Economic Myth Busted: In the US, Savings from Lower Gas Prices was Spent on even More Gas!

Remember the popular mantra/incantation “low oil prices equals more consumer spending”? (this applies not only to the US but elsewhere including Philippines too)

Well, in the US, a study debunks the popular myth: savings from lower gas prices was spent on even more gas!

And bizarrely, media and ‘experts’ blame such unexpected course of development on human irrationality!

From the New York Times  (bold mine)

When gas prices fall, Americans reliably do two things that don’t make much sense.

They spend more of the windfall on gasoline than they would if the money came from somewhere else.

And they don’t just buy more gasoline. They switch from regular gas to high-octane.

A new report by the JPMorgan Chase Institute, looking at the impact of lower gas prices on consumer spending, finds the same pattern as earlier studies. The average American would have saved about $41 a month last winter by buying the same gallons and grades. Instead, Americans took home roughly $22 a month. People, in other words, used almost half of the windfall to buy more and fancier gas.

This is not rational behavior. Americans spent about 4 percent of pretax income on gas in 2014. One might expect them to spend about the same share of any windfall at the pump — maybe a little more because gas got cheaper. Instead they spent almost half.

Americans, in short, have not been behaving like the characters in economics textbooks…

The study, based on the spending patterns of about one million JPMorgan customers, does not track the kind of gas consumers purchased. It shows that people bought more gas as prices fell, and that the increase in consumption is not sufficient to explain the entirety of the increase in spending on gas.

Here is what the law of demand says “all else being equal…as the price of a product decreases, quantity demanded increases.” 

"People bought more gas as prices fell..."

Have consumers not been “behaving like the characters in economics textbooks”? Really? Or have consumers not been behaving in accordance to the fictitious outcomes generated from econometric models?

Of course, such econometric models have been constructed principally on the assumptions that humans DO NOT act based on ever changing preferences and values, in the face of an equally dynamic complex environment, that shapes incentives and consequently their actions. Or in short, for the math pedagogues, humans are NOT humans but automatons or robots whose actions are programmed.

But one may retort, they shifted from “regular gas to high-octane gas”.

So why not? Perhaps high octane gas could have been seen as more "energy efficient" (more fuel savings or longer driving mileage). If so then this reinforces, the law of demand.

But refuting the mythological gas-savings-equal-to-consumption-binge meme goes beyond the statistical technicalities.

Yet as I have noted here and many times elsewhere: the economics of spending is MAINLY a derivative of INCOME conditions—secondarily the utilization of savings and of credit—and NOT from the changes in spending patterns or the redistribution of spending from static income.

And as for the perspective of economic punditry versus real world phenomenon, the great Ludwig von Mises warned (Misapprehended Darwinism, Refutation of Fallacies, Omnipotent Government p.120)

Nothing could be 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.

Now whose behavior have not been rational…acting humans or ‘experts’ whose views have been shaped by rigid econometric models?

IMF Declares Bulgarian Banks Safe Two Weeks before Bank Runs

This serves as a classic example of the establishment’s “kiss of death”

About two weeks ago, two major Bulgarian banks suffered a classic bank run where the European Commission bailed out the banking system with a €1.7bn emergency credit line.

The fun part has been that the IMF gave Bulgaria’s banking system a clean bill of health two weeks prior the crisis.

From the Macedonian International News Agency

Earlier this summer, IMF bureaucrats went to Sofia, Bulgaria to study the country’s economic progress.

And roughly a month ago, they released an official report which stated, among other things, that Bulgarian banks are “stable and liquid.”

Talk about epic timing. Because less than two weeks later, Bulgaria’s banking system was in the throes of a full-blown crisis.

There was a run on two of the nation’s largest banks—several hundred million dollars had been withdrawn in a matter of hours.

And the Bulgarian central bank had to step in and take over both of them or risk a collapse in the entire system.

From 'Stable and liquid' into a banking crisis.

The same mainstream article seems to have been aware of perils of the fractional reserve banking system

This is the modern miracle of fractional reserve banking. When you make a deposit, your bank only holds a tiny percentage of that cash.

The rest of it gets loaned out or invested in securities that pay a much higher rate of return than the pitiful amount you receive in interest.

Needless to say, the less money banks hold in reserve, the more money they’re able to invest… and the more profit they make.

This puts their incentives and our incentives at odds. Because as depositors, it’s better for us if the bank holds most (if not all) of our funds.

In typical form, though, governments stepped in to settle this dispute. And a century ago, they sided with the banks.

Because of this, it’s perfectly legal for banks to hold a tiny percentage of customer deposits. So now, anytime there’s the slightest spook (as happened in Bulgaria), it creates a panic.

‘Slightest spook” which “creates panic” has been implicitly attributed to either depositor’s irrationality or sabotage.

But such hasn’t really been the case with Bulgaria’s bank runs. 

For instance, the license to operate of Bulgaria’s fourth largest bank, the Corporate Commercial Bank, has just been revoked by the Bulgaria’s central bank, Bulgaria’s National bank. This has reportedly been due to the deficits or “‘hole’ in the bank” amounting to 3.5 billion leva as the majority stockholder Tsvetan Vassilev has allegedly been “draining his own bank”, according to a report from The Sofia Globe

In short, what “spooked” depositors had fundamental basis. The report also says that the Corporate Commercial Bank will be allowed to collapse. This means that the affected bank had more than just liquidity issues, it has a solvency problem. Depositors sensed this and the bank run ensued.

