Electronic Errors Caused a Flash Crash In India’s Stock Markets

Electronic malfunction caused a flash crash in India’s stock market yesterday.

From Bloomberg,

The plunge and rebound in Indian stocks that pushed the S&P CNX Nifty (NIFTY) Index down 16 percent over eight seconds underscored concern about financial markets.

Trading in the Nifty and some companies stopped yesterday in Mumbai for 15 minutes after the 50-stock gauge tumbled as much as 16 percent. A brokerage that mishandled trades for an institutional client was to blame, according to the National Stock Exchange of India.

Regulators around the world are probing market structure and electronic trading after a series of malfunctions. In May 2010, high-frequency orders worsened the so-called flash crash, which briefly wiped $862 billion from U.S. stocks. The Nasdaq Stock Market in May this year was overwhelmed by order cancellations and trade confirmations were delayed in the public debut of Facebook Inc. (FB), 2012’s largest initial public offering.

“Everyone is very sensitive to these electronic errors,” Adam Mattessich, head of international trading at Cantor Fitzgerald LP, said by phone in New York. “It’s the kind of thing that could be nothing or it could become a financial calamity.”

Orders entered by Emkay Global Financial Services Ltd. (EMKAY) that led to trades valued at 6.5 billion rupees ($126 million) caused the drop, NSE spokeswoman Divya Malik Lahiri said from New Delhi.

Circuit breaker limits enforced by the NSE get activated “after existing orders are executed,” Ravi Varanasi, head of business development at the exchange in Mumbai, said by phone. “We are investigating the reason behind the wrong orders and how checks and balances at the member’s end failed.”

Admittedly flash crashes from electronic errors can be a source of anxiety.

Intraday performance of the NIFTY

But as the above shows, markets eventually smooth out any anomalies.

Despite the intraday flash crash, India NIFTY was down only .7% yesterday and posted 1.9% gain over the week. From the start of the year the NIFY is up 24.28% as of Friday.

All charts from Bloomberg

Bottom line: Bugs happen. Politicization of the electronic flash crash isn’t required and won’t guarantee perfection. At worst, it may work to the contrary.

Politicization of the Entertainment Industry

While I am glad to see that the quality of singing artists seems to have immensely improved from participants around the world including the Philippines, it is sad to see that a recently concluded international popular singing contest seem to have been reduced to a specter of voting for nationalism. Such social signaling has dismayingly been ventilated all over social media.

Yet logic says that if the victor of such singing contest would be determined by such a manner of selection, instead of skills, then the winner would likely hail from the country that has MORE population, all things equal. And I guess that this has been the outcome. [Updated to add: the show's title itself and contestant eligibility rules limits participants to residents of the country where the show is held]

It’s even bleaker to see how political correctness has pervaded the local entertainment industry such that holier than thou groups seek out edicts or legislation through coercive government machinery to attempt to repress on the freedom of religion and of the freedom of speech-expression of the others. Yet such senseless protests over moralism also triggered exasperating traffics.

This just shows how politics has been dumbing down the public and how politics have turned away many people’s attention from productive activities towards unproductive and even confrontational groupthink fallacies or “us against them” mindset.

What Obamacare and Rising Yields Mean

``The public will think the health-care system is what Democrats want it to be. Dissatisfaction with it will intensify because increasingly complex systems are increasingly annoying. And because Democrats promised the implausible -- prompt and noticeable improvements in the system. Forbidding insurance companies to deny coverage to persons because of preexisting conditions, thereby making the risk pool more risky, will increase the cost of premiums. Public complaints will be smothered by more subsidies. So dependency will grow.” George F. Will, A battle won, but a victory?

One of the seemingly uneventful but seismic political shifts just occurred in the US.

Last week, President Obama’s signature health reform program, the Obamacare, had finally been forced into a law through procedural manipulations, in both the House of Congress dominated by President’s Obama’s party.

With over a year in power, and with elections drawing nearer, the risks of a decline in the political power held by the Democratic Party eventually prompted a desperate power manuever. As an old saw goes, what are we in power for? Or to quote Emmanuel Rahm, White House’s Chief of Staff popular view on the last crisis, `` it's an opportunity to do things you think you could not do before.” That could have been the rallying cry of the progressives, in passing a highly unpopular law, regardless of the public’s opinion, as manifested in almost every polls.

So only after a year in office has President Obama successfully convinced several dissent partymates to shift sides, after several horse trading and compromises, from initially opposing his European style welfarism.

There could be several reasons why the market seemed to have discounted the enactment of Obamacare.

One, markets already expected the eventuality of this program considering the dominance in the political spectrum by President Obama’s Democratic Party.

Two, markets assumed that since many parts of the law will take place years from now, the adverse affects will unlikely have an impact soon. Besides, with Senate elections slated this year, there could be manifold amendments that result to a massive facelift.

Three, markets may not be the normal functioning markets as we know of. Like most US markets today, they could be under the influence of various agencies of government, just possibly in disguise.

Fourth, the initial impact of the Obamacare, ignored mostly by mass media and the experts, could possibly be the surge in yields of the US treasuries, which came a day late.

Obamacare Equals Greater Risks Of Fiscal Wreck

How can Obamacare be related to rising yields? In essence; increased government spending.

There is one thing we can be sure of; when government promises to curb deficits or produce savings with massive new redistribution program, it is likely to be unfulfilled.

