. “The main reasons for rising demand for food reflect structural changes in the global economy that will not be reversed.”

True, food prices signify a minor component in the household expenditure pie for developed economies. But that doesn’t mean that rising oil, food and commodity prices won’t spillover to the rest of the economy. Eventually they will!

Chart from Northern Trust

When models try to isolate variables from people’s action (like isolating food and energy from inflation index as shown above-right window), then experts tend to underestimate real social activities, like inflation.

People do not act based on one or two or select variables. Our actions are bundled, as I previously wrote

We cannot isolate one variable from the other. People’s actions are responses to an ever dynamic “bundled” environment shaped by laws, markets, culture, environment, etc...

Bottom line: macroeconomics tends to deal with superficial issues that are bottled up in laboratory environment models rather than lay blame on what truly causes CPI inflation—inflationism (low interest rates and money printing) and interventionism (price controls, subsidies and etc..).

Quote of the Day: The Failure of Macro Economic Policies

From Columbia University Professor Joseph Stiglitz writing on the IMF Blog, (bold emphasis his) [hat tip: Greg Ransom]

The most remarkable aspect of the recent conference at the IMF was the broad consensus that the macroeconomic models that had been relied upon in the past and had informed major aspects of monetary and macro-policy had failed. They failed to predict the crisis; standard models even said bubbles couldn’t exist—markets were efficient. Even after the bubble broke, they said the effects would be contained. Even after it was clear that the effects were not “contained,” they provided limited guidance on how the economy should respond. Maintaining low and stable inflation did not ensure real economic stability. The crisis was “man-made.” While in standard models, shocks were exogenous, here, they were endogenous.

In short, math models fail to predict the complexities of human action.

Why Mainstream Economists Are Mostly Wrong

How could economists/experts get it (forecasting, policy prescriptions) so wrong?

This from Janus Lim of the World Bank (hat tip: Prof Antony Mueller) [bold emphasis mine, italics his]

It would seem that the current crop of modern macro models are not only ill-suited for prime-time policymaking in the developed world, they are also inadequate for the developing-country context. At some level, this is ironic. Developed economies are typically far more complex, with larger and more sophisticated product, financial, and labor markets. If anything, the relatively simple structure of DSGE models should be attractive to developing countries, since they are more likely to be successful in capturing the primary features of these economies.

Of course, it may well be the case that developing country policymakers are not quite ready for such sophisticated, state-of-the-art macro modeling tools. Perhaps so, but this seems to me to be a red herring. While ease of use is certainly relevant for capacity-constrained LDCs, the more important question to ask is whether such models can answer the questions foremost on the minds of developing country policymakers. If they can't, it matters much less that the developing world is not ready for them. It would be more that these models are not ready for the developing world.

For simplicity sake, the answer is because they substitute models for human action.

Prof Richard Ebeling writes,

The inability of the economics profession to grasp the mainsprings of human action has resulted from the adoption of economic models totally outside of reality. In the models put forth as explanations of market phenomena, equilibrium — that point at which all market activities come to rest and all market participants possess perfect knowledge with unchanging tastes and preferences — has become the cornerstone of most economic theory.

Economics Should Never Be Treated As Science

Here is a stinging rebuke by Telegraph's Ambrose Pritchard's on the supposed hubris of a Federal Reserve economist, who recently condemned economic bloggers as "chronically stupid and a threat to public order".

From Mr. Pritchard, (bold highlights mine)

``The 20th Century was a horrible litany of absurd experiments and atrocities committed by intellectuals, or by elite groupings that claimed a higher knowledge. Simple folk usually have enough common sense to avoid the worst errors. Sometimes they need to take very stern action to stop intellectuals leading us to ruin.

``The root error of the modern academy is to pretend (and perhaps believe, which is even less forgiveable), that economics is a science and answers to Newtonian laws.

``In any case, Newton was wrong. He neglected the fourth dimension of time, as Einstein called it, and that is exactly what the new classical school of economics has done by failing to take into account the intertemporal effects of debt – now 360pc of GDP across the OECD bloc, if properly counted.

``There has been a cosy self-delusion that rising debt is largely benign because it is merely money that society owes to itself. This is a bad error of judgement, one that the intuitive man in the street can see through immediately.

``Debt draws forward prosperity, which leads to powerful overhang effects that are not properly incorporated into Fed models. That is the key reason why Ben Bernanke’s Fed was caught flat-footed when the crisis hit, and kept misjudging it until the events started to spin out of control.

``Economics should never be treated as a science. Its claims are not falsifiable, which is why economists can disagree so violently among themselves: a rarer spectacle in science, where disputes are usually resolved one way or another by hard data.

``It is a branch of anthropology and psychology, a moral discipline if you like.