Yet the same fundamental basis has apparently been ignored or overlooked by the IMF. 

As you can see, mechanical quant or math model based analysis will hardly ever capture human activities operating behind scenes.

And without understanding the socio dynamics operating behind the numbers, pure number crunching will lead statisticians astray. This is because financial ratios or economic statistics can just be fabricated to look robust. Also since statistical models have been designed to incorporate certain variables, this tends to leave out other relevant factors, when everything in this world is interconnected.

Importantly, since numbers represent history, it would be patently misguided to simplistically extrapolate the past into the future. This should be emphasized considering that the world operates in a complex dimension.

And it is not just the IMF, Sovereign Man’s Simon Black writes,

In the case of Bulgaria, the EU Commission soothingly announced that “the Bulgarian banking system is well-capitalized and has high levels of liquidity compared to its peers in other member states.”

Whoa whoa wait a minute.

Are these geniuses really saying that the country experiencing a bank run due to its LACK of liquidity is MORE liquid than the rest of Europe??

Yes, that is exactly what they’re saying.

So it begs the question– if Bulgarian banks with their “high levels of liquidity” can suffer such shocks, what can happen to other European banks which are worse off?

I think the lesson here is clear: The people in charge of regulating the system and making these proclamations about bank safety are totally CLUELESS.

And the lesson from the miscalculation of Bulgaria’s case can likewise be seen in the risk asset markets around the world, including the Philippines.

In the US, record stocks have been construed by the mainstream as headed for "infinity and beyond" even when the consensus projections of the economic performance have repeatedly been downscaled over the past 4 years. The 2014 projections has shown to be the deepest (see chart above).

In short, while the consensus continues to predict the economic performance with consistent brazen inaccuracy, the record breaking stock markets streak means that the gullible public continues to believe in the "growth" story peddled by Wall Street.

As Contra Corner’s David Stockman wryly observed

There is nothing more predictable than the bevy of Wall Street economists who come charging out of the blocks early each year proclaiming that money printing by the Fed will finally work its magic, and that real GDP growth will hit “escape velocity”. But this year the markdowns have come fast and furious. After the disaster of Q1 and the limp data reported for Q2 to-date, the revised consensus outlook for 2014 at 1.7% is already below the tepid actual results of the last three years. So much for the year when “screaming” growth was certain to happen.

Such kind of outlook has been common in a manic phase.

In a post mortem analysis of pre Lehman crisis bubble deniers, Doug Noland of the Credit Bubble Bulletin at the PrudentBear.com refers to this piece by popular mainstream economist Ben Stein at the New York Times in August 12, 2007 (bold mine, italics original)

The job of an economist, among many other duties, is to put things into perspective. So, because I am an economist, among other duties, here is a little perspective on the recent turmoil in the stock and bond markets. First, when the story of this turbulence is reported, the usual explanation mainly has to do with some new loss in the subprime mortgage world… Here is the first instance in which proportion tells us that something is out of whack: The total mortgage market in the United States is roughly $10.4 trillion. Of that, a little over 13%, or about $1.35 trillion, is subprime — certainly a large sum. Of this, nearly 14% is delinquent, meaning late in payment or in foreclosure. Of this amount, about 5% is actually in foreclosure, or about $67 billion. Of this amount, according to my friends in real estate, at least about half will be recovered in foreclosure. So now we are down to losses of about $33 billion to $34 billion… The total wealth of the United States is about $70 trillion. The value of the stocks listed in the United States is very roughly $15 trillion to $20 trillion. The bond market is even larger… This economy is extremely strong. Profits are superb. The world economy is exploding with growth. To be sure, terrible problems lurk in the future: a slow-motion dollar crisis, huge Medicare deficits and energy shortages. But for now, the sell-off seems extreme, not to say nutty. Some smart, brave people will make a fortune buying in these days, and then we’ll all wonder what the scare was about.”

The above is a splendid example of statistical analysis clothed in economic wardrobe that hardly covers substantial investigation of the entwined dynamics of credit, money, prices and capital. In short, economic reasoning has been muddled with statistical reading predicated on data mining.

Secondly, fixation on the past numbers has led to the gross underestimation of risks. This has primarily been due to the misappraisal of the proportionality of risks that basically omitted the potentials of a contagion. Again numbers (or models) hardly ever captures the dimension of human response in the face of a meltdown.

This means that like the IMF, the EU Commission and conventional analysis, shouting and obsessing over statistics or historical numbers produces incorrigible myopia or hopeless cluelessness.

Ironically instead of the sell-off being “extreme” and “nutty”, from an ex-post perspective, the above article turns out to be a comic riffraff, a paragon of contorted perception of reality, mania ‘this time is different’ blindness, and importantly, a principal reason why one should not trust mainstream economists or experts.

As post Keynesian monetarist Joan Robinson rightly pointed out “The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists.”

Chart of the Day: The Fed’s Forecasting Models are Broken

(hat tip Prof John Cochrane)

This Bloomberg article shows that the Fed Chair Ms. Yellen has also been concerned over "broken" inflation forecasting models:

Federal Reserve Chair Janet Yellen is concerned that the standard models central banks use to forecast inflation may be broken.