In the case of the US Medicare, which was signed into a law in July 30, 1965[1], the initial estimates and actual expenditures turned out to be…you guessed it, was a mile apart. (see figure 4)

Figure 4: Cato.org: Huge Disparities in Projection and Actual Spending

Cato’s Daniel Mitchell refers to the testimony of Robert J Myers to the Joint Economic Committee as evidence, ``The federal government’s ability to predict healthcare spending leaves much to be desired. When Medicare was created in the 1960s, the long-range forecasts estimated that the program would cost about $12 billion by 1990. It ended up actually costing $110 billion that year, or nine times more than expected.[2]”

Government estimates that Obamacare’s spending will be modest, ``The CBO estimates the bill would cost $940 billion over a decade and that it would cut the deficit by $130 billion in the first 10 years and some $1.2 trillion in the second 10 years” notes the MSNBC.

However, Alan Reynolds of Cato argues otherwise, saying that government spending will vastly accelerate after the next 4 years[3], [bold emphasis mine, italics his]

``In fact, new spending is negligible for four years. At that point the government would start luring sixteen million more people into Medicaid’s leaky gravy train, and start handing out subsidies to families earning up to $88,000. Spending then jumps from $54 billion in 2014 to $216 billion in 2019. That’s just the beginning.

``To be unduly optimistic (more so than the CBO), assume that the new entitlement schemes only increased by 7% a year. At that rate spending would double every ten years — to $432 billion a year in 2029, $864 billion a year in 2039, and more than $1.72 trillion by 2049. That $1.72 trillion is a conservative projection of extra spending in one year, not ten. How could that possibly not add to future deficits?

``Could anyone really imagine that the bill’s new taxes and fines could possibly grow by 7% a year? On the contrary, most of the claimed revenues are either a timing fraud (such as treating $70 billion for long-term care premiums as newly found treasure) or self-defeating. The hypothetical tax on Cadillac plans (suspiciously postponed until 2018), for example, is designed to discourage such plans from being offered by employers or wanted by employees — that is, it’s designed to yield less and less over time.”

Figure 5: US Treasury on Government Debt Estimates and Heritage.org on welfare programs

In the Secretary of the Treasury’s ‘2009 Financial Report of the United States Government’ report which does not include the Obamacare in its estimates, it recently warned (see figure 5 left window), ``But the Government must simultaneously address the medium- and long-term fiscal imbalance resulting from past budget deficits, the impact of the economic downturn, and demands on the nation’s social programs, notably Medicare, Medicaid, and Social Security. As currently structured, the Government's fiscal path cannot be sustained indefinitely and would, over time, dramatically increase the Government's budget deficit and debt.[4]” [emphasis added]

So Obamacare is likely to shorten the reckoning period for the current unsustainable path of growing fiscal risks from a vastly expanding welfare program.

Politicization of US Healthcare

Moreover, the 2,400 page law is a quagmire of bureaucracy[5]. This means much of the America’s healthcare will be politicized and effectively rationed by the unelected officials. And the traditional symptoms from increased bureaucracy will likely adversely impact health care distribution via more red tape, cost overruns, risks of fraud, risks of corruption, shortages, delays in payment, higher taxes on the wealthy, delayed or waiting list treatment, possibly reduced payments to hospitals and physicians, diminished competition and innovation and etc.

Hence, rising taxes, added regulatory compliance and more bureaucracy is likely to lead to lesser productivity, reduced incentives for entrepreneurship and competition or an increase in the cost of doing business or higher economic cost structures.

Protectionists are likely to blame other countries for job losses anew, when redistribution programs as massive as this would likely be a major factor in reducing investments.

This, is aside from, the prospects of heightened inflation and credit risks which may have seminally manifested itself on the treasury markets, last week. Of course as explained above, the sweetspot of inflation may blur such risks for now.

As Robert Higgs aptly explains[6], ``because health-care-related economic activity is such a huge part of the overall economy, what happens in this sector will have significant consequences for the operation of other sectors. For example, when Obamacare turns out to be much more costly than the government has claimed it will be, the government’s demand for loanable funds will be greatly increased, with far-reaching effects on interest rates, investment spending, economic growth, and even the U.S. Treasury’s creditworthiness. It is not inconceivable that the burden of supporting this health-care monstrosity will prove to be the (load of) straw that breaks the back of the government camel in the credit markets, where the U.S. Treasury has long been able to borrow the greatest amounts at the lowest rates of interest because its bonds were considered virtually riskless” [bold highlights mine]

Nevertheless one of the investment opportunities from the pollicisation of American health care, which concerns us non-Americans, should be off shore or medical tourism.

The rest will just be more like today, more offshoring and outsourcing and diversification in search for cost effective ways to maximize profits.

---

[1] Medicare, Wikepidia.org

[2] Mitchell, by Daniel J Will Federal Health Legislation Cause the Deficit to Soar? [Joint Economic Committee, “Are Health Care Reform Cost Estimates Reliable?” July 31, 2009. The JEC cites 1967 testimony by Robert J. Myers.]

[3] Alan Reynolds, Cato.org, It’s NOT a Health Bill, NOT a Medicare Tax and It Can’t Possibly Cost Only $940 Billion

[4] Secretary of the Treasury, Director of the Office of Management and Budget (OMB) and and Acting Comptroller General of the United States, “2009 Financial Report of the United States Government,”

[5] Businessweek, Obamacare's Cost Scalpel

[6] Higgs, Robert The Health-Care Reform Act: Que Paso?, Independent.org

The Myths Of Government’s Managing The Economy

`The paradox of "planning" is that it cannot plan, because of the absence of economic calculation. What is called a planned economy is no economy at all. It is just a system of groping about in the dark. There is no question of a rational choice of means for the best possible attainment of the ultimate ends sought. What is called conscious planning is precisely the elimination of conscious purposive action.”- Ludwig von Mises Human Action

Overheard from a recent social gathering: “We need a president that can run the economy like a corporation!”

My impression is that the alluded corporation is one of a privately run enterprise.

Nevertheless this has been a popular myth advanced by government loving liberal experts, politicians and their media adherents which have likewise been widely espoused by the public.