The basic problem with bureau-technocrats and their adherents is that they mistakenly presume the monopoly of economic wisdom solely based on its treatment with mathematical and or scientific equations or from PhD degrees, which Mr. Pritchard rightly lambastes.

This reminds us of Ludwig von Mises who wrote in Omnipotent Government (p. 120),

``Nothing could by more mistaken than the now fashionable attempt to apply the methods and concepts of the natural sciences to the solution of social problems. In the realm of nature we cannot know anything about final causes, by reference to which events can be explained. But in the field of human actions there is the finality of acting men. Men make choices. They aim at certain ends and they apply means in order to attain the ends sought."

Update.

I read the controversial article, and the apparent targets of the Fed Economist Kartik Athreya commentary seem to be the populist bloggers who always paint the world as simple adjustable mechanical instruments.

Says Mr. Athreya, ``They are the patron saints of the “Macroeconomic Policy is Easy: Only Idiots Don’t Think So” movement: Paul Krugman and Brad Delong. Either of these men will assure their readers that it’s all really very simple (and may even be found in Keynes’ writings)...

But outside the unpleasant "ex-cathedra" and "PhD coursework" reference, Mr. Athreya makes some valid points...(bold highlights mine)

``The main problem is that economics, and certainly macroeconomics is not, by any reasonable measure, simple. Macroeconomics is most narrowly concerned with the tracing of individual actions into aggregate outcomes, and most fatally attractive to bloggers: vice versa. What makes macroeconomics very complicated is that economic actors... act. Firms think about how to make profits, households think about how to budget their resources. And both sets of actors forecast. They must. One has to take a view on one’s future income, health, and familial obligations to think about what to set aside for retirement, how much life insurance to buy, and so on. Of course, all parties may be terrible at forecasting, that’s certainly a possibility, but that’s not the issue. Even if one wanted to think of all economic actors as foolish and purposeless organisms making utterly random choices, one must accept that their decisions will still affect, and be affected by what others do. The finitude of resources ensures this “accounting” reality.

``Beyond this, some may recall that Economics 101 is usually insistent on reminding students of the Fallacy of Composition: what is true for some may not be true for all. Much of macroeconomics is dedicated precisely making sure that when we talk about the “economy”, we don’t fall afoul of this fallacy."

I guess what may have gotten Mr. Pritchard's goat is that his writings has been tilted towards the oversimplistic the macro perspective, which Mr. Athreya critiqued.

Nevertheless, Mr. Pritchard's argument about economics as distinct from science is valid, but doesn't refute Mr. Athreya's point on the simplistic macro perspective.

Does Macro Economics Matter?

In an article, "What's the Point of Macro?" Societe Generale Dylan Grise remarked,

``So my advice to anyone about to embark upon Einhorn's path of using macro to "actively manage your long-short exposure." is to think long, hard and honestly about what your sphere of competence actually is." (thanks to my dear friend Mr. Laird Smith)

If importation of product X is my business, and suddenly our government prohibits the imports of this item and its related lines, then what's the effect to my business? Obviously I'd have to either shift to other products where imports are allowed or close shop! [yes my dad suffered from this predicament nearly 30 years ago]. In short, business conditions respond to macro policies.

Thus my corollary: The more the government intervenes in the marketplace, the more macro perspective becomes relevant, and vice versa, in determining the viability of investments.

Put differently, the usefulness of the macro perspective relative to risk-reward tradeoff depends on the expected level or degree of government interventionism or inflationism.

As a caveat, while macro does matter, we shouldn't ignore the micro developments. Importantly, we should NOT depend on mathematical formalism to make macro appraisals.

A China Bubble Bust Is Unlikely Yet

``I write this piece to warn against the simplistic notions about China that permeate our media, and to challenge the powerful special interests that want to paint China as a nation to be attacked, not vigorously debated. We face a long and very challenging dialogue with China, and I believe knowledge is an infinitely better negotiating tool than crude propaganda and simplistic nationalism. Am I really saying China should be handled differently? No, just intelligently.” Mark W. Headley In China’s Shoes, Matthews Asia

Well the other main source of concern is no less than China.

Bears have been growling out louder about an imminent bubble bust in China.

As we wrote in China’s Attempt To Quash Its Homegrown Bubble and in China's Bubble And The Austrian Business Cycle, while we agree with the notion that China have been undergoing a bubble process, since most of the symptoms have manifested the typical Austrian Business cycle model, it is quite unclear that that they’ve reached a manic or terminal phase.

Besides, bubbles do not imply an immediate bust. Bubbles operate as a cycle, where it undergoes several phases. A busting bubble is the end game of the terminal or manic phase.

