Japan’s Solution To The Earthquake-Tsunami Problem: Inflate The System!

Central Bankers are almost so predictable.

For almost every social problem that crops up, the intuitive measures adapted appear to be always based on the path dependency of inflationism.

It’s no different with Japan.

From the Wall Street Journal, (bold emphasis mine)

The Bank of Japan jumped into action Monday to temper the economic blow from the earthquake, tsunami and nuclear emergency that hit northern Japan, doubling the size of its asset-purchase program and pouring a record 15 trillion yen ($183.17 billion) into money markets to ease liquidity concerns.

"What we were most concerned about was the possibility that increases in anxiety and risk-aversion moves would negatively affect the real economy, so we judged it appropriate to mainly boost purchases of risk assets," BOJ Gov. Masaaki Shirakawa said after the bank's policy board meeting, which was cut to one day from two because of the crisis.

The board boosted its purchases of riskier financial assets, such as corporate debt, exchange-traded funds and real-estate investment trusts, by a total of 3.5 trillion yen. It also will buy an additional 1.5 trillion yen of government debt.

That doubles the size of the central bank's asset-purchase facility—part of a temporary fund established on the bank's balance sheet—to 10 trillion yen. The BOJ also has a program under the fund to provide 30 trillion yen in three- and six-month loans at 0.1% interest.

To revise the popular quote of the late Senator Everett Dirksen, "A billion trillion here, a billion trillion there, and pretty soon you're talking real funny money."

The Phisix And The Boom Bust Cycle

``If it were not for the elasticity of bank credit, which has often been regarded as such a good thing, a boom in security values could not last for any length of time. In the absence of inflationary credit the funds available for lending to the public for security purchases would soon be exhausted, since even a large supply is ultimately limited. The supply of funds derived solely from current new savings and current amortization allowances is fairly inelastic, and optimism about the development of security prices would promptly lead to a "tightening" on the credit market, and the cessation of speculation "for the rise." There would thus be no chains of speculative transactions and the limited amount of credit available would pass into production without delay.”- Fritz Machlup, The Stock Market, Credit and Capital Formation

At this time of the year, many institutions and experts will be issuing their projections. Some, like me[1], have already done so late last year.

Most of the forecasts will be positive as they will likely be anchored on the most recent past performance. And I would belong to this camp but for different reasons.

The Phisix Boom Bust Cycle At A Glance

While the mainstream interpret and analyse events mostly from the lens of economic performance, technical (chart) and corporate financial valuations, as many of you already know, I look at markets based boom bust (business) cycles as a consequence of incumbent government policies (see figure 1).

Figure 1: Stages of the Bubble and Phisix Bubble Cycle of 1980-2003

As one would note, the Phisix played out a full bubble cycle over a 23 year period in 1980-2003 (right window). The cycle also shows that in the interregnum, there had been mini-boom bust cycles (1987 and 1989).

A formative bubble cycle appears in the works since 2003, with the 2007-2008 bear market representing a similar mini countercycle similar to the previous period.

The lessons of the previous bubble cycle impart to me the confidence to predict that the Phisix will likely reach 10,000 or even more before the cycle reverses.

Although one can never precisely foretell when or how these stages would evolve, as past performance may not repeat exactly (yes but it may rhyme as Mark Twain would have it), the important point is to be cognizant of the whereabouts of the current phase of the bubble cycle.

And evidence seems to point out that we are in the awareness phase of the bubble cycle as demonstrated by the swelling interest for Philippine assets. The latest success of the $1.25 billion PESO 25-year bond offering[2] and the upgrade of the nation’s credit rating by Moody’s[3] serve as good indications.

In addition, local authorities audaciously and ingeniously tested the global market’s risk appetite for the first time ever with a substantial placement at a long tenor that passed with flying colours. With 160 investor subscriptions mostly from the US and Europe, the Peso bond offering further illustrates the mechanics of cross currency arbitrages or carry trades arising from monetary policy divergences.

Of course for the mainstream, this will be read and construed as signs of confidence. For me, these events highlight the yield chasing phenomenon in response to present policies.

Figure 2: McKinsey.com[4] Global Financial Assets

And considering that the global financial markets have immensely eclipsed economic output as measured by GDP (see figure 2), the yield chasing dynamic will likely be magnified, largely driven by the disparities in money policies and economic performance. Another apt phrase for this would be ‘rampant speculation’.

To reiterate for emphasis, anent the Phisix, we don’t exactly know if there would be another countercyclical phase or if the present bubble cycle will persist unobstructed until it reaches its zenith.

In addition, we can’t identify how the rate of acceleration of the cycle will unfold nor can we ascertain the exact timeframe for each of the stages in succession.

Instead we can measure the bubble cycle by empirical evidences such as conditions of systemic credit, rate of asset or consumer price inflation and mass sentiment.

The Growing Influence Of Negative Real Interest Rates

With interest rates artificially suppressed, which fundamentally distorts the price signals that account for the time preference of the public over money and the economic balance of the credit market, policy influenced interest rates and the interest rate markets that revolve around them will lag the rate of inflation.

In short, real interest rate will be negative for an extended period.

In the milieu where government here and abroad have been working to stimulate ‘aggregate demand’ via the interest rate channel and for developed economies who employ unconventional monetary operations in support of the banking sector and the burgeoning fiscal deficits, the impact on consumer price inflation will likely go beyond the targets of their respective authorities.

As an aside, some governments in the Europe, such as Hungary, Bulgaria, Poland, Ireland and France have begun to “seize” private pensions[5], but applied in diverse degrees, all of which have been aimed at funding unsustainable deficits accrued from welfare programs and the cost of bailouts.

This only serves as evidence that governments are getting to be more desperate and would unflinchingly resort to unorthodox means to keep the status quo.