We cite 5 reasons why this thinking is seriously flawed.

First, it misses the fundamental nuances in the contribution of private enterprises and government to society.

A private enterprise generates revenues by producing goods and services that consumers need or want with which they pay for. In other words, the success or the failure of a private enterprise is entirely dependent on consumers voting with their money, this is known as capitalism or an economic system that thrives on profit and loss.

On the other hand, government as an institution survives mainly by taxation. It coercively takes from the pocket of Juan and gives to Pedro and keeps a share of it to finance the bureaucracy.

Essentially the government does not produce anything but consumes the nation’s resources which are funded by such taxes.

At a certain point, after the provision of basic public goods, such as police and military services, the safeguarding property rights and enforcing the sanctity of contracts, government becomes a net consumer of capital. The rate of taxation (Laffer’s Curve) which finances such increased social consumption eventually squeezes out productivity and further exacts a toll on the nation’s resources.

So if a government does not produce, and is a drain on the resources of the economy and is net consumer of capital, how can it possibly contribute by “managing” the economy?

Second, it’s all about incentives.

A private enterprise is incentivized to generate wealth by efficiently allocating scarce resources or by economizing in order to profit.

On the other hand, the government’s incentive is to theoretically find “optimal” ways to redistribute wealth.

However, redistribution of wealth is a political issue, simply because it chooses which sectors or interests groups that would both benefit from such privilege.

Meanwhile on the opposite end, the government ascertains the interest groups and sectors that would pay for such task. In short, it plays the analogical role of God in determining who survives or not.

Say for example, because of the popularity of OFWs as our economic saviors, policymakers decide to tweak the Peso lower by printing money.

While the families of the OFWs will have additional spending power because of a lower Peso, which may also partly buttress the export sector, on the other hand the unseen costs from inflating the system is to lower the amount of goods and services (due to price increases) that could be acquired by a depreciated peso. In other words, the benefits will be temporary for a certain segment of the society but at a greater cost to the whole over the long term.

Moreover because governments are politically oriented they don’t normally operate under the economic pressures, hence the proclivity to overspend.

As the illustrious economist Milton Friedman once said, ``There are four ways in which you can spend money. You can spend your own money on yourself. When you do that, why then you really watch out what you’re doing, and you try to get the most for your money. Then you can spend your own money on somebody else. For example, I buy a birthday present for someone. Well, then I’m not so careful about the content of the present, but I’m very careful about the cost. Then, I can spend somebody else’s money on myself. And if I spend somebody else’s money on myself, then I’m sure going to have a good lunch! Finally, I can spend somebody else’s money on somebody else. And if I spend somebody else’s money on somebody else, I’m not concerned about how much it is, and I’m not concerned about what I get. And that’s government.”

Furthermore, when government decides to spend money say, for example on “stimulus” packages or the highly popular “pump priming”, not only does it spends on things that the market does not see viable or necessary, it risks spending on inefficient projects which again consumes capital.

Also such expenditure could compete with private sector for resources resulting to the crowding out effect and a loss of productivity.

Worst, government spending increases the risks of bureaucratic corruption.

So how does politicization of the allocation of resources, wastefulness, deadweight loss (inefficient allocation of resources), and corruption contribute to the meaningful managing of the economy?

Third it’s also about accountability.

A private enterprise that fails to please the consumers, because of fatally wrong decisions, ends up losing money, filing for bankruptcy and or closing shop.

Reckless policies pursued by a political leader could lead to economic devastation yet the perpetrator’s political career can remain unaffected, Robert Mugabe of Zimbabwe could serve as an example.

Moreover a political leader may keep a big segment of the voting population happy by mass redistribution of wealth (tyrannical socialism, fascism, dictatorship) by extorting the most productive sectors or by buying off voters by benefiting from crony capitalism or corruption and may yet retain his/her career on election day.

So how can a self serving politician be responsible for managing the economy when his/her interest is to remain in power by political maneuvering?

Fourth is the dearth of economic calculation.

A private enterprise is guided by market pricing signals which determines the relationship of price and costs expressed in money terms and the coordination and allocation of resources in accordance to profit and loss statements.

A government which is not a profit seeking enterprise cannot make use of any economic calculation wrote Mr. Ludwig von Mises.

For instance, to quote Ludwig von Mises anew, the ``success or failure of a police department's activities cannot be ascertained according to the arithmetical procedures of profit-seeking business. No accountant can establish whether or not a police department or one of its subdivisions has succeeded. It is precisely when a manager is rewarded by a share of the profits that he becomes foolhardy because he does not share in the losses too”. (emphasis added)

In other words, the cost of delivering most public goods by the government cannot be accounted for in money terms.

So if government cannot account for its services then how can it ascertain how to manage the economy?

Fifth is the lack of local knowledge.

A private enterprise, operating under the market process and is directed by pricing signals, needs to acquire or get updated with the local knowledge of the market, one is serving or intends to cater to, for them to be able to operate profitably.

A central authority plagued with a lack of economic calculation is likewise handicapped by deficient local knowledge. The underlying response will be to rely on inaccurate statistics which may lead to inaccurate analysis and policy blunders.

As Friedrich A. Hayek described in "The Use of Knowledge in Society" ``The statistics which such a central authority would have to use would have to be arrived at precisely by abstracting from minor differences between the things, by lumping together, as resources of one kind, items which differ as regards location, quality, and other particulars, in a way which may be very significant for the specific decision. It follows from this that central planning based on statistical information by its nature cannot take direct account of these circumstances of time and place and that the central planner will have to find some way or other in which the decisions depending on them can be left to the "man on the spot." (bold emphasis mine)

Since regulatory policies are always imposed based on “social” motives, the economic viability of such motive needs to be established. Otherwise, such policies may lead to serious distortions in the marketplace which may result to adverse unintended consequences.