And betting against an imploding bubble requires some timing. Betting too early before the full stretch of the manic phase would leave shorts without underwears.

Mixed Bubble Signals

Figure 5: WSJ/US Global: Mixed Picture

Yes it is true that property prices and loans have meaningfully surged (see figure 5 left window from Wall Street Journal) enough to prompt for many to yell “fire!”, but it also would seem possible that the surge in property prices could have been reflecting on the pace of the increase in the per capita income of the population (see right window: US Global Fund), albeit the speed may have been quite too drastic.

And in the light of the dramatic expansion of loan and property prices, China reportedly is scheduled to raise its reserve requirements by 50 basis points on her banking system for the second time this year by next week (February 25^th).

As to the success of a soft landing from China’s attempt to quash her homegrown bubble is yet unclear. A more significant but adverse impact would be a continuing trend of falling asset markets and imploding malinvestments within the economy. This has not yet emerged.

Figure 6: Bloomberg: Shanghai (top) and Shenzhen (below) Stock Markets Seem Stabilizing

So far, China’s stock markets appear to be stabilizing following the repeated assaults by China’s government to control her bubbles.

Both the Shanghai and Shenzhen benchmarks seem to be bottoming in spite of the recent news to tighten lending. This is in sharp contrast to the violent responses seen in both benchmarks last January.

Have China’s stock markets been turning blasé or discounting the government actions? Or has this been a proverbial calm before the storm? Does this also imply that China’s bubbles are now confined to the property sector?

From my observation of the bubble cycles, bubbles have wide spillover effects. They tend to raise asset prices in general but with most of the impact seen on the areas where the malinvestments have been concentrated. This implies that a full pledge bubble should also be manifested in the stock markets.

This does not seem to be happening in China.

Why Stereotyping Misleads

It isn’t easy to read China. She hasn’t been as transparent and the accuracy of her statistics is likewise in doubt.

However, in my view, opaqueness doesn’t justify macro based heuristics to pass negative judgments. That’s because inaccuracy can work both ways: underestimation and overestimation. The bearish camp believes the latter.

Yet, the fact that China has entered into a free trade agreement with ASEAN and the other East Asian neighbors should be seen significantly in the positive light [see Asia Goes For Free Trade].

It would even be a flagrant mistake to compare China to a particular stock or a company.

Corporations are not like economies, the former operates on a profit and loss incentive while the latter functions on a highly complex but interrelated self-operating multiple parts composed of acting people. [see The Myths Of Government’s Managing The Economy]

As Jeffery Tucker of Mises.org explains, ``Society works not because a single mastermind has preset all the moving parts. It works because people find ways to cooperate through private actions that follow signs and rules that cannot be anticipated but can nonetheless be coordinated. Society and its workings cannot be mapped out and the attempt to do so can create frameable images but not civilizations.” (bold highlight mine)

Besides, China’s property markets isn’t anywhere like the US. For instance, the Chinese buy properties with sizeable upfront equity.

Shaun Rein in Forbes writes, ``when buying residential properties, consumers in China have to put down 30% before taking out a mortgage. For a second home, they have to put down 50%, no matter what their net worth.”

In addition, income in China has reportedly been underestimated, again Mr. Shaun rebuts China skeptics, ``If anything, incomes are grossly underreported in China. A simple look at how accounting works will show why. Whereas in the U.S. individuals must report their income to the Internal Revenue Service every year, in China all individual tax is reported and paid for by companies, except for that of high earners. Many Chinese companies limit the tax they pay by reporting low salaries and then paying their employees higher amounts while accounting for the difference as business expenses like phone bills. The employees are happy because they make every bit as much as they were promised, and the companies are pleased to lower their tax exposure.”

``Also, many companies pay for housing and cars for their employees, a holdover from the old system of state-run businesses. Most Western economists don't count those expenses as income, but they should. Deceptive accounting of income is so widespread that the government has announced plans to tax some business expenses in state-run enterprises--the kinds of expenses that let executives pay taxes on earnings of $300 a month while living in multimillion-dollar homes and driving Mercedes.” (all bold highlights mine)

As one can observe, comparing a society to another by simply stereotyping can lead to serious misappraisals.

So perhaps we’d stick to the actions in the stock markets, property and bond markets, interest rates and inflation, aside from sentiment indicators as the Art market and the Skyscraper Curse to identify signs of the whereabouts of the bubble cycle.

Nevertheless, China would have a lot of flexibility to deal with an imploding bubble given her inherent financial advantages.

