How Empires Die and the End of Centralization

Professor Gary North has a splendid article on the coming end of the empire states and of the centralized form of governments…

Death of the Empire

Empires disintegrate. This is a social law. There are no exceptions.

The first well-known social theorist to articulate this law was the prophet Daniel. He announced it to King Nebuchadnezzar. You can read his analysis in Daniel 2. Verses 44 and 45 are the key to understanding the law of empires.

The Roman Empire is the model. But there is a serious problem here. There are at least 210 theories of why it fell. There are so many that even my 1976 Ron Paul office colleague Bruce Bartlett gets credit for one of them – on Wikipedia, no less. He has made the big time!

In any case, Rome did not collapse. It wasted away over several centuries, wasting the treasure of its citizens along with it.

I suppose there were highly educated people who came to the voters in the late Roman republic and said something like this: "Unless decisive action is taken now, Rome will go bankrupt." If so, they were right. But it took a lot longer than they thought.

These days, it does not take nearly so long.

An empire grows at first almost unconsciously. No one goes to the powers that be and says, "Hey! Why don't we create an empire?" It is more like the person who says this: "I'm not greedy. All I want is to control the land contiguous to mine."

In military affairs, there are economies of scale. An army of warriors makes conquest cost-effective. There are also taxation advantages. An army of tax collectors makes tax collection cost-effective. "Hand over your money" is more effective. Pretty soon, you've got an empire.

But there is a law of bureaucracy that applies to empire. At some point, it costs more to administer the bureaucracy than the bureaucracy can generate through coercion. Then the empire begins to crack. It cannot enforce its claims.

So, the growth of empire has economics at its center: economies of scale. The fall of empire also has economics at its center: economies of scale.

I think this process is an application of the law of increasing returns. In the initial phase of the process, adding more of one factor increases total output. But, as more of it is added, another law takes over: the law of decreasing returns.

Example: water and land. Add some water to a desert, and you can grow more food. Add more water, and you can grow a lot more food. There is an accelerating rate of returns. The joint output is of greater value than the cost of adding water. But if you keep adding water, you will get a swamp. The law of decelerating returns takes over. Add more water, and the land is underwater. You might as well have a desert.

This law applies to power. Add power, and you generate more income. But if you keep adding power, expenses of the bureaucracy will begin to eat up revenues. Resistance will also increase: internal and external. The system either implodes or withers away.

With only one exception in history – the Soviet Union in 1991 – empires have not gone out of business without bloodshed.

In the case of the Soviet Union, the senior politicians privatized the whole system in December 1991. They handed over the assets to what immediately became the ultimate system of crony capitalism. They divvied up the Communist Party's money and deposited it in individual Swiss bank accounts. The suicide of the USSR was "Vladimir Lenin meets David Copperfield." Now you see it; now you don't. In the history of Marxism, no event better illustrates Marx's principle of the cash nexus. It seduced Lenin's vanguard of the proletariat.

Notice the pattern of empire. It begins slowly, building over centuries: the Roman Empire, the Russian Empire, the French Empire. Then the empire either erodes or else it is captured by revolutionaries, as was the case in France (1789-94) and Russia (1917). But this only delays the reversal. It does not overcome it.

Death of the Modern Centralized States

Economies of scale shaped the development of the modern nation-state. In 1450, the governments of Western Europe were small. They controlled little territory. They were remnants of the medieval world, which had been far more decentralized.

By 1550, this had begun to change. The beginnings of the modern nation-state were visible.

Tax revenues flowed into the centralizing kingships. Trade was growing. Revenues were increasing. Weaponry was advancing. All of this had been going on for half a millennium. But, like an exponential curve, the line began to move upward visibly around 1500.

Maritime empires grew: Spain, Portugal, England. They challenged each other on the seas. Then came the Netherlands and France. The fusion of naval power and trade monopolies lured nations into competition for trade zones. The idea of free trade was centuries away, except in the academic enclave of the school of Salamanca.

The law of increasing returns was evident in this process. It paid rulers to tax more and extend the jurisdiction of the nation-state at the expense of local governments internally and foreign governments externally. The benefits accrued mostly to the political hierarchy and its system of connected families.

Economies of scale drove the process. The division of labor favored centralization. Local units of civil government could not compete.