As Professor Art Carden eloquently wrote, ``Any social policy must be economically possible before it can be considered morally desirable.”

So if central planners don’t have the right information to make the strategic decisions on important aspects of the “local” economy, how can they manage?

In the 80s, as Japan went into a bubble, I recalled the much ballyhooed Japan Inc...

It was a moniker describing the relationship of Japan’s public-private sector partnership that luxuriated in the glory of easy money policies.

In looking at Investopedia.com we saw a short narrative on its miserable ending as follows, ``The high degree of collusion between Japan's corporate and political sectors led to corruption throughout the system and contributed to the downfall of the overvalued Nikkei.”

A Deeply Embedded Inflation Psyche

``What deflationists always overlook is that, even in the unlikely event that banks could not stimulate further loans, they can always use their reserves to purchase securities, and thereby push money out into the economy. The key is whether or not the banks pile up excess reserves, failing to expand credit up to the limit allowed by legal reserves. The crucial point is that never have the banks done so, in 1990 or at any other time, apart from the single exception of the 1930s. (The difference was that not only were we in a severe depression in the 1930s, but that interest rates had been driven down to near zero, so that the banks were virtually losing nothing by not expanding credit up to their maximum limit.) The conclusion must be that the Fed pushes with a stick, not a string.” –Murray Rothbard, Making Economic Sense

Many have touted today’s action in the marketplace as a manifestation of success from government intervention.

Given public’s predisposition to focus on the short-term and interpret heavily on current information, especially after repeatedly being seduced from the incentives provided for by inflationary policies, today’s appearance of success equals tomorrow’s seismic crisis.

Betting The House On Too Big To Fail

In the US, the “Too Big To Fail” syndrome is becoming deeply entrenched in the heavily regulated banking industry.

An article by Peter Eavis at the Wall Street Journal entitled “Uncle Sam Bets the House on Mortgages” gives as a stirring depiction of the growing intensity of systemic concentration risks.

(bold highlights mine)

``It is a stunning change, but is it good for the housing market, and to what extent will it boost profits over the long term for this elite trio: Wells Fargo, Bank of America and J.P. Morgan Chase?”

Graph 1: Wall Street Journal: Too Big To Fail Getting Bigger

``Right now, housing remains on government life support. Treasury-backed entities are guaranteeing about 85% of new mortgages, while the Fed buys 80% of the securities into which these taxpayer-backed mortgages are packaged.”

``The optimistic take is that this support, though large, will shrink when market forces regain confidence. But there is a darker possible outcome: The emergency assistance is entrenching a system in which the taxpayer takes the default risk on most mortgages, while a small number of large banks get a larger share of the fee revenue from originating and servicing mortgages.

``That is what is happening now. While big banks are originating lots of mortgages, they are selling nearly all of them to Fannie Mae and Freddie Mac. Indeed, combined single-family mortgages held on the balance sheets at J.P. Morgan, BofA and Wells actually fell 3.5% in the first half. Before the bust, these banks sold large amounts of loans to Fannie or Freddie, but they also held on to products like jumbo mortgages. The volumes for those large loans now have tumbled.”

What you have here is essentially the politicization of the US banking industry, where the top 3 banks have cornered the meat of the “economic rent” from mortgage servicing and issuance which it deals with the US government.

And this concurrently, becomes an issue of moral hazard, where these highly privileged banks, which operates on implied guarantees from US government that they are “too big to fail”, may indulge on more aggressive risk taking activities at the expense of US taxpayers.

Moreover, the US government stands as THE market for home mortgages.

Alternatively, this also posits that since the US government is a political entity and is less constrained by economic pressures, the pricing structure for transacting these mortgage securities have been above what the market is willing to pay for. Thus, government intervention translates to massive tax payer subsidies to cover losses meant to keep the banking system afloat.

Analyst Doug Noland in his Credit Bubble Bulletin recently dissected the Federal Reserves 2^nd Quarter Flow of Fund and construed that instead of targeting stabilization for conventional mortgages, the Fed has been propping up private label Mortgage Backed Securities.

He says (all bold emphasis mine), ``So, the Fed is amassing quite a stockpile of “conventional” GSE MBS, but often these are “private-label” mortgages recently “refinanced” into GSE securities. And as the Fed buys the new GSE MBS, newly created funds become available to flow back to reliquefy the formerly illiquid ABS marketplace (along with agencies, Treasuries, corporates, and equities). To be sure, placing essentially federal government backing upon previously “private-label” mortgages dramatically changes the market’s perception of these securities’ worth (“moneyness”) – especially with fed funds pegged for an extended period at near zero and the Fed in the midst of a $25bn weekly purchase program in order to fulfill it commitment to purchase $1.25 TN of mortgage securities….”

``Not only is the vast majority of new mortgage Credit this year government-backed, Washington guarantees are being slapped on hundreds of billions of existing “nonconventional” mortgages. This intrusion and transfer of (Credit and interest rate) risk has terrible long-term ramifications. Although in the near-term this mechanism provides a powerful stabilizing force for both the Credit system and real economy.”

Here is an example of the “privatization of profits and socialization of losses” from which would most likely exact a heavy toll on US productivity and which would likewise be reflected on the economy, as the productive segments will be penalized dearly for the subsidies or the losses incurred by the US banking system.

Nevertheless all these accounts for the priorities of the incumbent officials and their penchant to salvage a preferred industry via the inflation route, as we discussed in Governments Will Opt For The Inflation Route.