Doug Noland of Prudent Bear’s Credit Bubble Bulletin rightly observes, ``First of all, authorities are sitting on an incredible war chest of $2.4 TN of reserves. This hoard today provides virtually unlimited capacity to recapitalize its vulnerable banking system. This hoard also provides unusual protection against a run on the Chinese currency. Never, it seems, has a Credit system enjoyed such flexibility to run so hot for so long. At this point, I have to believe that the policy objective is not to rein in excess as much as it is to slow bank lending to what is believed to be a more sustainable $1.1 TN annual pace.”

In short, the economies of scale from massive surpluses matters, I’d like to add her savings too.

Considering all these variables, I wouldn’t bet on the imminence of a bubble bust. Perhaps not this year.

Video Interview: Macro Economist Kenneth Rogoff Versus 'Enterpreneur' Tom Gloser On The Global Economy

This is an interesting video interview by CNBC of Harvard's Ken Rogoff and Tom Gloser of Thomson Reuters in Davos.

It is interesting because the message of both distinguished personalities evokes deeply contrasting views, even if they claim to represent different approaches (Mr. Rogoff-macro while Mr. Gloser-micro) in how they see the world.

Besides, CNBC's designated title "Economy to Crash if It Keeps Debt Appetite: Rogoff" seem to mislead, because Mr. Rogoff says it's gonna "get worse before it gets better" which hardly implies of a crash. Moreover, Mr. Rogoff consumed about only 5-10% of the total time interviewed, yet got the top billing for the video's title. If this is not a case of sensationalism, I don't know what is.

I say contrasting too, because while Mr. Rogoff spoke of difficult times ahead, Mr. Gloser sanguinely articulated on his ex-US "cautious" but manifold expansions, primarily on the "places that are growing", particularly the BRICs in order to "stay a step ahead".

For me, this exhibits the classic informational conflict between the interpretation of statistical aggregates against that of the information from what F. A. Hayek calls as the "man on the spot" or localized knowledge in ascertaining changes in the economy.

Another very important distinction is that while one operates in the realm of theories, the other votes with risk money. I wonder who among them would be right. Interesting indeed.

Investment Is Now A Gamble On Politics

``Central bank will not allow large banks to fail. This means that it will not allow the fractional reserve process to implode through bank failures and the contraction of the money supply.”- Gary North, 'Dr. Deflation' Changes His Mind After 27+ Years

What amounted to one month of rainfall gushed over the Philippine metropolis in just 6 hours! In the wake of typhoon Onyok, a vast part of Metro Manila have been turned into a virtual swamp, enough for the Philippine government to declare the affected areas in a state of calamity. According to news reports, the devastating floods from the typhoon Saturday, had been the worst in nearly 40 years.

From our perspective, this serves essentially as an example of a high impact, hard to predict rare event which classifies as a Black Swan, in terms of weather.

While one may argue that the approaching typhoon was predictable, the intensity of the rainfall, according to the local weather bureau, wasn’t.

In as much as Black Swans happens in nature, it also occurs in the marketplace. And this has been a contingent that we have been striving to prepare for, so as to achieve the entrepreneurial goal of optimizing profits via risk identification and damage control.

Of course Black Swans don’t just apply from the negative point of view but can also be seen from a positive light. Technological innovations are just vivid illustrations of these.

Nevertheless the important point is to identify where the larger distribution of risks lies as possible source of market based Black Swans.

Deflation’s Ipse-Dixitism

The recent weaknesses in many parts of the global financial marketplace have been used by the bear camp, mostly populated by the deflationistas, to extol on their “bear market rally” theme.

Figure 1: Stockcharts.com: Falling Markets

For varied indicators as the falling Baltic Dry Index (BDI), Friday’s slump in oil (WTIC) and gold (GOLD), rallying US treasuries and the struggling enfeebled market leader in China’s Shanghai index seems to have all converged.

The bear camp argues that the rally has ended on the corroding effects of stimulus, recessionary forces regaining an upperhand, prices acting “way too far, too fast”, possible escalation of trade war and the demobilized consumers from exercising their extenuated spending powers.

While we don’t belong to the camp which advocates more inflation since we think inflation is immoral and generally baneful to the society, as a market participant we understand inflation to be a political process- where policymakers make political decisions of picking winners or salvaging select interest groups or industries or companies at the cost of the taxpayers.

As Henry Hazlitt wrote, `` For inflation does not come without cause. It is the result of policy. It is the result of something that is always within the control of government—the supply of money and bank credit. An inflation is initiated or continued in the belief that it will benefit debtors at the expense of creditors, or exporters at the expense of importers, or workers at the expense of employers, or farmers at the expense of city dwellers, or the old at the expense of the young, or this generation at the expense of the next. But what is certain is that everybody cannot get rich at the expense of everybody else. There is no magic in paper money.” (bold emphasis mine)

In other words, for as long as the governments attempt to vehemently prevent the required market adjustments from previously misdirected allocation of resources, mostly by promoting credit expansion and spending, and by government directly purchasing assets with “money from thin air”, they are undertaking inflationary programs.