Behind her disquiet: the failure of the models to foresee the path of prices in the U.S. during the last recession and its aftermath and in Japan during its deflationary period from 1998 to 2012. U.S. inflation has been higher than the simulations suggested, while Japanese price declines proved more persistent.

Yellen alluded to her concerns in a speech last week, saying the Fed has to “watch carefully” to see if inflation picks up as the central bank projects -- and hopes -- during the next few years.

From broken GDP to inflation forecasts, yet whatever the monetary politburo says financial markets seem to believe them. [As a side note: This applies not only to the Fed but to other central banks as well.]

The great Austrian economist Ludwig von Mises tells us why they will keep making the same mistakes:  (bold mine)

In the equations of mechanics we can introduce constants which have been determined with reasonable exactness through empirical experimentation. In this way we can ascertain unknown quantities from given data with an accuracy sufficient for technology. In the field of human action, however, there are no such constants. The equations of mathematical economics are therefore useless for all practicai purposes

A former Central Banker's Confession: Central Bankers are making up as they go along

The analytical underpinnings of what we [mainstream economists] do are actually pretty shaky. A reflection of that fact, is that virtually every aspect you can think of with respect to monetary policy, about best practice, has changed and changed repetitively over the course of the last 50 years. So, this stuff ain’t science.

Think about what’s happened recently. One, its completely unprecedented. People are making it up as they go along. This is hardly science – building on the pillars of the past.

Secondly, what they’ve been making up as they go along actually differs across central banks [The Bundesbank, for example, is fighting the threat of high inflation, whereas the Fed is more concerned about the prospect of deflation]. They can’t even agree amongst themselves about what’s the best way to do things.

I’m becoming more and more convinced that all of the models we use are basically useless.

It’s surprising that we’ve had this huge crisis that the mainstream didn’t predict. It’s gone on for years, which the mainstream absolutely didn’t predict. I would have thought this was a basis for a fundamental rethink about what we used to think we believed. But that hasn’t happened.

The policies that we’ve followed – on the monetary side at least – since 2007 are just more of the same demand-stimulating policies that we’ve been following, I think, erroneously, for the last 30 years.

We’ve got the potential to do so much harm by not getting the creation of fiat credit and money right. We’ve got the capacity to do so much harm that we should be focusing much more on making sure that doesn’t happen.

(bold mine)

This is from William White, former central banker (Bank of England, Bank of Canada and the Bank of International Settlements) and current chairman of Economic Development and Research Committee (EDRC) at the OECD, as quoted by Tim Price at the Sovereign Man. 

Central bankers have turned the world into guinea pigs, whose costs are carried by the average non-political citizenry.

How Western Environmentalism Shaped China’s One Child Policy

Ideas have consequences. 

China’s one child policy hasn’t been a communist idea, writes author Matthew Ridley. Instead this has emanated from western environmentalist ‘Malthusian’ concept, which had been embraced by a Chinese missile scientist who repackaged and pushed these to Chinese policymakers. The result from the adaption, as usual, has been unintended consequences

A slice from Mr. Ridley:

As China’s one-child policy comes officially to an end, it is time to write the epitaph on this horrible experiment — part of the blame for which lies, surprisingly, in the West and with green, rather than red, philosophy. The policy has left China with a demographic headache: in the mid-2020s its workforce will plummet by 10 million a year, while the number of the elderly rises at a similar rate.

The difficulty and cruelty of enforcing a one-child policy was borne out by two stories last week. The Chinese film director Zhang Yimou, who directed the Beijing Olympics’ opening ceremony in 2008, has been fined more than £700,000 for having three children, while another young woman has come forward with her story (from only two years ago) of being held down and forced to have an abortion at seven months when her second pregnancy was detected by the authorities.

It has been a crime in China to remove an intra-uterine device inserted at the behest of the authorities, and a village can be punished for not reporting an illegally pregnant inhabitant.

I used to assume unthinkingly that the one-child policy was a communist idea, just another instance of Mao’s brutality. But the facts clearly show that it was a green idea, taken almost directly from Malthusiasts in the West. Despite all his cruelty to adults, Mao generally left reproduction alone, confining himself to the family planning slogan “Later, longer, fewer”. After he died, this changed and we now know how.

Susan Greenhalgh, a professor of anthropology at Harvard, has uncovered the tale. In 1978, on his first visit to the West, Song Jian, a mathematician employed in calculating the trajectories of missiles, sat down for a beer with a Dutch professor, Geert Jan Olsder, at the Seventh Triennnial World Congress of the International Federation of Automatic Control in Helsinki to discuss “control theory”. Olsder told Song about the book The Limits to Growth, published by a fashionable think-tank called the Club of Rome, which had forecast the imminent collapse of civilisation under the pressure of expanding population and shrinking resources.

Read the rest here

Quote of the Day: Economists are about as useful as a fork in a sugar bowl

If you suspected that mainstream economists are useless at the job of seeing a crisis in advance, you would be right. Dozens of studies show that economists are completely incapable of forecasting recessions. But forget forecasting. What's worse is that they fail miserably even at understanding where the economy is today. In one of the broadest studies of whether economists could predict recessions and financial crises, Prakash Loungani of the International Monetary Fund wrote very starkly, "The record of failure to predict recessions is virtually unblemished." This was true not only for official organizations like the IMF, the World Bank, or government agencies but for private forecasters as well. They're all terrible. Loungani concluded that the "inability to predict recessions is a ubiquitous feature of growth forecasts." Most economists were not even able to recognize recessions once they had already started.