Bernanke’s Fascism Risks An Inflation Crisis

One would have to wonder whether Fed Chair Ben Bernanke is a chronic prevaricator or has been captured by the industry he regulates or operates with a tacit vested interest on the industry or has been fanatically blinded by ideology to declare that the Fed won’t monetize debt and likewise yearn for expanded powers or control over more parts of the economy including the proposed regulation of banker’s pay. Mr. Bernanke failed to predict, was in denial of the crisis and panicked in front of Congress to ask for bailout money.

To quote John H. Cochrane And Luigi Zingales who wrote on a Wall Street Op-ed on the Lehman anniversary, `` these speeches amounted to the financial system is about to collapse. We can't tell you why. We need $700 billion. We can't tell you what we're going to do with it." That's a pretty good way to start a financial crisis.”

Yet the justification to “help the agency act more decisively to reduce the chances of a recurrence” would only entrench the growing politicization, reduce the systemic efficiency and transition the US market economy into fascist state.

In the definition of Sheldon Richman, Fascism is ``where socialism nationalized property explicitly, fascism did so implicitly, by requiring owners to use their property in the “national interest”—that is, as the autocratic authority conceived it. (Nevertheless, a few industries were operated by the state.) Where socialism abolished all market relations outright, fascism left the appearance of market relations while planning all economic activities. Where socialism abolished money and prices, fascism controlled the monetary system and set all prices and wages politically. In doing all this, fascism denatured the marketplace.” (bold emphasis mine)

Yet, the diminishing role of institutional check and balances and an increasingly centralized flow of power would only amplify the systemic concentration risks that could spark a runaway inflation crisis (given Bernanke’s tendency to inflate).

One man’s error could lead to another global systemic mayhem.

The Fed didn’t monetize debt?

Again Doug Noland on the Fed Fund Flow, ``In total, Rest of World purchased $403bn SAAR of Treasuries during Q2, about a quarter of total issuance ($1.896 TN SAAR). Who were the other major purchasers? The Fed monetized $647bn SAAR, the Household Sector bought $343bn SAAR, and Broker/Dealers accumulated $404bn. And while it is positive that American households are buying Treasuries and saving more, this does not change the fact that this so called “savings” was bolstered by income effects from massive government spending increases.”

For us, the outcome of inflation or deflation is a result of a deliberate policy. It’s only the fat tails or the extreme outcomes that function as a form of unintended consequences, similar to the meltdown post Lehman bankruptcy in 2008.

Moreover we don’t believe that inflation can only occur via a revitalized US consumer.

Such view myopically underestimates the role of fiscal channels [Noland: “bolstered by income effects from massive government spending increases”] or an increasing concentration or centralization of power by central banking [Richman: “Where socialism abolished money and prices, fascism controlled the monetary system and set all prices and wages politically”].

In addition, given today’s increased globalization or deepened integration by global economies and financial system, there are transmission mechanisms or interlinkages from global governments undertaking the same inflationary tools [Noland: “Rest of World purchased $403bn SAAR of Treasuries during Q2, about a quarter of total issuance ($1.896 TN SAAR)”].

Hence while the risks of debt deflation seem a concern for some parts of the world, it does not apply to all. Yet if debt deflation is premised from a monetary phenomenon perspective, based on country specific issues, then the argument crumbles especially when applied to countries that have been least leveraged.

Not even a “ghost fleet of recession” or massive number of ships idly anchored in Asia in the absence of international trades arising from the recession would be enough to circumvent a steadfastly determined central bank to inflate a system.

A central bank can simply print a dollar per every dollar of liability, even if it means hundreds of trillions, if it deems it as beneficial.

Zimbabwe’s recent example should be a reminder that no amount of capacity utilization, unemployment rate, velocity of money [see last week’s Velocity Of Money: A Flawed Model], consumer spending or consumer debt and other traditional econometrics used by mainstream experts deterred a tyrant (operating on centralized power and a politicized economy) and an inflation obsessed central banker in Dr. Gideon Gono from fanning 89,700,000,000,000,000,000,000% hyperinflation in 2008.

While the US or UK may not be the same as Zimbabwe, an increasing centralization of power and politicization of the economy could neutralize any inherent advantages thereof. As former Fed Chief Alan Greenspan quoted in Bloomberg commented, ``It’s the politics in the United States that worries me, whether the Congress will basically feel comfortable” with the Fed withdrawing its stimulus, Greenspan said in a broadcast to Tokyo clients of Deutsche Bank Securities Inc. today. He later said that “if inflation rears its head, it will swamp long-term markets,” referring to bonds.”

In short, Mr. Greenspan appears sardonically worried about the US government’s addiction to inflation, a policy which incidentally, he applied extensively throughout his tenure. One might say that he inured the world with the “Greenspan Put” or Mr. Greenspan’s repeated policy of rescuing or providing support for the markets with artificially lowered interest rates during the 1987 stock market crash, the Gulf War, the Mexican Tequila crisis, the 1997 Asian crisis, the LTCM debacle, Y2K, the burst of the internet bubble, and the 9/11 terror attack.

Not until a significant part of the world becomes as deeply indebted as those afflicted by the recent bubble, will deflation become a meaningful threat to the global banking system or perhaps not until the destruction of the present currency system.

Yet deflation is a natural and rightful antidote to the excesses of inflation.

Exploding Bond Markets, From Periphery To The Core

Moreover, while debt deflation advocates continue to tunnel onto the banking system as the key source for benchmarking credit market conditions, they seem to forget the existence of the bond market as an alternative venue for credit access.

However, the difference is that credit via the bond markets won’t trigger the fractional reserve nature of today’s banking platform that would expand monetary aggregates. Nonetheless it helps push up prices of securities.

This from the Financial Times, ``European bond issuance has hit $2,000bn so far this year, the fastest ever pace of issuance, as companies race to refinance in the bond markets and banks remain reluctant to lend.