Figure 3: Global Negative Real Interest Rates[6] and Record Food Prices (courtesy of US Global Funds and Bloomberg)

Real interest rates were at the negative zone for several countries (see figure 3 left window) even as 2010 had largely been benign.

But with the most recent explosion of food prices[7] to record levels on a global scale as measured by the Food and Agriculture Organization Index (FAO- right window), aside from surging energy prices, we should expect consumer price inflation rates to ramp up meaningfully.

Meanwhile, Federal Reserve Chairman Ben Bernanke imputes high oil prices to “strong demand from emerging markets”[8]. This would represent as a half truth as Mr. Bernanke eludes discussing the possibility of the negative ramifications from his policies.

In the Philippines, such broad based price increases in many politically sensitive products or commodities have even triggered alarmism of the local media. Similar to Fed chair Ben Bernanke, local authorities and the media seem to have conspired to sidetrack on the scrutiny of the real origins[9] of such price hikes.

Nonetheless, most governments will, as shown above, try to contain interest rates from advancing, as this would increase the cost of financing of many of their liabilities. But this will only signify a vain effort on their part as politics will never overcome the laws of scarcity.

For the public, the growing recognition of widening negative real interest rates will further spur the dynamics of reservation demand—call it speculation, hoarding or punting, or in the terminology of the Austrian economists the “crack-up boom” or the flight to commodities as the purchasing value of money erodes.

And that those who expect fixed income to deliver positive returns while underestimating on the impact of changes in the rate of inflation will suffer from underperformance.

Yet the same dynamics are likely to incite further “risk taking” episodes (note again: reservation demand and not consumption demand), one of the fundamental source of boom bust or bubble cycles.

As a caveat, I am not an astrologer-seer who will predict day-to-day movements, rather in taking the role of an entrepreneur we should see or parse the business or bubble cycle as an active process that is subject to falsification.

This also means market actions won’t be moving in a linear path.

Figure 4: Markets Drive Policies (source: Danske Bank and economagic.com)

And as earlier stated, policy interest rates trail inflation.

And where market based rates partly reflect on prevailing inflation conditions, one would observe that market rates almost always lead policy rates (see figure 4 right window). Despite the Fed’s QE program aimed at keeping interest rates low, markets have started pricing US treasuries higher. In other words, policy interest rates react to market developments than the other way around.

In a parallel context, the interest rate markets seem to also price aggressively[10] Fed fund rate futures (left window) contradicting the promulgated policy by the US Federal Reserve.

Bottom line: the surging consumer inflation signifies as unforeseen consequences to the current polices.

The Continuing Policy of Bailouts

Of course higher interest rates, at a certain level, will ultimately be detrimental to local or national economies, particularly to those in the hock.

But the risk of a high interest rate environment will depend on the leverage of policymaking. Debt in itself will not be the main source of the risk, prospective policy actions will.

Many government institutions (or even politicians) are aware of the risks of overstretched debt levels.

In the US, the Federal Reserve has its 220 PhDs and many more allied economists in the academia or in financial institutions[11] to apprise of the debt-economic conditions and the available policy options and their possible implications. The problem is that they are math model based and hardly representative of actual state of human affairs.

Besides, most of them are predicated on Keynesian paradigms whose fundamental premises are in itself structurally questionable. Thus, market and economic risks come with the methodology guiding the policy actions that are meant to address present concerns.

For instance, should the problem of debt be resolved by taking on more debt?

Applied to US states whom are in dire financial morass, will the US, through the US Federal Reserve, bail them out?

Ben Bernanke pressed by the Senate recently said no[12], but his statements can’t be relied upon as proverbially carved in the stone. That’s because this would largely depend on the degree of exposure of the banking system’s ownership of paper claims of distressed States on its balance sheets. A ‘no’ today can be a ‘yes’ tomorrow if market volatility worsens and if credit market conditions deteriorates based on the financial conditions of the banking system.

Early last year, Ben Bernanke spoke about ‘exit strategies’[13] when at the end of the year exit strategies transmogrified into QE 2.0 and where talk of QE 3.0[14] has even been floated. Talk about flimflams.

In short, since the banking system is considered as the most strategic economic sector by the present political authorities, enough for them to expose tens of trillions worth of taxpayer money[15], then the path dependence by the Fed would be to intuitively bailout sectors that could weigh on their survival.

The fact that the US has had an indirect hand in the bailout of Europe[16], via the IMF and through the activation of the Fed swap lines hammers the point of Bernanke’s preferred route.

And of course, we shouldn’t be surprised if the Fed collaborated anew with European governments to any new bailout schemes in case of any further escalation in the financial woes of European banks and or governments.

So the US has been in a bailout spree: the US banking system, the Federal government, Europe and the rest of the world (through Fed swaps and through the transmission mechanism of low interest rates), so why stop at US states?

Hence given the policy preference, we should expect a policy of bailouts as likely to continue and should hallmark a Bernanke-led Federal Reserve.

And the policy of bailouts is likely to also continue in developed economies affected by the last crisis.

All these cheap money will have an impact on the relative prices of assets and commodities worldwide.

Thus, we see these internal and external forces affecting the Philippine assets--equities, real estate and corporate bonds.

What Would Stop Bailouts?

The preference for bailout option would only be stymied by natural (market) forces—higher interest rates from heightened inflation expectations (through broad based price signals-we seem to be seeing deepening signs of this)—which reduces the policy tools leverage available to the authorities, the resurrection of bond vigilantes as seen in the deterioration of the credit quality of sovereign papers, or a Ron Paul.

Of course the Ron Paul option, I would see as most unlikely given that a one man maverick is up against very well entrenched institutionalized vested interest groups which have been intensely associated with the government.