Let me give an example from the field of historiography. The historian of colonial America can write about lots of topics: immigration, technology, family structure, town planting, economic development, intellectual trends, and so forth. He writes about the issues of life that affected people's daily lives. He cannot write about national politics until after May of 1754: the "battle" of Jumonville Glen.

The Battle of Jumonville Glen is unknown to all historians except specialists in colonial America. This is a pity, because that battle was the most important military event in the history of the modern world. It literally launched the modern world. It led to (1) the French & Indian War (Seven Years' War), (2) the Stamp Act crisis, (3) the American Revolution, (4) the French Revolution, (5) Napoleon, (6) nationalism, (7) modern revolutionism, (8) Communism, (9) Fascism, and (10) the American Empire. It was started by Virginia militia Major George Washington, age 22.

Before the ratification of the U.S. Constitution, it is both possible and wise to write about America without tying the narrative to politics. After 1788, every textbook writer is drawn like a moth to the flame: Presidential elections. He cannot narrate the text without hinging everything on the outcome in the four-year system of national covenant renewal-ratification.

We are fast approaching a day of judgment. It has to do with economies of scale. It has to do with the law of decreasing returns.

The best account of this process is a book by Israeli military historian Martin van Creveld: The Rise and Decline of the State (Cambridge University Press, 1999). He traces the history of the Western nation-state from the late Renaissance until the late twentieth century. He argues that there will be a break-up of nation states and a return of decentralization.

Read the rest here.

The transition from the decaying centralized social structures out of the law of decreasing returns is presently being compounded by the widespread adaption of massive advances from technology.

People will need ideological justifications for such transition. Remember, the world does not operate on a vacuum.

And with the democratization of knowledge through the web or the cyberspace, people’s perception, mentality and attitudes will likely adapt to favor decentralized social orders.

Futurist Alvin Toffler calls this the Third Wave. From his 1980 book,

The Third Wave thus begins a truly new era--the age of the de-massified media. A new info-sphere is emerging along-side the new techno-sphere. And this will have a far-reaching impact on the most important sphere of all, the one inside our skulls. For taken together, these changes revolutionize our images of the world and our ability to make sense of it

The Arab Spring revolts of 2011 has partly been manifestations of the combination of the law of decreasing returns on centralized social orders and of technology facilitated knowledge revolution in process.

Several welfare states in the Eurozone are in the process of a monumental collapse from a debt trap.

This will deepen overtime.

Quote of Day: The Last Hurrah of Socialist Welfare States

Today’s main quote of the day comes from Brian S. Wesbury, chief economist at the First Trust

The Social Welfare State is dying. Like the Berlin Wall and the Iron Curtain, the cradle-to-grave social welfare experiment must eventually collapse. A system of taxing work and profits, while subsidizing leisure, sloth, and retirement, must eventually fail.

The end of the Social Welfare State is painful for many, and it will not end quickly or quietly as the elections of this past weekend prove. Francois Hollande, a Socialist, was elected president of France, while Greece saw a surge in votes for “anti-bailout” political parties in parliament.

These elections are described as blows against “austerity.” They are also seen as anti-German. Germany resisted bailouts and pushed spending cuts.

In theory, a rejection of austerity could be a good thing. Some people include tax hikes in the concept of austerity and avoiding tax hikes would be a good thing for Europe. France has a top income tax rate of 45%, a wealth tax of 0.5% and a Value Added Tax (VAT) of 21.2%. Greece has a top income tax rate of 45% and a VAT of 23%. These burdensome tax rates hinder growth, investment and work effort and still don’t cover all the spending.

To solve the deficit problem, Francois Hollande wants to raise France’s top income tax rate to 75%. Greece’s “anti-bailout” parties, mostly on the left, also want higher taxes on the upscale, plus defense cuts. The Greek military helps break up domestic riots, so this is a self-serving demand.

So, in reality, French and Greek rejection of austerity does not mean policies that would enhance long term economic growth. Instead, it means they want to temporarily pull the wool over their own eyes, resist the obvious need to reduce government spending, and just hope for the best.

This chapter of the French story will not end well. The country has already gone much further along the road to socialism than the US, with general government spending equal to about 56% of GDP, very near the highest of any advanced or emerging market in the world. Greece, at 49%, is not far behind. Yet, voters are doubling down.