Yet this avowed policy direction by global authorities to inflate and the penchant by several participants to adamantly insist of a deflationary outcome seem quite self contradictory.

Why the deflation risk is a bogeyman?

For one, we have noted that central banks have the capacity to match or even exceed the issuance of money to offset every outstanding liability a political economy has been blighted with, for as long as the banking system remains afloat.

Two, macro analysis looks at problems on oversimplified basis or from one dimensional aspect of product, labor and capital. Moreover, money is often seen as a constant, where marginal supply of additional money into the economy doesn’t impact prices.

In addition, macro analyses have been predisposed to models that apply only to selective and not on general conditions.

In the case where money is construed as a constant, this fitting remark from Professor Gary North, ``Whenever an economic theory of how the world works makes an exception for monetary theory, the proposed monetary theory is incorrect, or the general theory is incorrect, or both are incorrect.” (emphasis added)

Three, inflation is fallaciously anchored as mainly a consumer dynamic.

Fourth, deflationists disregard pricing levels from a relative perspective. For instance, deflationists tend to ignore the impact from technology’s early adopter buyers. More importantly, they gloss over the fundamental law of pricing based demand and supply allocations, where low prices extrapolate to higher demand.

Fifth, deflationists discount the transmission mechanism from monetary policies given today’s US dollar currency standard platform. Remember, 23 countries (wikipedia.org) are pegged to the US dollar which means these countries are fundamentally importing Bernanke’s policies.

And since debt levels and capital structure vary from country to country, the impact of recessionary forces or debt deflation or consumer spending retrenchment from bubble afflicted economies will be different from those countries importing US policies. In addition, a further variance would be the effect from applying the same home based stimulus programs.

As CLSA’s high profile analyst Christopher Wood in a Bloomberg article, ``It’s wholly wrong to view Asia as a correlated train wreck with the U.S. consumer.”

Therefore, deflation in an absolute sense signifies as ipse dixitism or unsupported dogmatic assertion.

Unworthy Paradigms: Great Depression And Japan’s Lost Decade

Sixth, deflation proponents generally make comparisons with that of the Great Depression and the Japan experience even if both circumstances have been totally different from today.

The Great Depression was a byproduct of an amalgam of:

-Massive monetary contraction (30%),

-Regime uncertainty or investors’ reluctance to participate in a perceived hostile atmosphere resulting from a string of adverse policies imposed, which appears to have threatened property rights and prevented the necessary price adjustments, such as wages.

To quote Benjamin Anderson from Robert Higgs’ Regime Uncertainty “The impact of these multitudinous measures—industrial, agricultural, financial, monetary, and other—upon a bewildered industrial and financial community was extraordinarily heavy”, and

-high taxes and protectionism amidst a recession which metamorphosed into a depression [see earlier post Lessons From The Great Depression: Taxes, Protectionism and Inflation].

Japan's stagnation, on the other hand, which has been popularly but erroneously known as suffering from deflation (technically defined as contracting money supply), had likewise been a consequence of a mélange of regulatory mess, particularly high tax regime, policies that propped up the legacy of obsolescent zombie industrial companies [see Asia: Policy Induced Decoupling, Currency Values Aren’t Everything], reluctance to liberalize due to cultural idiosyncrasies (bad management of companies due to interlocking relationships among companies and the ``disdainful of the idea of shareholder value and of traditional profit metrics” notes James Surowiecki) and the conflict of interest issues from Japan’s bureaucracy which embraced state capitalism.

The recently victorious Democratic Party of Japan (DPJ) declared it would reduce the latter’s influence, but the question is always HOW?

Moreover, Japan’s lost decade has been largely insulated from the world as most of its liabilities had been denominated in local currency. The culturally high savings quirk by the Japanese financed most of the failed boondoggles during the nearly 2 decade long of stagnation. However, demographic issues (which has been depleting savings) and current conditions (weaning off from the US consumers and reorienting trade towards China and Asia) imply that the old model is about to make a major transformation.

MAD “Mutually Assured Destruction” Policies

Seventh, deflationists often switch gears from using the monetary aspects to excess capacities or current account balances or non-monetary (usually trade) dimensions in rationalizing deflation on a global scale or data mine facts to fit their arguments.

For instance, the Global Savings Glut theory has been prevalently used as an attempt to shield the US from policy flaws which pins the blame on “currency manipulation” by Asian savers.

Hardly anyone from the mainstream incorporates the role of the US dollar, as the world’s de facto currency reserve, in the discourse of the origins of today’s imbalances.