As Murray N. Rothbard exposited[17], (bold highlights mine)

But bankers are inherently inclined toward statism. Commercial bankers, engaged as they are in unsound fractional reserve credit, are, in the free market, always teetering on the edge of bankruptcy. Hence they are always reaching for government aid and bailout. Investment bankers do much of their business underwriting government bonds, in the United States and abroad. Therefore, they have a vested interest in promoting deficits and in forcing taxpayers to redeem government debt. Both sets of bankers, then, tend to be tied in with government policy, and try to influence and control government actions in domestic and foreign affairs.

This leaves us with inflation and credit quality which I think are tightly linked underpinned by a feedback mechanism.

A bubble bust elsewhere in the world from high interest rates would drain capital, but if inflation remains high this will reduce authorities leverage to conduct further bailouts. Think the stagflation days of 1970s (the difference is the degree of overindebtedness today and in the 70s).

In addition, high interest rates at a certain point will puncture global governments liquidity bubble which will expose nations propped up by the liquidity mask to deteriorating credit quality.

And at this point, crisis affected governments, including the US, are likely to choose between the diametrically opposed extreme options of continuing to inflate that may lead to hyperinflation or to declare a debt default (Mises Moment).

As a side note, under such scenario, people who argue that the US dollar’s premier status as international reserve won’t be jeopardized would be proven wrong, if, for instance, the policy route would be to inflate.

The health of any currency greatly depends on society’s perception of the store of value function. Once the public recognizes that debasement of the currency has been a deliberate policy and likely a process that would persist overtime, the perception of the store of value function corrodes significantly. And the public will likely look for an alternative.

In finding little option among the available choices, society may choose to revert to a commodity linked currency as default currency, as it always has.

Albeit the worst alternative would be that debasement of the currency or inflationism will lead to totalitarianism.

As Friedrich von Hayek warned[18],

At present the prospects are really only a choice between two alternatives: either continuing an accelerating open inflation, which is, as you all know, absolutely destructive of an economic system or a market order; but I think much more likely is an even worse alternative: government will not cease inflating, but will, as it has been doing, try to suppress the open effects of this inflation; it will be driven by continual inflation into price controls, into increasing direction of the whole economic system. It is therefore now not merely a question of giving us better money, under which the market system will function infinitely better than it has ever done before, but of warding off the gradual decline into a totalitarian, planned system, which will, at least in this country, not come because anybody wants to introduce it, but will come step by step in an effort to suppress the effects of the inflation which is going on.

So the policy tethers will depend on the conditions of several factors such as the rate of commodity and consumer price inflation, real and nominal interest rates, falling bond prices or rising yields, currency volatility and administrative policies choices of protectionism or globalization/economic freedom and capital and price controls vis-a-vis the status quo.

Profiting From Folly: The Inflationary Boom And Cyclical Banking Crisis

For now, the incipient signs of commodity inflation and rising rates have yet to diffuse into alarming levels.

Thus, I perceive that much of the applied inflationism will likely get assimilated into financial assets, thereby projecting an inflationary boom.

So going back to assembling of the pieces of the jigsaw puzzles, the Philippine bubble cycle will merely represent as one of the symptoms of the escalating woes wrought by the paper money system.

Figure 5: World Bank[19]: Surging Banking Crisis Post 1970s

The Philippine markets like other emerging markets have been the one of the main beneficiaries of the transmission mechanisms of the monetary policies of developed economies aside from the impact from the domestic low interest rate policies.

This favourite chart of mine (see figure 5) reveals of the manifold banking crisis post the Bretton Woods dollar-gold exchange convertibility standard.

While many in the mainstream blame the spate of crisis on capital account liberalization and international capital mobility, this misleads because it is the capacity to inflate (or expansion of circulation credit) rather than capital flows that causes malinvestments. Capital flows merely represent as transmission channels for inflating economies. Like in most account, the mainstream misreads effects as the cause. The repeated banking crisis suggests of a continuing cycle which implies of more crisis to come in the future, despite new regulations introduced meant to curb future crisis.

So while the mainstream will continue to blabber about economic growth, corporate valuations or chart technicals, what truly drives asset prices will be no less than the policies of inflationism here and abroad that leads to cyclical boom and bust in parts of the world including the Philippines.

And that would be the most relevant big picture to behold. Yet relevance seems not a measure of importance for most.

Nevertheless, we’ll heed Warren Buffett’s sage advice,

Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.

Get it? Our objective then is to profit from folly by playing with the cycle rather than against it.

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[1] What To Expect In 2011, December 20, 2010

[2] FinanceAsia.com Philippines and Stats ChipPac usher in new year with style, January 7, 2011

[3] Inquirer.net Moody’s upgrades PH outlook to ‘positive’, January 6, 2011

[4] McKinsey.com Mapping global capital markets: Fourth annual report, January 2008

[5] csmonitor.com European nations begin seizing private pensions, January 2, 2011

[6] US Global Investors Investor Alert, December 31, 2010

[7] Bloomberg.com World Food Prices Jump to Record on Sugar, Oilseeds, January 5, 2011

[8] WSJ Blog, Bernanke on Munis, Oil and Fed’s Mandate, January 7, 2011

[9] The Code of Silence On Philippine Inflation, January 6, 2011

[10] Danske Bank, 2011 off to a good start, Weekly Focus, January 7, 2011

[11] Grim Ryan Priceless: How The Federal Reserve Bought The Economics Profession, Huffington Post, September 7, 2009

[12] Reuters.com Bernanke balks at bailout for states, January 7, 2011

[13] Testimony of Chairman Ben S. Bernanke on the Federal Reserve's exit strategy Before the Committee on Financial Services, U.S. House of Representatives, Washington, D.C. February 10, 2010

[14] QE 3.0: How Does Ben Bernanke Define Change, December 6, 2010

[15] $23.7 Trillion Worth Of Bailouts?, July 29, 2010

[16] Reuters.com U.S. plays 2 roles in European bailout plan, May 11, 2010

[17] Rothbard, Murray N. Wall Street, Banks, and American Foreign Policy, 2005 lewrockwell.com