“Doubling down” simply means accelerating the pace of degeneracy that leads to an eventual collapse which will be marked by government bankruptcies and the dissolution of the EU via a series of debt default or through hyperinflation. As James Turk of goldmoney.com wrote (for the second related quote of the day),

the ideological bankruptcy of socialism will be laid bare by government insolvency

In Pictures: The Eurozone’s “Austerity” Programs

I’ve been saying that whatever politicians, media and their zealot followers label or lay claim as “austerity” programs has been a blatant canard.

The precious deck of graphs below from tradingEconomics.com give us the perspective

First the Eurozone’s Government Debt to GDP

Ok, one might argue that the steady ascent of government debt relative to GDP has been happening because of recessions or economic growth slowdown.

So the second set of graphs which exhibits their respective fiscal conditions is meant to give us a better understanding.

Note, reference points of comparisons are very important and sensitive to making claims.

It is TRUE that government spending in the aforementioned countries above has somewhat been reduced compared to, or when based from 2010.

But except for Portugal, whose authorities have admitted that government spending does NOT work, spending levels have substantially been elevated compared to, or based from 2000-2007 for most of the Eurozone, especially the crisis afflicted nations. Add to this the ballooning balance sheets of the ECB.

From the above, we can see that whatever claims of “austerity” have been representative of half-truths, and which in reality, signifies as terminological prestidigitation.

So the return of pro-welfare governments will only exacerbate their current woes based on unsustainable political economic conditions and amplifies the transmission of the many risks (credit, currency, inflation, interest rate and etc...) to the world.

Has the European Crisis been about the Welfare State?

Yes, according Fredrik Erixon, director of an independent think tank in Brussels, the European Centre for International Political Economy.

At the Bloomberg Mr. Erixon writes (hat tip Dan Mitchell)

When it comes to overspending on social welfare, though, Europe has no angels.

Even the “good” Scandinavians, and governments that appeared to be in sound fiscal shape in 2008, but were then undone by unsustainable private-sector debts, were spending too much and will have to restructure. The only question is whether this will be done gradually, or via shock therapy.

Take the four countries at the epicenter of the euro-area crisis: Greece, Ireland, Portugal and Spain. They are in many ways different, but they have three important characteristics in common.

First, total debt in these countries expanded rapidly throughout the past decade -- either because of increased government borrowing (Greece and Portugal) or through a rapid buildup of private debt (Ireland and Spain). Second, they all ran substantial current-account deficits in the years before the crisis. Third, government spending in those nations grew at remarkably high rates. In Greece and Spain, nominal spending by the state increased 50 percent to 55 percent in the five years before the crisis started, according to my calculations based on government data. In Portugal, public expenditure rose 35 percent; in Ireland, almost 75 percent. No other country in Western Europe came close to these rates.

Clearly, the welfare-state expansion in Greece and Portugal was part of the reason these two countries ended up as clients of Europe’s bailout mechanisms. But Ireland and Spain had problems with the rapid expansion of the state, too. A big part of rising affluence during the boom years was generated by escalating real-estate bubbles, which caused private debt to soar. They boosted the construction sectors and, more generally, pushed domestic consumption to the point where Spain had to borrow as much as 8 percent of gross domestic product every year to finance its current account deficit. Like other bubbles, they spearheaded economic growth, which allowed governments to expand the state rapidly.

Read the rest here.

Bottom line is that today’s euro crisis represents the cumulative impact of intertwined government policy failures.

This includes monetary ‘bubble’ policies, which pumped up malinvestments and incentivized state profligacy, as well as, increased political centralization through webs of regulations which resulted to the lack of competitiveness (most pronounced in the labor markets), and the unsustainable social welfare systems (which also had been boosted by the bubble).

Quote of the Day: Moral Bankruptcy Leads to Economic Decadence

In essence, we're headed towards economic and financial bankruptcy. But that's mostly because society has been largely intellectually and morally bankrupt for some time. I don't believe a society can rise to real prosperity without a sound intellectual and moral foundation – that's why the US was so uniquely prosperous for so long, because it had such a foundation. And it's also why societies like Saudi Arabia will collapse as soon as the exogenous things that support them are pulled away. It's why the USSR collapsed. It's the reason why countries everywhere across time reach a peak (if they ever do), then stagnate and decline.