``European sovereigns, agencies and companies have sold 38 per cent more than the $1,450bn issued in 2008 in the year to date, according to analysts at data provider Dealogic, who add that issuance has never previously stood at such a high level so early in the year.

``Non-financial companies accounted for a record $446.3bn so far this year, 55 per cent more than in all of 2008….

``Financial issuers have sold a record of $542.8bn year to date, 24 per cent more than issued in 2008.”

In Asia, a somewhat similar dynamics could be at work as bond market growth has also been robust see figure 2.

Figure 1: ADB Bond Monitor: Hefty Growth in Bond Markets

According Standard & Poors as quoted by Researchrecap ``Notwithstanding a near universal attempt by central banks to ease monetary conditions, bank lending—still the predominant source of funds in the emerging markets—has varied from country to country. China is a standout, having reportedly injected as much as $1.1 trillion in new lending during the first six months of 2009. For many other markets, however, credit growth is decelerating (and, in some cases, contracting) in comparison with a year ago. This suggests that banks, even those that were largely unscathed by the financial crisis, are remaining cautious to stave off a potential increase in nonperforming loans.” (bold highlights mine)

In short given the fresh memory of the 2008 setback, some banking system in the region has opted to remain conservative in their lending practice. Nonetheless, the other route has been through the debt markets.

According to the ADB’s Bond Monitor, (bold underscore mine)

``Emerging East Asia’s bond market grew by 12.8% year-on-year (y-o-y) on an local currency (LCY) basis to USD3.94 trillion in the first half of 2009. The market also expanded by 5.2% quarter-on-quarter (q-o-q) in 2Q09 as financial markets showed signs of stabilization and the region’s growth showed signs of recovery. This lifted the growth rate for outstanding LCY bonds for the first half of the year…

``The strongest improvements in y-o-y bond market growth rates on an LCY basis in the first half of 2009 were in Hong Kong, China (19.4%); the People’s Republic of China (PRC) (14.8%); Republic of Korea (Korea) (13.1%); Indonesia (12.3%); and the Philippines (8.2%).”

Anyway, one of the publicly listed companies in the Philippines, the SM Investments, successfully sold $500 million worth of bonds from which two-thirds of the placements had been made local investors (FinanceAsia). This is a testament of the immense liquidity of the domestic system which had been reinforced by a faster growth clip in July (BSP).

In addition, domestic bank credit growth has remained vigorous in terms of trade and production, household consumption and bank repo lending activities (BSP).

And the growth in both the banking and bond markets have been indications of inflationary policies gaining continued traction in Asia. This as we repeatedly been saying is simply due to low systemic leverage, high savings rate, unimpaired banking system, current account surpluses and an apparent trend towards a deepening regionalization, and likewise, integration with the world economic system.

And as discussed in The Growing Validity Of The Reflexivity Theory: More PTSD And Periphery, we proposed that growth dynamics would probably shift from the core (US consumers) to the periphery (emerging markets), ``money appears as being transmitted to support growth in the developing countries as part of the collaborative efforts to inflate the system.”

Morgan Stanley’s Joachim Fels, takes a parallel view in his recent outlook, ``near-zero interest rates in the US and Europe eased monetary conditions in those emerging market economies that peg to the dollar or the euro, adding to their domestic stimulus packages. Thus, it didn't come as a surprise that China was the first major economy to emerge from recession, given that it imports easy money from the US through the exchange rate link without having the US's financial sector problems.

``The point worth noting here is that we may all still be underestimating the effects of the stimulus that has already been put into place and is still playing out. If so, growth would not moderate from its current 4%+ global pace going into 2010 as in our base case, but accelerate further. The most plausible upside scenario, in our view, would be one where Asia keeps motoring ahead with domestic demand strengthening further in response to the stimulus, leading to a surprisingly strong revival of global trade.” (bold emphasis added)

Stages Of Inflation Redux

Instead of the deflation scenario, today’s sweet spot in inflation could actually signify as the initial phase of the three stages of inflation as also discussed in Warren Buffett’s Greenback Effect Weighs On Global Financial Markets.

To quote Henry Hazlitt, ``What we commonly find, in going through the histories of substantial or prolonged inflations in various countries, is that, in the early stages, prices rise by less than the increase in the quantity of money; that in the middle stages they may rise in rough proportion to the increase in the quantity of money (after making due allowance for changes that may also occur in the supply of goods); but that, when an inflation has been prolonged beyond a certain point, or has shown signs of acceleration, prices rise by more than the increase in the quantity of money. Putting the matter another way, the value of the monetary unit, at the beginning of an inflation, commonly does not fall by as much as the increase in the quantity of money, whereas, in the late stage of inflation, the value of the monetary unit falls much faster than the increase in the quantity of money. As a result, the larger supply of money actually has a smaller total purchasing power than the previous lower supply of money. There are, therefore, paradoxically, complaints of a "shortage of money." (bold emphasis mine)

What could be seen as some pockets of deflation today, could actually be the initial phases of inflation. And a continued rise in the commodities space even if it signifies as a currency “pass through” from the sagging US dollar would likely intensify the inflation expectations.

Then when the late stage of inflation have been reached, where the value of monetary unit falls faster (or consumer prices are rising faster) than the increase in the quantity of money which leads to the perception of “a shortage of money”, the central bank under the auspices of the government would either elect to print money at an ever accelerating “exponential” rate to meet such shortages-ergo the hyperinflation scenario, or opt to withhold feeding the boom (or by declaring a default) -the deflation scenario.

Again this will all be a result of policy choices.

So simply reading conventional metrics when governments have taken a lead role in the marketplace will lead to misdiagnosis and mass confusions on the disconnection between the market from economic reality. Analyzing how political trends will shape policy decision making will likely be a better alternative [see Stock Market Investing: Will Reading Political Tea Leaves Be A Better Gauge?]