In plain English, economists don't have a clue about the future.

If you think the Fed or government agencies know what is going on with the economy, you're mistaken. Government economists are about as useful as a fork in a sugar bowl. Their mistakes and failures are so spectacular you couldn't make them up if you tried…

Why do people listen to economists anymore? Scott Armstrong, an expert on forecasting at the Wharton School of the University of Pennsylvania, has developed a "seer-sucker" theory: "No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers." Even if experts fail repeatedly in their predictions, most people prefer to have seers, prophets, and gurus with titles after their names tell them something—anything at all—about the future.

This is from John Mauldin and Jonathan Tepper at the Casey Research.

Global Cooling: Artic Ice Cap Grows 60% in One Year

The Daily Mail twits at the errors of BBC’s environmental scare mongering

The highlights:  

-Almost a million more square miles of ocean covered with ice than in 2012

-BBC reported in 2007 global warming would leave Arctic ice-free in summer by 2013

-Publication of UN climate change report suggesting global warming caused by humans pushed back to later this month

From the Daily Mail

A chilly Arctic summer has left nearly a million more square miles of ocean covered with ice than at the same time last year – an increase of 60 per cent.

The rebound from 2012’s record low comes six years after the BBC reported that global warming would leave the Arctic ice-free in summer by 2013.

Instead, days before the annual autumn re-freeze is due to begin, an unbroken ice sheet more than half the size of Europe already stretches from the Canadian islands to Russia’s northern shores.

Scare mongering based on flawed models

The pause – which has now been accepted as real by every major climate research centre – is important, because the models’ predictions of ever-increasing global temperatures have made many of the world’s economies divert billions of pounds into ‘green’ measures to counter  climate change.

Those predictions now appear gravely flawed.

The religion of environmental politics is being exposed for what they truly are.

Quote of the Day: Quackroeconomics

In discussions of macroeconomic policy in Washington and in the press, these four propositions are taken as given:

(S) Spending is what drives the economy. Spending creates jobs, and jobs create spending. When unemployment is high, the problem is too little spending.

(M) Monetary policy must steer the economy carefully between overheating and slumping. Doing so requires high levels of skill and intellectual resources.

(F) Fiscal policy is just as important. When there is unemployment, monetary policy cannot do the job alone, because the Federal Reserve also has to keep an eye on inflation. So the Federal government must engage in deficit spending to stimulate the economy.

(C) Computer models are essential tools that enable economists to forecast the economy and assess the impact of alternative economic policies. Using computer models, the Congressional Budget Office is able to score the number of jobs a particular policy will add to or subtract from the economy.

These four propositions are what I term quack macroeconomics, or quackroeconomics for short. Like quack medicine, quackroeconomics is unproven, unreliable, inconsistent with the views of leading researchers in the field, and possibly dangerous.

This is from economic blogger and author Arnold Kling at his blog. 

I would add to quackroeconomics the mistake of rigidly interpreting statistical (historical-empirical) data as economic analysis.

10 things economists won’t tell you (why you shouldn’t listen to them)

The above can be restated as “10 reasons why you shouldn’t trust economists”

From Marketwatch.com (hat tip Professor Mark Thornton)

1. “We can’t predict the next crisis...”
2. “...but we may help cause it.”
3. “We’re not above a little guesswork.”
4. “Those bold predictions? Blame the testosterone.”
5. “Our measures of prosperity don’t work.”
6. “Ours is a dismal science, but not an exact one.”
7. “We lean to the left.”
8. “We might have an agenda.”
9. “We may as well be speaking Klingon.”
10. “We sell you what you already know.”

Read the explanations here

How Financial Experts Bamboozle the Public

Money pros had been taken to the woodshed according to the Global Association of Risk Professionals. (hat tip EPJ) [bold mine]

Americans would like an apology from Wall Street for the financial crisis.

They probably aren't going to get it.

But how about giving the number crunchers and investment managers a "time out" to reflect a little on the era of financial alchemy and greed that did so much damage?

That's what was happening in Chicago this week, where about 2,000 of the financial industry's quantitative minds and investment professionals gathered for their annual CFA Institute conference. They got some verbal punishment from some of the industry's stalwarts, who were admonishing their chartered financial analyst peers to think rather than allow mindless financial models and dreams of success to drive them to endorse the kinds of aggressive investment decisions that can create riches for themselves -- and destroy wealth for others.

"If you are attracted to a job in finance because the pay is so generous, don't do it," said Charles Ellis, one of the elder statesmen of the profession. "That's a form of prostitution."

Rather, Ellis said, his profession needs to return to the days he knew in the 1960s, when the emphasis was on counseling investment clients and not on churning out esoteric products and pushing people to buy them blindly.

Today the emphasis too often is on "complexity rather than common sense," said James Montier, asset allocation strategist for investment manager GMO. "In finance, we love to complicate. We rely on complexity to bamboozle and confuse."

In the local arena, such conflict of interests has hardly been about “churning out esoteric products” but about the pervasive cheerleading of politically colored quack statistics into “pushing people to buy them blindly”. "Them" here is applied to conventional financial assets.