[18] Hayek, F. A. A Free-Market Monetary System, p. 23

[19] World Bank Data Statistics Worldview 2009 p.9

Why EURO Skeptics Are Wrong

The big culprit in all of this is short-term debt. There would be no crises if governments had issued long-term debt to match long-term plans to repay that debt. If investors become gloomy about long-term debt, bond prices go down temporarily—but that's it. A crisis happens when there is bad news and governments need to borrow new money to pay off old debts. Only in this way do guesses about a government's solvency many years in the future translate to a crisis today. There are two lessons from this insight. First, given that the Europeans will not let governments default, they must insist on long-term financing of government debt. Debt and deficit limits will not be enough. Second, the way to handle a refinancing crisis is with a big forced swap of maturing short-term debt for long-term debt. This is what "default" or "restructuring" really means, and it is not the end of the world.- Professor John Cochrane 'Contagion' and Other Euro Myths

Since political developments have weighed heavily on the marketplace, it would a mistake to isolate politics or interpret the marketplace outside of the political dimensions. That’s because governments, which are socio-political institutions, are made up of human beings. And as human beings, their actions are driven by incentives and purposeful behaviour premised on their respective operating environments.

Additionally, as regulating bodies or agencies, they likewise interact with participants of the marketplace. Thus, any useful analysis must incorporate the role of the political economy.

Current Government Actions Validate Our Call

I am glad to say that it’s not only in the markets where our outlook appears to get substantial validation but likewise in our predictions of the political economy.

We have repeatedly argued that faced with a crisis, the predisposition or mechanical response or path dependency of today’s global political leaders is to inflate the system (or throw money at the problem). And these actions are primarily channelled through central banks.

As we declared last week[1],

And like the US dollar, the Euro will be used as an instrument to achieve political goals but coursed through the central bank (ECB).

Here are some recent evidences which corroborates on our call.

Central banks appear to surreptitiously encroach on the fiscal aspects of democratic governments in developed economies.

From Bloomberg[2], (bold highlights mine)

``European Central Bank officials tried to force Ireland to seek a bailout earlier this month and European officials are now trying to do the same to Portugal, Irish Justice Minister Dermot Ahern said.

“Clearly there were people from outside this country who were trying to bounce us in as a sovereign state, into making an application, throwing in the towel before we had even considered it as a government,” he told Irish state broadcaster RTE in an interview today. “And if you notice, they are doing the same with Portugal now.”

``Asked about who was pressuring Ireland, he said “quite obviously people from within the ECB.”

Markets do not only make opinion, importantly they affect policymaking.

Yet in a world where the morbid fear of deflation has been instilled by mainstream economics, governments would use to the hilt its inflationary magic wand.

Another news report from Bloomberg[3], (bold emphasis mine)

``The European Central Bank delayed its withdrawal of emergency liquidity measures and bought more government bonds as President Jean-Claude Trichet pledged to fight “acute” financial market tensions.

``Under pressure from investors to lead the charge against the spreading sovereign debt crisis, Trichet said the ECB will keep offering banks as much cash as they want through the first quarter over periods of up to three months at a fixed interest rate. As he spoke, ECB staff embarked upon a new wave of purchases, triggering a surge in Irish and Portuguese bonds.”

And bailouts of the privileged political class will never end until forced by the markets.

From Bloomberg[4],

``Belgian Finance Minister Didier Reynders said the euro region could increase the size of its 750 billion-euro ($1 trillion) bailout fund, breaking ranks with German Chancellor Angela Merkel and France’s Nicolas Sarkozy.

``Reynders told reporters in Brussels yesterday that the current cash pool could be increased if governments decide to create a larger fund as part of a permanent crisis mechanism in 2013. “If we decide this in the next weeks or months, why not apply it immediately to the current facility?”

``European officials are under pressure to find new ways to stop contagion spreading from Greece and Ireland amid concern the bailout package may not be large enough to rescue Spain if needed. While Sarkozy and Merkel rejected expanding the fund on Nov. 25, European Central Bank President Jean-Claude Trichet on Dec. 3 indicated governments should consider just such a move.”

A popular analyst misleadingly labelled the Euro a political currency[5] in the assumption that US dollar epitomizes as more of an “economic currency”.

Yet in contrast to such false claim, the recent disclosure by the US Federal Reserve on recipients of bailout money during the 2008 crisis suggests otherwise.

According to the Wall Street Journal Editorial[6],

``We learn, for example, that the cream of Wall Street received even more multibillion-dollar assistance than previously advertised by either the banks or the Fed. Goldman Sachs used the Primary Dealer Credit Facility 85 times to the tune of nearly $600 billion. Even in Washington, that's still a lot of money. Morgan Stanley used the same overnight lending program 212 times from March 2008 to March 2009. This news makes it impossible to argue that either bank would have survived the storm without the Fed's cash.

``The same goes for General Electric, which from late October to late November 2008 tapped the Fed's Commercial Paper Funding Facility 12 times for more than $15 billion. Thanks to the FDIC's debt-guarantee program, GE also sold $60 billion of government-guaranteed debt (with a balance left of $55 billion). The company finished a close second to Citigroup as the heaviest user of that program from November 2008 to July 2009. GE is lucky it was too big to fail, or it might have failed as smaller business lender CIT did.

``The blogosphere was hurling pitchforks yesterday because some foreign banks also took the Fed's money, including such prominent names as UBS, Barclays and BNP Paribas, and even names like Dexia and Natixis that most Americans might confuse with pharmaceuticals marketed on TV. But this was inevitable given the interconnectedness of the global financial system, and the fact that these foreign banks had U.S. subsidiaries. The Fed could not have quelled the panic by offering only U.S. banks access to these loan facilities.”

As seen above, the Fed bailouts were extended heavily to the banking system in the US and abroad, which shows of the immense reach of the political redistribution process, apparently designed to save the system or the status quo.