Professor Robert Triffin rightly predicted more than 40 years ago of the accruing imbalances that a reserve currency would endure. That’s because of the incremental tensions which would amass from conflicts of national monetary policies vis-à-vis global monetary policies (provider of international liquidity). This is known as the Triffin dilemma, where the reserve currency can remain overvalued from which it would continue to accumulate deficits or undergo proportional devaluation in order to stabilize or shrink deficits [see previous discussion in The Nonsense About Current Account Imbalances And Super-Sovereign Reserve Currency].

So while the mainstream goes into a perpetual blaming spree alongside with their sanctimonious omniscient prescriptions, they don’t seem to realize that this has been the operating nature of reserve currencies, especially from a “paper money” standard.

Moreover, the recent trade dispute between US President Obama and China over increased tariffs over tires have breathed “protectionism” as an excuse for deflation.

Figure 2: BCA Research China: Tempest In A Teacup, For Now

While the risk of an escalation of a trade war appears plausible, I am predisposed to the view that these politically motivated actions has been designed to wangle some short term deal with vested interest groups, particularly the labor union-the United Steelworkers or protectionist policymakers.

However we share the optimism with BCA Research when they wrote, ``However, there are good reasons to believe that the recent tensions are likely to be contained. For one, the amount of trade in question is a tiny fraction of total trade flows between the two countries. Chinese sales of tires and steel pipes to the U.S. amount to about US$4 billion a year (compared to $US230 billion of total Chinese exports to the U.S.). Meanwhile, Beijing’s action in taking the trade dispute to the WTO shows China’s willingness to resolve disputes within the legal framework of international trade rather than via direct bilateral confrontation. Overall, the Obama administration’s seemingly toughened stance towards China-related trade issues is mainly a maneuver designed to garner domestic political support rather than an outright intention to wage a trade war. The biggest risk that could significantly heighten trade tensions and economic confrontation is if the U.S. government and lawmakers once again challenge China’s exchange rate policy and tax rebates for its exporters. Bottom line: Chinese authorities will likely continue to focus on the big picture of promoting domestic growth, so long as there is no systematic challenge to the country’s trade and foreign exchange policies to complicate its growth-boosting strategy.” (bold underscore mine)

Put differently, the Tire tariff was perhaps meant as diversionary tactic or as a concession in order to diffuse far larger protectionist tensions held by some quarters in the august halls of the US congress. In short, if we are right, the controversial enactment of the Tire tariff appears to be more symbolic than of a real risk.

In addition, it would also be plain naive to extrapolate for the US to arbitrarily lure China into a trade war when US officials are aware that the Chinese holds the largest share, about $800 billion (as of July), of US treasuries or nearly a quarter share of the foreign owned pie see figure 3.

Figure 3: Wikipedia.org: Foreign Holders of US Treasuries

As the legendary trader Julian Robertson of Tiger Management says in a recent CNBC interview, ``“We’re totally dependent now on the Chinese and Japanese” [as posted in Julian Robertson: We are going to have to Pay the Piper].

In short, President Obama significantly depends on China, Japan and Asia’s largesse to sponsor his administration’s “borrow and spend” program.

This also means that it would be utter lunacy, if not suicidal, for Pres. Obama to engage in mutually assured destructive (MAD) policies, which should hurt more of the US than China. Further this would accelerate the inflationary process in the US (…unless this serves as an opportunity for the US to seize the moment from a hostile China response to be used as a Casus Belli to declare a default! But the US owes Japan and the rest of the world too.).

Since there will be lesser access to savings globally, the court of last resort will be Chairman’s Bernanke’s printing press.

Here, Mr. Robertson estimates 15-20% annual inflation rates for the US once China and Japan desists from financing the US.

Scared Of One’s Own Shadows

Last and most importantly, deflationists belittle the role of central banking in the economy and the economic ideology underpinning the global political leadership.

In short, deflationists rule out the ramifications from the political aspects of government intervention in the economy.

It is also kindda odd to see some deflationist scared to wits about the prospects of deflation when they have been influenced by the same ideology that espouse on government intervention that paves way for the inflation-deflation boom bust cycles. It’s analogous to being afraid of one’s own shadow.

Deflation basically comes in two forms. One is a consequence of inflationary policies. The other is an outcome of productivity, which means economic output greater than the supply of money. This had been much of the case during the gold standard based, Industrial Revolution.