More on the use of aggregate model based analysis:

Too many in his profession, Montier said, are trying inappropriately to apply physics to investing, where it doesn't belong, and they are ignoring inconvenient truths. Complex mathematics is valued but not necessarily used honestly, he said.

"A physicist won't believe that a feather and brick will hit the ground at the same time, and they won't use models to game the system. But that's what finance does with models," Montier said. "They take them as though they are reality."

Montier, speaking to financial professionals who design, evaluate and sell investment products to individuals and institutions, warned that all professionals in finance need to be thinking more, rather than following the herd.

"Who could have argued that CDOs were less risky than Treasurys with a straight face?" he said. But that's what happened. "Part of the brain was switched off, and people took expert advice at face value.

True. Mathematical and statistical formalism serves as the major instrument used by “experts” to hoodwink the vulnerable public on so-called economic analysis. The public is usually awed or overwhelmed by facade of numerical equations and economic or accounting terminologies.

These experts forget that economics hasn’t been about physics but about the science of incentives, purposeful behavior or human action.

As the great dean of Austrian school of economics wrote, (italics original, bold mine)

Indeed, the very concept of "variable" used so frequently in econometrics is illegitimate, for physics is able to arrive at laws only by discovering constants. The concept of "variable," only makes sense if there are some things that are not variable, but constant. Yet in human action, free will precludes any quantitative constants (including constant units of measurement). All attempts to discover such constants (such as the strict quantity theory of money or the Keynesian "consumption function") were inherently doomed to failure.

Governments love Wall Street models too

Government regulators and the Federal Reserve are guilty, too, of blindly putting their confidence in flawed models, he said. And if his profession and the regulators continue to ignore the dangers of financial concoctions involving massive leverage and illiquid assets, financial companies again will create an explosive brew that will result in calls for another government bailout.

This means because authorities has embraced economic bubble policies as a global standard, which engenders boom bust cycles, we should expect more crisis ahead. Thus the prospective “calls for another government bailout.”

To add, in reality, the government’s love affair with models has been undergirded by an unseen motivation: the expansion of political power.

Every crisis bequeaths upon the governments far broader and extensive social control over the people via bailouts, inflation, more regulations higher taxes and etc...

This legacy quote from a politician, during the last crisis, adeptly captures its essence

You never want a serious crisis to go to waste..This crisis provides the opportunity for us to do things that you could not do before.

Bottom line: many financial experts seem to in bed with politicians to promote political agendas either deliberately or heedlessly. Thus, financial expert-client relations usually embodies the principal-agent problem.

Nassim Taleb would call such mainstream experts as having "no skin in the game", thus would continue to blather about nonsense while promoting fragility.

Finally one doesn't need to be a CFA to know this. As James Montier in the above article said it only takes "common sense" which experts try to suppresss with "complexity". 

I would add to common sense; critical thinking.

Moody’s on the Philippines: No Property Bubble, Move along Nothing to see here

An official of Moody’s claims that there has been “no property bubble” in the Philippines.Moving along nothing to see here.

The Businessworld writes,

Real estate has again become a hot-button topic after banks saw their exposure to the industry breach regulatory limits in 2012. At P821.7 billion and comprising 20.9% of their total loan portfolio, the amount exceeded the BSP-mandated 20% cap.

The breach, though, was due to a new definition of "exposure." Banks were required to report not just real estate loans but also investments in debt and equity securities that finance real estate activities. These activities range from the acquisition, construction and development of properties, as well as buying and selling, rental and management.

Banks also had include loans for socialized and low-cost housing developments, which were previously exempted from the reportorial requirements.

Mr. Tremblay said the figure was no cause for alarm, noting: "The new definition of ‘exposure’ includes loans to low-cost and socialized housing and these segments tend to be less susceptible to speculation."

The BSP is mulling raising the 20% cap to accommodate the new definition as well as property market growth since 1997, when the limit was first introduced.

"Prospectively, we are not too fixated on any specific numerical cap. There is no magic number that can determine the point beyond which real estate exposure becomes a credit concern," Mr. Tremblay said.

The focus, instead, should be on factors such as demand and supply, underwriting standards, loan-to-value ratios and the leverage of households and firms. These can more accurately show whether the appreciation of prices and borrowers’ behavior is driven by fundamentals or speculation, he pointed out.

"So far, trends in these areas have remained within reasonable limits," Mr. Tremblay claimed. -

The Moody’s expert says the market should focus on demand and supply. Totally agreed.

But if domestic demand has been growing at anywhere at 6-9%, part of which has been financed by debt, and that the supply side has been growing at the rate of about 25% or more bolstered mainly by credit, then are these not signs of burgeoning imbalances? Particularly the ballooning variance between demand, on one side, and on the other, the growth of credit, as well as, the supply side, are not signs of bubbles? 

And when such exemplary growth in credit and the supply side is being clustered into popular sectors (real estate, shopping malls, casino, BPO vertical offices), these do not account for as signs of asset bubbles? 

Where then is economics in the above article which the Moody’s expert supposedly preaches?

One does not establish the presence or absence of a bubble by reading only statistics and by proclaiming immense faith on authorities for managing them. 

Statistics are historical data. They don’t tell much about the future.