In effect, the US Federal Reserve can be said to have been transformed as lender of the last resort of the world[7].

Let me further clarify that instead of the whole banking system, the bailouts had been concentrated to the politically connected elite or the “too big to fail” banking behemoths.

This means the US dollar is even more representative of a political currency than the Euro (As a caveat all paper money are political in nature)

Bailouts Equals Crony Capitalism

For Euro bears, it is also a fatal mistake to imply of the political correctness of bailouts when done or executed geographically or within borders. To argue that Germans are unlikely to agree to a bailout of Greece or that Texans are unlikely to agree to a bailout of the Illinois seems like a strawman.

Bailouts, as shown above, hardly represent geographical boundaries. For instance in the case of the Euro, none EU members such as Sweden, United Kingdom and Denmark have even participated in the recent Irish bailout[8] while Norway[9] have offered to join the non-EU consortium. In other words, taxpayers of these non-EU nations have been exposed to credit risks.

Instead, bailouts function as a redistributive process in support of a politically favoured class regardless of territorial boundaries.

Bailouts, in principle, equates to crony capitalism. As Cato’s Gerald P. O'Driscoll Jr. explains[10]

(bold emphasis mine)

Distorted prices and interest rates no longer serve as accurate indicators of the relative importance of goods. Crony capitalism ensures the special access of protected firms and industries to capital. Businesses that stumble in the process of doing what is politically favored are bailed out. That leads to moral hazard and more bailouts in the future. And those losing money may be enabled to hide it by accounting chicanery.

In short, bailouts signify a form of protectionism that only benefits the politically connected or the “insiders” at the expense of the public.

The act itself is condemnable, where boundaries do not mitigate its iniquities.

And apparently, as the Irish bailout and the Fed bailout of 2008 demonstrate, the global banking class has been the privileged insider.

The Endowment Effect And The Euro’s Regional Political Imperatives

Moreover, Euro bears seem to be afflicted by a cognitive bias known as the endowment effect. Such bias, according to wikipeida.org[11], is “where people place a higher value on objects they own than objects that they do not”.

Figure 6: Euro Zone Members as U.S. States[12] (Wall Street Journal Blog)

In other words, Euro bears could possibly be underestimating the deficiencies of the US dollar, while on the other hand, overestimating on the omissions of the Euro simply because many of these Euro bears are domiciled in the US.

Another way to vet such behaviour is to see such bias in the light of nationalism.

Yet in measuring the relative scale of problems (as shown in Figure 6), one would note that the problematic states of the US today[13], according to their pecking order: Illinois, California, New York and New Jersey, which ranks in terms of US GDP[14] 5^th, 1^st, 3^rd, and 8^th respectively, would dwarf the PIIGS of the Eurozone.

Seen in a different light, when ranked according to world GDP[15], Illinois is 21^st, California 8^th, New York 15^th and New Jersey 25^th compared to Portugal (58^th), Ireland (47^th), Italy (7^th), Greece (40^th) and Spain (8^th).

Figure 7: US Troubled States: Calm Before The Storm? (chart from Bespoke Invest[16])

Fortunately, the focus of credit quality concerns has yet shifted to the PIIGS rather than to these problematic states. Otherwise, whatever disintegration blarney that has been bruited by the Euro bears should also apply to the US.

Lastly, Euro bears seem to forget that the Euro or the EU was NOT forged overnight. The Euro was founded on the premise of the avoidance to indulge in repeated wars which has tormented her for last centuries as earlier discussed[17]. Thus, a free trading zone operating under a hybrid[18] of supranationalism and intergovernmentalism, was established to reduce tensions from nationalistic tendencies.

While we don’t see the Euro as an ideal currency, as she falls into the same “power inducing” trap that intrinsically haunts paper based currencies, the Euro ultimately will share the same fate of their forbears as with the US dollar.

However, at present the Euro has been less inflationary than the US, which serves as the main bullish argument for the Euro.

Moreover, these regional politics imperatives postulate that domestic politics will be subordinated, as reflected even by the actions of the non-EU members in facilitating for the Irish bailout.

Bottom line: Aggregate demand, deflation (whatever this means, that’s because for Euro bears deflation has many definitions which makes the term amorphous) and the inability to devalue a currency don’t make a strong case for the disintegration of EU.

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[1] See Ireland’s Bailout Will Be Financed By Monetary Inflation, November 28, 2010

[2] Bloomberg.com ECB Tried to Force Ireland Into Bailout, Minister Says, November 30, 2010

[3] Bloomberg.com ECB Delays Exit, Buys Bonds to Fight ‘Acute’ Tensions, December 2, 2010

[4] Bloomberg.com, Reynders Says Bailout Fund May Be Boosted in Break With Merkel, December 5, 2010

[5] See Paper Money Is Political Money, December 4, 2010

[6] Wall Street Journal Editorial, The Fed's Bailout Files, December 2, 2010

[7] Bloomberg.com Fed May Be ‘Central Bank of the World’ After UBS, Barclays Aid, December 2, 2010

[8] Guardian.co.uk, Ireland bailout: full Irish government statement, November 28, 2010

[9] Reuters.com Oil-rich Norway may lend direct to Ireland, November 29, 2010

[10] O'Driscoll Gerald P. Jr. An Economy of Liars, Cato Institute, April 20, 2010

[11] Wikipedia.org Endowment effect

[12] Wall Street Journal Blog, Euro Zone Members as U.S. States, December 1, 2010

[13] See Global Debt Concerns Overwhelmed by Liquidity, October 15, 2010

[14] Wikepedia.org List of U.S. states by GDP

[15] Wikepedia.org Comparison between U.S. states and countries nominal GDP

[16] Bespoke Invest, State Default Risk Levels, December 2, 2010

[17] See Inflationism And The Bailout Of Greece, May 02, 2010

[18] Wikipedia.org European Union

QE 2.0: It’s All About The US Banking System

``But the administration does not want to stop inflation. It does not want to endanger its popularity with the voters by collecting, through taxation, all it wants to spend. It prefers to mislead the people by resorting to the seemingly non-onerous method of increasing the supply of money and credit. Yet, whatever system of financing may be adopted, whether taxation, borrowing, or inflation, the full incidence of the government's expenditures must fall upon the public.” Ludwig von Mises

It’s time for a little gloating.