Anyway, a hyperinflation episode would also lead to deflation once the hyperinflated currency have been eschewed and replaced by another currency. The recent case of Zimbabwe which has abrogated its currency, the Zimbabwean Dollar, for the US dollar and South African Rand is a prime example.

At the end of the day, global policymakers will continue to bask on the triumphalism from present day policies and will most likely continue to keep the booze flowing.

Hence even if markets don’t move in a straight line they will likely respond positively to policy sustained policy accommodations over this early phase of the inflation cycle.

Will China’s Stock Market Correction Spread Globally?

``We have seen that according to popular thinking, an asset bubble is a large increase in asset prices. A price is the amount of dollars paid for a given thing. We may just as well say, then, that a bubble is a large increase in the payment of dollars for various assets. As a rule, in order for this to occur there must be an increase in the pool of dollars, or the pool of money. So, if one accepts the popular definition of what a bubble is, one must also concede that without an expansion in the pool of money, bubbles cannot emerge. If the pool of money is not expanding, then people — irrespective of their psychological disposition — simply do not have the ability to generate bubbles in various markets.” Frank Shostak, How Can the Fed Prevent Asset Bubbles?

It looks likely that we may have reached a turning point for this cycle.

I’m not suggesting that we are at the end of the secular bull market phase, but given the truism that no trend moves in a straight line, a reprieve should be warranted.

To consider, September and October has been the weakest months of the annual seasonal cycle, where most of the stock market “shocks” have occurred. The culmination of last year’s meltdown in October should be a fresh example.

Although, this is not to imply that we are about to be envisaged by another crisis this year (another larger bust looms 2-4 years from now), the point is, overstretched markets could likely utilize seasonal variables as fulcrum for a pause-or a window of opportunity for accumulation.

A China Led Countercyclical Trend

My case for an ephemeral inflection point is primarily focused on China.

Since China’s stockmarket bellwether, the Shanghai Index (SSEC), defied “gravity” during the predominant bleakness following last year’s crash, and most importantly, served as the inspirational leader for global bourses, its action would likely have a telling impact on the directions of global stock markets.

In short, my premise is that global markets are likely to follow China.

True, the SSEC had a two week correction, which have accounted for nearly 11% decline (as seen in Figure 1) but this has, so far, been largely ignored by global bourses.

Figure 1: Stockcharts.com: The Shanghai Index Rolling Over

Nevertheless, the action in China’s market appears to weigh more on commodities on the interim. This should impact the actions in many commodity exporting emerging markets.

The Baltic Dry Index (BDI) which tracks international shipping prices of various dry bulk cargoes of commodities as coal, iron ore or grain has been on a descent since June.

This has equally been manifested in prices Crude oil (WTIC) which appears to have carved out a “double top” formation.

In short, there seems to be a semblance of distribution evolving in the China-commodity markets.

The possible implication is perhaps China’s leash effect on global stock markets will lag.

From a technical perspective, using the last major (Feb-Mar) correction as reference, a 20% decline would bring the SSEC to a 50% Fibonacci retracement, while a 25% fall would translate to 61.8% retracement.

And any decline that exceeds the last level may suggest for a major inflection point, albeit technical indicators are never foolproof.

Moreover, from a perspective of double top formation in oil; if a breakdown of the $60 support occurs then $49-50 could be the next target level.

As a reminder, for us, technicals serve only as guidepost and not as major decision factors. The reason I brought up the failure in the S&P 500 head and shoulder pattern last July [see Example Of Chart Pattern Failure] was to demonstrate the folly of extreme dependence on charts.

As prolific trader analyst Dennis Gartman suggests in his 22 Trading rules, ``To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.”

In short, understanding market sponsorship or identifying forces that have been responsible for the actions in the marketplace are more important than simple pattern recognition. Together they become a potent weapon.

So despite the recent 11% decline of the SSEC, on a year date basis it remains up by a staggering 67%.

Politicization Of The Financial Markets

Some experts have suggested that when global stock markets would correct, such would transpire under the environment of a rising US dollar index, since this would signal a liquidity tightening.

I am not sure that this would be the case, although the market actions may work in such direction where the causality would appear reflexive.

Unless the implication is that the impact from the inflationary policies has reached its pinnacle or would extrapolate to a manifestation of the eroding effects of such policies, where forces from misallocated resources would be reasserting themselves, such reasoning overlooks prospective policy responses.

The US dollar index (USD) has recently broken down but has been drifting above the breached support levels (see above chart).

It could rally in the backdrop of declining stock markets and commodity prices, although it is likely to reflect on a correlation trade than a cause and effect dynamic.

By correlation trade, I mean that since the markets have been accustomed or inured to the inverse relationship of the US dollar and commodities, any signs of weaknesses in the commodities sphere would likely spur an intuitive rotation back into the US dollar.

Some may call it “flight to safety”. But I would resist the notion that the US dollar would represent anywhere near safehaven status given the present policy directions.

However, if the US dollar fails to rally while global stocks weaken, then any correction, thus, will likely be mild and short.

So yes, the movement of the US dollar index is an important factor in gauging the movements of the global stock markets.

But one must be reminded that last year’s ferocious rally in the US dollar index was triggered by a dysfunctional global banking system when the US experienced a near collapse prompted by electronic “institutional” bank run.

This isn’t likely to be the case today.

So far, aside from the seeming “normalization” of credit flows seen in the credit markets, our longstanding premise has been that global authorities, operating on the mental and theoretical framework of mainstream economics, will refrain from exhausting present gains from which have been viewed as policy triumph.

Hence our bet is that they will likely pursue the more of the same tact in order to sustain the winning streak. The latest US FOMC transcript to maintain current policies could be interpreted as one.

Why take the party punch bowl away when the financial elite are having their bacchanalian orgy?