Nobel prize winner Friedrich A. Hayek in a speech about Choice In Currency, A Way To Stop Inflation eloquently describes the shift from stability into today’s woes,

``The chief root of our present monetary troubles is, of course, the sanction of scientific authority which Lord Keynes and his disciples have given to the age-old superstition that by increasing the aggregate of money expenditure we can lastingly ensure prosperity and full employment. It is a superstition against which economists before Keynes had struggled with some success for at least two centuries. It had governed most of earlier history. This history, indeed, has been largely a history of inflation; significantly, it was only during the rise of the prosperous modern industrial systems and during the rule of the gold standard, that over a period of about two hundred years (in Britain from about 1714 to 1914, and in the United States from about 1749 to 1939) prices were at the end about where they had been at the beginning. During this unique period of monetary stability the gold standard had imposed upon monetary authorities a discipline which prevented them from abusing their powers, as they have done at nearly all other times. Experience in other parts of the world does not seem to have been very different: I have been told that a Chinese law attempted to prohibit paper money for all times (of course, ineffectively), long before the Europeans ever invented it!”

So it is another deeply held erroneous belief that deflation is the greater evil, when 200 years of the gold standard brought about great prosperity. This is in contrast to today’s deepening intermittent boom bust cycles, which only enriches only certain segments of the society and hurts the rest of society when a bust transpires.

Deflation from an inflation bubble simply cleanses the system.

Yet the same camp of deflationists argues for more inflation.

From UK’s Prime Minister Gordon Brown (quoted by Bloomberg), ``The stimulus that we have still got to give the world economy is greater than the stimulus we have already had. What we want to do is safeguard a recovery from a recession we feared would develop into a depression.”

Moreover, the US Federal Reserve recently decided to extend and complete its $1.25 trillion buying program into the mortgage market. According to Bloomberg, ``The central bank has purchased $694 billion of mortgage- backed securities since January and plans to spend $556 billion more by April 2010 to keep interest rates down. The debt-buying is the biggest program in the Fed’s arsenal.”

Isn’t these powerful signal enough, a manifestation of both economic ideology and policy direction? It’s more than just words or propaganda, it reflects action in progress.

And as we argued in Governments Will Opt For The Inflation Route and last week’s A Deeply Embedded Inflation Psyche, for us, it has been a policy tool for the US Federal Reserve to juice up the stock market for the same reasons- economic ideology (to paint the impression of economic recovery by reanimating the irrational “animal spirits”) and policy direction.

As we previously pointed out, the US government today stands as THE mortgage market, why is this so? Aside from trying to “stabilize” the mortgage market, the US banking system holds tonnes of assorted mortgages on their balance sheets.

In short, the US government has been preventing the outright collapse of some important segments of its banking system by providing implicit guarantees on the banking system’s assets.

Moreover, the US government has also acquired ownership representation among the biggest financial institutions. This acts as another form of implicit guarantee.

Aside, the ownership accounts for interventions or interferences aimed at conveying its political objectives into the company’s business operations.

Further by undertaking quantitative easing, the US Federal Reserve reliquefies the marketplace by acting as market maker of the last resort to the illiquid markets.

If the US Federal Reserve hasn’t been the key influence of the stock market, why would issues, which accounted for most of the recent government rescues, have accrued most of the jump in the trading volume at the NYSE? (See figure 4)

Figure 4: William Hester: Without Phoenix Stocks, Volume Continues to Contract

According to William Hester of Hussman Funds (bold highlights mine), ``But almost the entire rise in volume during the last month and half has come from a handful of stocks. Examples include Fannie Mae, Freddie Mac, Citigroup, AIG, and Bank of America. These are just five. There are a couple of other stocks that are interchangeable with these companies and would produce similar results – but the characteristic they all share is that they are financial stocks that only recently were on the brink of collapse. And since the Government's rescue of these and other financial firms, the group has risen up from the ashes. For ease of reference, we'll call these Phoenix stocks.

``The rise in trading volumes in some of these stocks has been considerable. The shares of AIG now often trade with 15 times the volume they traded a year ago. Citigroup has traded at 12 times the amount from a year ago. This helps explain why the trades in these companies' shares are taking up a larger fraction of total share volume.”

Has US government zombie institutions been using their excess reserves or proceeds from the Fed’s QE reliquification program to trade their own shares or trade shares among themselves?

Figure 5: Andy Kessler: Monetary Base versus Dow Jones

Is it just merely a coincidence that monetary base has been growing while stock market has been rising (see figure 5)?

Some would argue, but the other money aggregates have turned south. However, what if banks haven’t been lending but instead speculating on assets?

Besides, there has been no clear agreement as to which of the monetary aggregates should serve as the true representative or as accurate indicator of money conditions in the US or globally. This makes the chart above “correlated but not causal”, as much as those arguing the opposite.

Further, the boom in the bond markets has also revealed that credit has been expanding but has been short circuiting the banking system.

By going direct through the capital markets, credit intermediation hasn’t triggered the banking system’s fractional reserve platform, hence hasn’t been reflected in traditional monetary aggregates.