Last week we noted how global financial markets would likely respond to two major events that just took place in the US this week.

Globalization Versus Inflationism

We noted that while the outcome of the US elections would matter, it would be subordinate to the US Federal Reserve’s formal announcement of the second phase of the Quantitative Easing or QE 2.0.

Nevertheless we mentioned that in terms of the US Midterm Elections, still the odds greatly favoured a rebalancing of power from a lopsided stranglehold by left leaning Democrats towards the conservative-libertarian right that could result to what mainstream calls as “political gridlock”.

Such stalemate would thereby reduce the chances of government interventionism, which should have positive implications for both the markets and the US economy[1].

Figure 1: The Drubbing Of Keynesian Policies (USA Today[2])

Of course, what the surveys earlier conveyed had been merely translated into actual votes-Americans largely repudiated the highhanded Keynesian spend and tax policies adapted by the Obama administration. This also signifies as a decisive defeat for President Obama’s illusory “Change we can believe in”.

Except for the Senate which had only 37 seats, out of the 100, contested, Republicans swept the House (239-188) and the Governorship position (29-18). Yet, even in the Senate, the chasm in the balance of power held by the Democrats had been significantly narrowed (from 57-41 to 51-46).

To rub salt into the wound, even President Obama’s former seat at Illinois was won by a GOP candidate[3], Mark Kirk.

The burgeoning revolt against interventionist Keynesian policies has likewise been an ongoing development in Europe[4].

And as we have repeatedly been pointing out, two major forces have been in a collision course: technology buttressed globalization (represented by dispersion of knowledge and the deepening specialization expressed through free trade) and inflationism (concentration of political power).

The rising tide against Keynesianism, which translates to a backlash from these two grinding forces, can be equally construed as a manifestation of an evolving institutional crisis or strains from traditional socio-political structures adjusting to a new reality.

As Alvin and Heidi Toffler presciently wrote[5],

``Bureaucracy, clogged courts, legislative myopia, regulatory gridlock and pathological incrementalism cannot but take their toll. Something, it would appear will have to give...

``All across the board –at the level of families firms industries national economies and the global system itself—we are now making the most sweeping transformation ever in the links between wealth creation and the deep fundamental of time itself. (italics mine)

For now, the forces of globalization appear to be the more influential trend.

Validated Anew: QE 2.0 Is About Asset Price Support

However, as we also noted, Keynesianism hasn’t entirely been vanquished[6]. They remain deeply embedded in most of the political institutions represented as unelected officials in the bureaucratic world. Importantly, they are personified as stewards of our monetary system.

Here is what I wrote last week[7],

``The QE 2.0, in my analysis, is NOT about ‘bolstering employment or exports’, via a weak dollar or the currency valve, from which mainstream insights have been built upon, but about inflating the balance sheets of the US banking system whose survival greatly depends on levitated asset prices.

Straight from the horse’s mouth, in a recent Op-Ed column[8] Federal Reserve Chair Bernanke justifies the Fed’s QE 2.0,

``This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion. (bold highlights mine)

Once again I have been validated.

The path dependency of Ben Bernanke’s policies has NOT been different[9] from his perspective as a professor at Princeton University in 2000 when he wrote along the same theme.

``There’s no denying that a collapse in stock prices today would pose serious macroeconomic challenges for the United States. Consumer spending would slow, and the U.S. economy would become less of a magnet for foreign investors. Economic growth, which in any case has recently been at unsustainable levels, would decline somewhat. History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse. (bold emphasis mine)

Figure 2: stockcharts.com: Global Equity Markets Explode!

The net effect of QE 2.0 has been almost surreal.

Global equity markets (DJW), as expected, skyrocketed to the upside from the higher than expected $600 billion or $75 billion a month (for 8 months) of US treasury long term security purchases that the Federal Reserve will be conducting with new digital dollars. Markets reportedly estimated the QE program at $500 billion[10].

And the Federal Reserve made sure in their announcement that $600 billion will not be a limiting condition. The FOMC said that they “will adjust the program as needed to best foster maximum employment and price stability”[11].

It’s simply amazing how the Fed’s QE 2.0 transmission mechanism has been worldwide. Whether in Asia (P1DOW-Dow Jones Asia), Europe (E1DOW-Dow Jones Europe) or Emerging markets (EEM-iShares MSCI Emerging Markets Index), the story has all been the same—markets breaking out to the upside.

I’d like to add that such bubble blowing policies has NOT been limited to the Federal Reserve.

Immediately after the Fed’s announcement, the Bank of Japan voted unanimously to support the domestic stock market by engaging on their own version of QE that would include “exchange-trade funds linked to the Topix index and Nikkei Stock Average, and Japanese real-estate investment trusts rated at least AA, the bank said. It said it would begin buying Japanese government bonds under its new program next week.[12]” (bold emphasis mine)

Add to these the inflation of global central banks international reserve position to the tune of $ 1.5 trillion over the past 12 months[13].

Hence the consequences of massive inflationism are likely to be fully felt yet in the markets.

The False Premise: Aggregate Demand Story

The substantiation of our analysis isn’t limited to Bernanke’s statements alone. Markets have likewise bidded up the major beneficiaries of the QE 2.0 program—the banks and the financial industry (see figure 3).