As we noted in last week’s Crack-Up Boom Spreads To Asia And The Philippines, ``Where financial markets once functioned as signals for economic transitions, it would now appear that financial markets have become the essence of global economies, where the real economy have been subordinated to paper shuffling activities.”

Where policymakers inherently sees rising financial assets as signals of economic growth, the reality is that most of the current pricing stickiness has been fueled by excessive money printing that has prompted for intensive speculations more than real economic growth.

Figure 2: New York Times: Hints of a Rebound in Global Trade?

For instance, Floyd Norris of the New York Times has a great chart depicting the year on year changes of global trade based on dollar volume of exports.

While there has indeed been some improvements coming off the synchronized collapse last year, the growth rates haven’t been all that impressive.

In short, rapidly inflating markets and a tepid growth in the global economy manifest signs of disconnect!

Yet global policymakers won’t risk the impression that economic growth will falter as signaled by falling financial asset prices. Hence, they are likely to further boost the “animal spirits” by adopting policies that will directly support financial assets and hope that any improvements will have a spillover effect to the real economy via the “aggregate demand” transmission mechanism.

Alternatively, one may interpret this as the politicization of the financial markets.

To give you an example, bank lending in China has materially slowed in July see figure 3. This could have accounted for the recent correction in the SSEC.

Figure 3: US Global Investors: Declining Bank Loans

According to US Global Investors ``China’s new lending data for July may be a blessing in disguise, as the slowdown can partly be attributed to a sharp month-over-month decrease in bill financing. Excluding bills, July’s new loans to companies and households were comparable to May and higher than April. With more higher-yielding, long-term loans replacing lower interest-bearing bill financing, margins at Chinese banks should improve as long as corporate funding demand remains strong and overall loan quality stays healthy.”

While this could be seen as the optimistic aspect, the fact is that aside from the overheated and overextended stock markets, property markets have likewise been benefiting from the monetary shindig- property sales up 60% for the first seven months and where residential investments “rose 11.6 percent, up from 9.9 percent in the six months to June 30” “powered by $1.1 trillion of lending in the first six months” (Bloomberg)

True, some of these have filtered over to the real economy as China’s power generation expanded by 4.8% in July (Finfacts) while domestic car sales soared by 63% (caijing) both on a year to year basis.

So in the account of a persistent weak external demand, Chinese policymakers have opted to gamble with fiscal and policies targeted at domestic investments…particularly on property and infrastructure.

Remember, the US consumers, which had been China’s largest market, has remained on the defensive since they’ve been suffering from the adjustments of over indebtedness which would take years (if not decades) to resolve (see figure 4).

Figure 4: Danske Research: US Consumers In Doldrums

And since investments accounts for as the biggest share in China’s economy, as we discussed in last November’s China’s Bailout Package; Shanghai Index At Possible Bottom?, ``the largest chunk of China’s GDP has been in investments which is estimated at 40% (the Economist) or 30% (Dragonomics-GaveKal) of the economy where over half of these are into infrastructure [30.8% of total construction investments (source: Dragonomics-Gavekal)] and property [24% of total construction investments]”, the object of policy based thrust to support domestic bubbles seem quite enchanting to policymakers.

Besides, if the objective is about control, in a still largely command and control type of governance, then Chinese policymakers can do little to support US consumers than to inflate local bubbles.

Aside, as we discussed in last week’s The Fallacies of Inflating Away Debt, “conflict-of –interests” issues on policymaking always poses a risk, since authorities are likely to seek short term gains for political ends or goals.

From last week ``policymakers are likely to take actions that are designed for generating short term “visible” benefits at the cost of deferring the “unseen” cumulative long term risks, which are usually are aligned with the office tenure (let the next guy handle the mess) or if they happen to be politically influenced by the incumbent administration (generates impacts that can win votes)”

In China, political incentive issues could be another important variable at work in support of bubble policies.

Michael Kurtz, a Shanghai-based strategist and head of China research for Macquarie Securities Michael Kurtz, in an article at the Wall Street Journal apparently validates our general observation.

From Mr. Kurtz (bold highlights mine),

``…far from being an accidental consequence of loose monetary policy, stand out as the purpose of that policy. The fact that housing construction must carry so much of the growth burden means policy makers likely prefer to err well on the side of too much inflation rather than risk choking off growth too early by mistiming tightening.

``Meanwhile, China's political cycle may exacerbate risks of an asset bubble. President and Communist Party Chairman Hu Jintao and other senior leaders are expected to step down at the party's five-year congress in October 2012. Much of the jockeying for appointments to top jobs is already under way, especially for key slots in the Politburo. Mr. Hu will want to secure seats for five of his allies on that body's nine-member standing committee, ensuring his continued influence from the sidelines and allowing him to protect his political legacy.

``This requires that Mr. Hu deliver headline GDP growth at or above the 8% level that China's conventional wisdom associates with robust job creation, lest he leave himself open to criticism from ambitious rivals. The related political need to avoid ruffling too many feathers in China's establishment also may incline leaders toward lower-conflict approaches to growth, rather than deep structural reforms that would help rebalance demand toward sustainable private consumption. Easy money is less politically costly than rural land reform or state-enterprise dividend restructuring. This is especially the case given that much of the hangover of a Chinese asset bubble would fall not on the current leadership, but on the next.”

So the “window dressing” of the Chinese economy for election purposes fits our conflict of interest description to a tee!

Overall, it would seem like a mistake to interpret any signs of a prospective rally in the US dollar on “tightening” simply because policymakers (in China, the US, the Philippines or elsewhere) are likely to engage in more inflationary actions for political ends (policy triumph, elections, et. al.).

Hence, any signs of market weakness will likely prompt for more actions to support the asset prices.