All told, deflation seems more like a bogeyman widely used to justify more politicization of the marketplace.

Investment Is Now A Gamble On Politics

There are two more very significant developments the deflationists have sorely missed.

The recent weakness in the markets in gold, commodity and China hasn’t triggered a meaningful jump in the US dollar index to confirm the debt destruction and the impotence of central banking, similar to the meltdown of last year.

Moreover, it hasn’t reflected a general tightening of credit conditions out of default fears…yet.

Figure 6: Danske Weekly Credit

As you can see from the Danske Charts above, major credit indicators have all turned lower or has materially improved, all of which hasn't been emitting any trace of “deflation” tremors.

Moreover, there have been reports that the Fed has been exploring ways to tap the funds from the money market to implement its exit strategy. According to the Yahoo Finance ``The Fed would borrow from the funds via reverse repurchase agreements involving some of the huge portfolio of mortgage-backed securities and U.S. Treasuries that it acquired as it fought the financial crisis, the newspaper reported, without citing any sources. This would drain liquidity from the financial system, helping to avoid a burst of inflation as the economy recovered”. (emphasis added)

Yet analyst like Zero Hedge’s Tyler Durden sees this as one of the many subterfuges employed by the FED to “reflate” the system.

This from Mr. Durden (bold highlights mine), ``And the Fed finds a way to screw everyone over yet again. Contrary to expectations that the Fed will use reverse repos to remove excess liquidity (which, by definition, such an action would) it appears that Bernanke's wily scam is to push even more money out of money market funds and into capital markets. Even though banks currently have about $800 billion in excess reserves which the Fed is paying interest on, and which would be a damn good source of liquidity extraction as the Fed considers to shrink its ever expanding balance sheet, the Chairman is rumored to be considering money market funds as a liquidity source…All in all, the Chairman is determined, come hell or high water, to part consumers with their savings: whether it be through zero deposit interest rates, through money market guarantee removals, through talk of inflation or, ultimately, through actions like these. After all, America has gotten to the point where the Fed is beating the drum on the need to keep blowing the capital market bubble bigger and bigger: anything less, and just as Madoff investors discovered, the entire pyramid collapsed overnight, and where people thought there was $50 billion, there was really $0.”

In addition, even while the Fed has declared that it would undertake the completion of its $1.25 trillion QE program by buying $556 billion more on mortgages, there seems to be a problem, it is only left with an estimated $10 billion for US treasuries which is expected to be expire by October.

This implies that should foreign central banks continue to recycle their surpluses on short term Treasury bills, the yield curve should soon steepen as the long end rises (on condition that the Fed holds course by not additionally monetizing US treasuries).

And rising treasury yields places further constraints or pressures to the financing of US government programs.

This from Professor Michael S. Rozeff (all bold underscore mine), ``The government will have problems funding its programs. It will be under pressure to raise taxes and cut back on its programs. Since it will be reluctant to do either, the problems will fall upon the dollar and on the government debt. This will place the government in an untenable position because the higher interest costs of the debt will add to the deficit. A negative feedback cycle will occur in which deficits cause higher interest costs which cause more deficits which cause higher interest costs, and so on. No amount of taxation can solve the government’s fiscal problem that lies ahead. Greater taxes will only make them worse by slowing the economy. That option is foreclosed.”

Ultimately, this brings us to the potential outcome of deflation-inflation debate.

Again Professor Rozeff, ``The two problems – the dollar and debt – are joined. If the FED tries to save the dollar, it affects government debt adversely. The FED can relieve pressure on the dollar by deflating its bloated balance sheet. To do that it needs to sell off the mortgage-backed securities that it has accumulated and not buy the rest that it is now in the process of buying. If it ever does sell off these securities, it will pressure the government debt market. This is very unlikely. Instead I expect it to pay interest on reserves, which will not solve its problems and will only add to the government deficit and start an exponential process of increase in interest paid. If the government tries to save the debt market by having the FED support it as it is now doing, that affects the dollar adversely. The central bank and the government are between a rock and a hard place. One or the other or both of the dollar and the debt are slated to have problems. Enactment of Obama’s health care and energy measures, even in diluted form, will confirm the existing course. Their rejection will be more favorable for the dollar and for government debt. As the political winds shift, so will the fortunes of the dollar and the government debt markets. Investment is now a gamble on politics.”

In short, the US government, not the US consumers, has become the ultimate driver of marketplace. And investing returns would mean reading accurately from political tea leaves.

And once emergent weaknesses in the marketplace becomes increasingly pronounced, governments will be expected, given their Keynesian interventionist ideology, to massively re-inflate the system to the point where the political option would translate to the extreme choice of ‘Mises moment’ endgame: relative deflation possibly via a default or a currency crisis.