Figure 3: Financial Industry: From Laggards to Leaders (charts from US global Investors and stockcharts.com)

The mainstream wisdom goes this way: Money printing does not create inflation. With low inflation, printing money is, therefore, needed to generate demand that would spur inflation. This form of circular reasoning[14], which characterizes Keynesian economics, is what is sold to public as rationalization for the current policy. The mainstream sees it as an aggregate demand problem that can only be addressed by money printing.

The mainstream fails to see that there is NO such thing as a free lunch or that prosperity cannot be conjured or summoned by the magic wand of the printing presses.

All these so-called technocratic experts refuse to learn from history or deliberately distort its lessons, where debasing money has always been meant to accommodate for the political goals or interests of the ruling class.

Yet monetary inflation eventually crumbles to nature’s laws of scarcity for the simple reason that it is unsustainable. Printing of money does NOT equate anywhere to the same degree as producing goods and services. Printing of money can be limitless, while production of goods and services are limited to the available scarce resources.

Unknown to many, printing of money is subject to the law of diminishing returns (getting less for every extra output or a law affirming that to continue after a certain level of performance has been reached will result in a decline in effectiveness[15]) and law of diminishing marginal utility (general decrease in the utility of a product, as more units of it are consumed[16]).

And it is why repeated experiments with paper money throughout the ages of human affairs have repeatedly failed[17]. And I don’t see why the grand US dollar standard experiment today as likely to succeed either. The QE programs fundamentally reflect on the same symptoms of any degenerating or festering de facto money regime. We should expect more QE programs to happen.

Yet the aggregate demand story is basically premised on debt. To promote aggregate demand is to promote debt. Debts either incurred by the private sector or by governments in lieu of the private sector. While productive debt and consumption debt are hardly distinguished, consumption debt is promoted. Savings are disparaged as economically harmful. And the promotion of debt is the essential or critical element to fostering bubbles.

Figure 4: World Bank: Banking Crisis Since the 1970s

Hasn’t it been a wonder that since the closing of the Bretton Woods gold-dollar window in 1971, bubbles became a permanent fixture worldwide?

Yet, the public hardly can see through who the major beneficiaries from the debt based aggregate demand story. Obviously, it is the banking and the financial industry as they represent as the major funding intermediaries or financiers to both the private sector and importantly to the government.

And the banking system had been structurally incented to hold (or buy or finance) government debts into their balance sheets as they have been classified as less risky assets and thus requires less capital in accordance to the Basel Accord[18].

During the last crisis the unholy alliance of the central banking-banking industry cartel had been exposed as seen by the trillions worth of bailouts by the US Federal Reserve[19].

Yet the politicized nature of central banking (everywhere) obviously leads to cartel structured relationships, as survivability depends not on profitability based on market forces, but from the privileged conditions bestowed upon by the political strata.

And the QE 2.0, which I argued as having been unmoored from the prospects of the US or global economy, but rather aimed at safeguarding the balance sheets of the banking system has successfully boosted the prices of financial equity benchmarks, such as S&P Bank Index (BIX), the Dow Jones Mortgage Finance Index (DJUSMF), the S&P Insurance (IUX) and the Dow Jones US General Financial Index (DJUSGF), all along the lines of Bernanke’s design.

The industry that had miserably lagged[20] the recent stock market recovery in the US has in one week suddenly outclassed the rest.

Of course people who argue about the success or failure of policies frequently look at the effects depending on the time frame that support their bias.

For instance, policies that induce bubbles will benefit some participants, during its heydays. Hence, policy supporters will claim of its ‘success’ seen on a temporary basis as the bubble inflates. Yet overtime, an implosion of such bubbles would result to a net loss to the economy and to the markets. The overall picture is ignored.

And the same aspects would also apply to those arguing that the Fed’s rescue of the banking system has been worthwhile. They’re not. The benefits of a temporary reprieve from the recent crisis envisages greater risks of a monumental systemic blowup. If Fed policies had been successful, then why the need for QE 2.0?

So for biased people, the measure of success is seen from current activities than from the intertemporal tradeoffs between the short term and long term consequences of policies.

In other words, yes, the QE 2.0, which constitutes the continuing bailout of the US banking industry, seems to successfully inflate bubbles, mostly overseas. But at the end of the day, these bubbles will result to net capital consumption, if not the destruction of the concurrent monetary regime.

The next time a major bubble implodes there won’t likely be free lunch rescues as these will be limited by today’s massive debt overhang.

The Effects of QE 2.0: Promotes Poverty And A Shift To A New Monetary Order

Of course while the equity price performance of the US financial industry stole the limelight the next best performers have been the Energy and the Materials Index.

In other words, as I have long been predicting, the accelerating traction of the inflation transmission channels are presently being manifested in surging prices of commodities and commodity related equity assets aside from global equity markets.

While this should benefit equity owners and producers of commodity related enterprises, aside from the financial sector, those who claim that inflationism is justifiable and a moral policy response to the current conditions are just plain wrong. Such redistributive policies to the benefit of the banking sector come at the expense of the underprivileged.

What is hardly apparent or seen is that the current government structured inflation indices have been vastly underreporting inflation.

Yet surging agricultural and food prices would not only harm a significant percentage of financially underprivileged by reducing their money’s purchasing power but also promote poverty in the US and elsewhere.

Figure 5: Food Expenditures By Income Level

Tyler Durden of Zero Hedge quotes a JP Morgan study[21], (bold emphasis mine)

When the Fed considers the possible consequences of a falling dollar resulting from QE2, it should perhaps focus on food and energy prices as much as on traditionally computed core inflation. First, the food/energy exposures of the lower 2 income quintiles are quite high (see chart). Second, the core CPI has a massive weight to “owner’s equivalent rent”, which suggests that the imputed cost of home occupancy has gone down. Unfortunately, this is not true for families living in homes that are underwater, and cannot move to take advantage of it (unless they choose to default and bear the consequences of doing so). Due to the housing mess, there has perhaps never been a time when traditionally computed core inflation as a way of measuring changes in the cost of things means less than it does right now.