While governments have been pursuing activist policies, this does not ensure the sustainability of current trends for the simple reason that their actions merely signifies as "extend and pretend" or "kick the can down the road". All such actions will have serious ramifications. Japan's much ballyhooed Abenomics has as of this writing triggered riots in the Japanese bond markets. If the riots escalate then we might soon see a debt crisis in Japan that will have a domino effect around the world. Does the Moody's see this?

It’s the same reason why mainstream economists failed to see the bubble which culminated with the Lehman bankruptcy in 2008 from which UK’s Queen Elizabeth censured them. In reality most of them were cheerleading the bubble until the bubble boomeranged on their faces.

Moody’s has also not failed to see the US bubble, but even played an important part in the lowering of credit standard by becoming stamp pads for issuers of structured securities.

Yet what Moody’s ignore, is the most critical factor: the trajectory of credit growth both from the supply and demand side, not limited to real estate but to other sectors associated with them.

Importantly what needs to be established are the incentives that will drive such trajectory.

When the Philippine government promotes zero bound rates to induce “domestic demand” and at the same time reduce SDA rates purportedly for “banks to withdraw some of their funds parked in the BSP, thereby increasing money circulating in the economy” , these policies don’t incentivize or promote debt a build-up?  

And what’s the purpose of credit rating upgrades? 

Investopedia on Credit ratings:

Credit is important since individuals and corporations with poor credit will have difficulty finding financing, and will most likely have to pay more due to the risk of default.

So upgrades extrapolates to an ease of finding credit finance. In short, it is a reward for borrowers or an inducement to borrow. So current upgrades doesn’t provide incentives to further fuel a bubble through more debt?

This is basic economic logic which seem to operate in a vacuum.

Apparently in the eyes and mind of the mainstream, "economics" is a convenient word used to disguise pseudo expertise from the truth and to pander to a politically brainwashed crowd who has been mesmerized by the four most dangerous words of investing, “this time is different”.

Yet unfortunately such mentality is in itself a sign of the manic phase of a bubble cycle in motion. 

Caveat emptor.

The Flaws of BSP’s Real Estate Monitoring and Banking Stress Tests

Rushing in defence over growing concerns of the risks of asset bubbles, the Philippine central bank, the Bangko Sentral ng Pilipinas conducted a real estate exposure test monitoring which included a partial banking stress test[1].

In the report the BSP has not explicitly issued a confirmation or a denial of the risks of a domestic bubble. But they placed into the context the following

-The Philippines’s total banking exposure on real estate was at Php 821.7 billion as of December 2012.

-The BSP continues to monitor the 20 percent cap on RELs since 1997 where current report includes “loans by developers of socialized and low-cost housing, loans to individuals, loans supported by non-risk collaterals or Home Guarantee Corporation guarantee as well as exposures by bank trust departments and thrift banks.”

-The thrust to examine the banking sector’s exposure in real estate “is in line with the BSP’s pursuit of financial stability”

-The BSP hasn’t shown any signs of worries, due to stable non-performing RELs ratio which was “reported at 3.7 percent as of end-December 2012”

-And the BSP seems confident there is enough capital to withstand any potential shocks “with capital adequacy ratio of tested U/KBs and TBs will stand at 15.77 percent despite a 50 percent simulated default on residential real estate loans.”

First of all, the BSP does not mention that Real Estate Loans (REL) at 821.7 billion pesos and with a total loan portfolio TLP (net of interbank lending) of 3,938.9 billion pesos, real estate loans as a share of TLP would now account for 20.86%.

And so if my interpretation of their data is accurate then the banking sector has essentially hit its speed limits on issuing loans to the property sector. Will the BSP put on the brake and reverse the boom? How?

Next, it isn’t clear what the BSP means by “financial stability”? If they are referring to controlling price inflation my question is—are there no opportunity costs in in implementing “financial stability” measures? Or why should moderating price inflation come at the costs of blowing asset bubbles?

Let me cite the former chief of Monetary and Economic Department at the Bank of International Settlement’s William R. White in his 2006 paper who argued against price stability policies (bold mine)[2]

…price stability is indeed desirable for a whole host of reasons. At the same time, it will also be contended that achieving near-term price stability might sometimes not be sufficient to avoid serious macroeconomic downturns in the medium term. Moreover, recognising that all deflations are not alike, the active use of monetary policy to avoid the threat of deflation could even have longer term costs that might be higher than the presumed benefits. The core of the problem is that persistently easy monetary conditions can lead to the cumulative build-up over time of significant deviations from historical norms – whether in terms of debt levels, saving ratios, asset prices or other indicators of “imbalances”.

Also Non Performing Loans (NPLs) are coincident if not lagging indicators. NPLs are low because the current boom continues. NPLs become reliable indicators, when asset quality deteriorates or when the credit boom is in the process of reversing itself into a bust. Again they are coincident if not lagging indicators.

In addition, the BSP appears to have isolated its bank stress test by limiting “simulated default on residential real estate loans”. Why? Doesn’t the BSP know that economies are complex and vastly interdependent such that economies do not operate on isolation as the BSP model presumes?

A bursting bubble will ripple through not only through the residential real estate segment but would also impact commercial property sectors (office, shopping malls, casinos etc...) or firms that are highly leveraged.