Figure 6: ADB[22] Asia’s Share of Food Expenditure to Total Expenditure

And as said above the effects are likely to hurt the underprivileged of the emerging markets more than the US.

So inflationism or QE 2.0 poses as a major risk to global poverty alleviation and prosperity, a blame that should be laid squarely on these policymakers and their supporters.

Of course as the ramifications of inflationary policies worsen, the subsequent scenario would be for political trends to shift towards holding the private sector responsible for elevated prices and for ‘greed’ in order to institute more government control and inflationism.

As the great Ludwig von Mises once wrote[23],

``They put the responsibility for the rising cost of living on business. This is a classical case of the thief crying "catch the thief." The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices. While the [the government] is busy annoying sellers as well as consumers by a flood of decrees and regulations, the only effect of which is scarcity, the Treasury [and the Fed] go on with inflation”

Here free trade will likely give way to protectionism; that is if public remains ignorant of true causes of inflation and if the world would stubbornly stick by the US dollar as preferred global medium of exchange.

Of course Asian nations were hardly receptive to the unilateral actions by the Federal Reserve. The conventional recourse in dealing with QE 2.0 has been via currency appreciation, tightening of domestic liquidity by raising bank reserves or increase policy rates or lastly ‘temporary’ capital controls. So far some countries as South Korea have threatened to impose some variation of capital controls.

Yet we should expect the world to shift out of the US dollar regime once inflationism becomes rampant enough to pose as a meaningful hurdle to national economic development and global trade. The Bloomberg quotes China’s Central Bank adviser Xia Bin[24],

``China should counter the U.S. through regional currency alliances, speeding international use of the yuan and seeking stability in exchange rates through the Group of 20, which holds a summit next week”

A currency from a political economy that engages in significantly less inflationism, has deep and developed sophisticated markets, has a convertible currency and hefty geopolitical exposure is likely to challenge the US dollar hegemony, whether this would be the yuan (which for the moment is unlikely) or the Euro, only time will tell.

Of course, we can’t discount gold’s role in possibly being integrated anew in the reform of the monetary architectural system.

Figure 7: Virtual Metals[25]: Central Bank Gold Holdings and Sales

Global Central banks appears to be rediscovering gold as possibly reclaiming its role as money in a new monetary order. A new monetary order is not question about an if, but a when.

Once as net sellers, central banks seem to be transitioning into potential net buyers.

So again, our peripheral insight seems being validated with the ongoing process of shifting expectations by authorities on the functions of gold.

As I pointed out last year[26], gold is presently seen by an ECB official as a form of economic security, risk diversification, a confidence factor and an insurance against tail risks. Once these factors become well entrenched, a store of value role would likely be the next step. And more QE’s would only serve to push gold towards such a path.

Those who obstinately relish the bias that gold is nothing but a barbaric relic will likewise suffer from taking on the wrong positions. But they eventually will succumb to the shifting expectations as with many monetary authorities today. The reflexive process of having prices influence fundamentals has clearly been taking shape.

With gold prices at $1,390 mainstream economists like celebrity Nouriel Roubini[27], who last year debated savvy investor Jim Rogers and declared “Maybe it will reach $1,100 or so but $1,500 or $2,000 is nonsense”, must be squirming on his seat for the likelihood to be proven wrong once again.

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[1] See US Midterm Elections: Rebalancing Political Power And Possible Implications To The Financial Markets, October 31, 2010

[2] USA Today, 2010 Elections: Live Results

[3] Politico.com Roland Burris will serve in November, November 5, 2010

[4] See An Overextended Phisix, Keynesians On Retreat And Interest Rate Sensitive Bubbles, October 25, 2010

[5] Toffler, Alvin and Toffler, Heidi Revolutionary Wealth Random House p.40

[6] See Trick Or Treat: The Federal Reserve’s Expected QE Announcement, October 31, 2010

[7] Ibid

[8] Bernanke, Ben What the Fed did and why: supporting the recovery and sustaining price stability, Washington Post, November 4, 2010

[9] Bernanke, Ben A Crash Course for Central Bankers, Foreign Policy.com or wikiquote Ben Bernanke

[10] Macau Daily Times Asian markets rise, dollar falls, November 5, 2011

[11] Board of Governors of the Federal Reserve System, November 3, 2010 Press Release

[12] Marketwatch.com Bank of Japan holds steady, details asset plans, November 4, 2010

[13] Noland, Doug QE2 Credit Bubble Bulletin, Prudent Bear.com

[14] See Thought Of The Day: The Keynesian Circular Thought Process, June 22, 2010

[15] Wordnetweb.princeton.edu law of diminishing returns

[16] Wiktionary.org law of diminishing marginal utility

[17] See Surging Gold Prices Reveals Strain In The US Dollar Standard-Paper Money System, November 1, 2010

[18] See The Myth Of Risk Free Government Bonds, June 9, 2010

[19] See $23.7 Trillion Worth Of Bailouts?, July 29 2010

[20] See The Possible Implications Of The Next Phase Of US Monetary Easing, October 17, 2010

[21] Durden Tyler, How Ben Bernanke Sentenced The Poorest 20% Of The Population To A Cold, Hungry Winter, Zerohedge.com November 5, 2010

[22] Asian Development Bank: Food Prices and Inflation in Developing Asia: Is Poverty Reduction Coming to an End? April 2008

[23] Mises, Ludwig von The Truth About Inflation

[24] Bloomberg.com Asians Gird for Bubble Threat, Criticize Fed Move November 4, 2010

[25] Virtualmetals.co.uk The Yellow Book September 2010

[26] See Is Gold In A Bubble? November 22, 2009

[27] See Jim Rogers Versus Nouriel Roubini On Gold, Commodities And Emerging Market Bubble, November 5, 2009