More importantly, once the real estate sector gets slammed by the entwined factors of financial losses and deleveraging, such will likewise impact all sectors that have exposure on them, and so with the banks.

And affected secondary sectors will also hit firms from different industries connected to them, and so forth.

Thus the complex latticework of commercial networks means that the feedback mechanisms from the bubble busts will have a domino effect and thus spawn a crisis.

So models will not be able to capture the contagion effects from a real-estate-stock market bust for the simple reason that models tend to mathematically oversimplify what truly is a complex reality.

The fundamental flaw with BSP’s implied defence of the risks of asset bubbles has been to interpret statistics as economics.

The above diagram represents the compounded average of 15%. A compounded average of 15% means a doubling of anything in 5 years. This applies to leveraging or economic imbalances.

Let us assume that a doubling of leveraging or imbalances will put an economy to a state of vulnerability to financial risks. It would not be helpful to say that, if we are at the T-3 stage, where statistics show only 152.09, to claim that there is no risk because of the current state. While such statement may be true, it essentially denies the imminence based on the trajectory.

In other words, the shifting of the burden of risk analysis from the rate of growth to reading today’s numbers would represent as misleading analysis and a denial.

The same logic applies to a pre-debt crisis build up as shown by history.

.

In the chronicle of about 250 crisis in 8 centuries, Harvard’s Carmen Reinhart and Kenneth Rogoff notes of the same pattern[3] (bold mine)

domestic debt is not static around default episodes. In fact, domestic debt often shows the same frenzied increases in the run-up to external default as foreign borrowing does. The pattern is illustrated in Figure 5, which depicts debt accumulation during the five years up to and including external default across all the episodes in our sample. Presumably, the comovement of domestic and foreign debt is produced by the same procyclical behavior of fiscal policy documented by previous researchers. As shown repeatedly over time, emerging market governments are prone to treating favorable shocks as permanent, fueling a spree in government spending and borrowing that ends in tears.

Again it is the trajectory that matters.

In short, it is the presence or absence of the factors that drives the incentives for these frenzied desire to accumulate debt that needs to be identified and curtailed.

Unfortunately since the genesis of such incentives have been political which have been effected through social policies, and from which the untoward impact from such polices are invisible and incomprehensible to the public, such policies will hardly be stopped until a blowback from the marketplace occurs.

And as for the state of euphoria, where governments think that they have reached a state of presumed perfection, the passing of the bank stress test in Cyprus in 2011 should serve as a fantastic example:

From the Cyprus Mail[4],

In Nicosia the Finance Ministry issued a statement saying: “The measures which the banks are taking or planning to take will further increase solvency.”

The statement also referred to a “removed possibility” of having to support the banks, stating the government was ready to “immediately take any necessary measures to maintain financial stability.”

BoC “successfully passed the test” because of its strong capital base, fluidity and satisfactory profitability, Bank of Cyprus’ Chief Executive Officer, Andreas Eliades.

Strong capital base, fluidity, increase solvency and satisfactory profitability, all turned on its head, March this year. The rest is history.

I know, the Philippines is not Cyprus. But the important lesson from the Cyprus episode is one of overconfidence that leads to complacency that further enhances systemic buildup of risks.

Remember bubbles are manifestations of the reflexive feedback loop between expectations as influenced by prices, and actions as influenced by expectations, which are enabled and facilitated by debt and incentivized by policies.

Overconfidence and complacency fosters systemic instability which is hardly “the pursuit of financial stability”

The BSP’s Wealth Transfer

These two charts embody the structural deficiencies of the Philippine political economy.

The BSP estimates that only 21.5% of households have access to the formal banking sector[5].

Yet domestic credit provided by the banking sector accounts for 51.54% of the GDP in 2011[6]. I would guess that the latter figure would be substantially higher today, given the credit boom mostly channelled through the banking sector.

Yet what these two diagrams say is that statistical economic growth has been immensely tilted towards those less than 21.5 households who have access and or have used credit from the banking system.

Not all depositors like me have used credit from the banking sector for whatever purpose. Yes I have credit cards but I which I use infrequently.

The BSP confirms this; they estimate that only 4% households have credit cards.

The lopsided exposure to the banking industry has been likewise reflected on the stock market.

As of 2011, according to Bloomberg/Matthews Asia[7] the wealthy elites control 83% of the market capitalization of the Philippine Stock Exchange

And considering the low penetration levels to the banking system and to the stock market, it would be even more conceivable that the general public hardly has any access to the more complex bond markets.

Again capital markets and the banking system have been greatly biased to the formal economy and to the oligarchs and plutocrats who control them.

Though we know that this has been an inherited problem, there has been little attempt by the powers-that-be to distribute them through liberalization ever since.

The procrastination by the PSE to hook up with the ASEAN trading link or the integration of ASEAN bourses[8] is an example. Philippine political and economic elites seem apprehensive over the prospects of losing their privileges with an ASEAN interconnection. The same applies with the lack of commodity markets where such markets would undermine the privileges of these plutocrats.

The much ballyhooed policy reforms has been more of the same. For example, government spending based on public-private partnerships, would only mean that the politically connected will be rewarded with such economic opportunities or concessions.

Yet foisting a zero bound rates in order to supposedly boost domestic demand doesn’t really help the real economy, for the simple reason that the informal economy has little direct access to the formal sector. And this will not change unless the government deregulates or liberalizes.

On the contrary credit easing policies has only boosted the wealth of the politically privileged elite.

As to quote anew the Atlantic[9]:

In 2012, Forbes Asia announced that the collective wealth of the 40 richest Filipino families grew $13 billion during the 2010-2011 year, to $47.4 billion--an increase of 37.9 percent. Filipino economist Cielito Habito calculated that the increased wealth of those families was equivalent in value to a staggering 76.5 percent of the country's overall increase in GDP at the time.

In short, BSP policies represent transfers of resources from the real economy to the political class (via bigger government spending and bigger bureaucracy) and politically connected economic elites.

Thus the manipulated boom, which has been peddled by media and bought for by the gullible public, has been used as license via populist mandate to extend on such privileges.

BSP’s Underbelly: The Philippines’ Shadow Banks

Now going back to the direction of BSP policies.

Promoting “domestic demand” through expanded access of credit has been the purported reason for zero bound rates and the lowering of interest rates of the SDAs[10].

Combine these with the recent credit rating upgrades from major international credit agencies, all these means subsidizing or rewarding debt. Thus the natural outgrowth of accelerating debt.

So the BSP’s direction has been to promote debt. But on the other hand they claim that they would regulate or control it. So the BSP essentially operates in a cognitive dissonance, holding two conflicting ideas as policies. This is a wonderful example of the idiom “the left hand doesn’t know what the right hand is doing”: a self-contradiction

Now that the real estate sector has reached its limits as noted above, the question is will the BSP act?

Even if the BSP does, I am quite sure that many market participants would resort to regulatory arbitrage to circumvent them.

They may shift the use of loans even if they are classified as non-real estate into real estate or into the stock market, such as the fateful Bangladesh stock market crash in 2011[11]. Banks may use off balance sheets. Others may resort to bribery.

Of course, given the huge domestic informal economy, the most likely avenue for regulatory arbitrage is to use the nexus between the formal and the informal economy: the shadow banking system.

The BSP believes that they have the banking sector within their palms, but the World Bank says otherwise 

Shadow banking system in Philippines and Thailand accounts for more than one-third of total financial system assets[12]. One would note in the right chart that the Philippine shadow banking system has seen an intensifying rate of growth which has polevaulted since 2009 and has nearly surpassed Thailand’s level.

Aside from common informal microfinancing[13] as 5-6 lending, “paluwagan” or pooled money, “hulugan” instalment credit, much of the growth in the shadow banking system has reportedly been in the real estate sector, particularly the in-house financing from developers[14].

The BSP claims that it would investigate[15] these even if they hardly control the formal system.

The shadow banking system has become a worldwide phenomenon and has grown to as high as $67 trillion in 2011 according to the CNBC[16] or nearly 83% of the $80 trillion world economy. The risks of the shadow banking sector doesn’t intuitively or automatically emerge out of “lack of regulation”, rather, the shadow banking industry has been largely a product of overregulation via regulatory arbitrage. Where an economic or financial system has been hobbled by politics, risks becomes centralized and thus systemic.

Bottom line: Loans to the real estate sector have significantly been more than the caps set by the BSP. Easy money policies have apparently filtered into the informal sector. This means systemic leverage has been far more than what the BSP oversees and supervises. Lastly the BSP hardly has solid control over the formal sector. The same is amplified with the informal or shadow banking system.

Like almost every central bankers today, BSP policies supposedly meant to promote “domestic demand” will be pushed to the limits, despite the rhetoric. And this will further fuel the mania phase in both the stock market and the property sector.

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[1] Bangko Sentral ng Pilipinas BSP Releases Results of Expanded Real Estate Exposure Monitoring, May 10, 2013

[2] William R. White Is price stability enough? Bank of International Settlement April 2006

[3] Carmen M. Reinhart and Kenneth S. Rogoff The Forgotten History of Domestic Debt September 21, 2010 Harvard University

[4] Cyprus Mail Cyprus banks pass EU stress test, July 16, 2011

[5] Bangko Sentral ng Pilipinas 2012 Annual Report Volume 1

[6] Tradingeconomics.com DOMESTIC CREDIT PROVIDED BY BANKING SECTOR (% OF GDP) IN PHILIPPINES

[7] Kenneth Lowe Kicking the Tires Asian Insight Matthews Asia 2013

[8] See Phisix 7,200: Up, up and away! The Illusions of Comfort May 6, 2013

[9] See The Atlantic on Philippine Economic Boom: Looks Great on Paper May 8, 2013

[10] See Phisix and the BSP: This Time is Different? March 17, 2013

[11] See Bangladesh Stock Market Crash: Evidence of Inflation Driven Markets January 11, 2011

[12] Swati Ghosh, Ines Gonzalez del Mazo, and İnci Ötker-Robe Chasing the Shadows: How Significant Is Shadow Banking in Emerging Markets? World Bank September 2012

[13] See Phisix: In The Eyes of Asia’s Bond Market, Deflation Phantom, Hedge Against Inflation June 29, 2008

[14] Businessworld Research The pros and cons of shadow banking February 8, 2013

[15] Inquirer.net BSP to probe ‘shadow banking’ allegations October 1, 2012

[16] CNBC.com 'Shadow Banking' Still Thrives, System Hits $67 Trillion November 18, 2012