This isn't a matter of academic contemplation, for the same reason that it doesn't matter much if you're in a first-class cabin when the ship it's in is taking on water…

In any event, it's rare that anyone goes bankrupt because of a single bad decision. It takes many missteps, and consistently bad decisions aren't accidents. Consistently bad decisions are the product of a flawed moral philosophy. Moral philosophy guides you as to what is right or wrong.

That’s from investment guru and philosopher Doug Casey. You can read the rest of the trenchant article here.

California’s Welfare Crisis

The Greek tragedy is being played out in the US through California

Writes Professor Michael Boskin and Professor John Cogan at the Wall Street Journal, (hat tip Professor Antony Mueller) [bold emphasis mine]

No one should write off the Golden State. But it will take massive reforms to reverse its economic decline…

California's rising standards of living and outstanding public schools and universities once attracted millions seeking upward economic mobility. But then something went radically wrong as California legislatures and governors built a welfare state on high tax rates, liberal entitlement benefits, and excessive regulation. The results, though predictable, are nonetheless striking. From the mid-1980s to 2005, California's population grew by 10 million, while Medicaid recipients soared by seven million; tax filers paying income taxes rose by just 150,000; and the prison population swelled by 115,000.

California's economy, which used to outperform the rest of the country, now substantially underperforms. The unemployment rate, at 10.9%, is higher than every other state except Nevada and Rhode Island. With 12% of America's population, California has one third of the nation's welfare recipients.

Partly due to generous union wages and benefits, inflexible work rules and lobbying for more spending, many state programs and institutions spend too much and achieve too little. For example, annual spending on each California prison inmate is equal to an entire middle-income family's after-tax income. Many of California's K-12 public schools rank poorly on standardized tests. The unfunded pension and retiree health-care liabilities of workers in the state-run Calpers system, which includes teachers and university personnel, totals around $250 billion.

Meanwhile, the state lurches from fiscal tragedy to fiscal farce, running deficits in good times as well as bad. The general fund's spending exceeded its tax revenues in nine of the last 10 years (the only exceptions being 2005 at the height of the housing bubble), abetted by creative accounting and temporary IOUs.

There is no currency union to put the blame on this time.

Yet the above exposes much of the fraud in analyzing the Greek crisis. Both Greece and California have been plagued by the unsustainable welfare state system.

And like Greece, the repercussion has been a stream of ongoing business exodus

From Fox Business

Quote of the Day: Bank Privacy is Dead

Bank privacy is dead, and murdered by crisis affected governments conspiring through new edicts channeled to “inter-governmental partnership” with various governments to financially repress (read: plunder) on people’s savings.

So argues Simon Black

There are two key points I’d like to make here-

1) There is no such thing as banking privacy. Do not trust your banker to keep secrets for you, and definitely do not trust a government-regulated banking system to keep secrets for you. If you have undeclared income that’s been nestled offshore, it should be obvious at this point that such arrangements will soon unravel.

Voluntary disclosure is always better than getting caught by your home government’s tax authorities. And, especially if you’re a US citizen where tax noncompliance is a criminal offense, paying hefty penalties is a much better outcome than going to court and ending up in a day-glow orange jumpsuit.

2) Most people who are interested in financial privacy tend to use cash. But since carrying large amounts of cash is more and more being criminalized (and confiscated), this is no longer a viable option.

The best form of financial privacy at the moment is physical gold, at least until a better option for digital currency hits the market. Gold may not be useful for day-to-day transactions, but as a store of value tucked away in an anonymous offshore facility, there is no better way of maintaining financial privacy.

Mr. Black hit on the head. I was almost made criminal for unknowingly having brought marginally excess Peso cash out of the country.

This just goes to show how welfare based governments are deeply into the muck and are desperately resorting to anything to preserve a collapsing system.

The Implications of Cuts in Saudi Arabia’s Oil Production and Exports

In the light of $100 oil, Saudi Arabia, the world’s largest oil producer and exporter has reportedly cut production.

The CNBC reports,

The world’s top oil exporter, Saudi Arabia, appears to have cut both its oil production and export in December, according to the latest update by the Joint Organizations Data Initiative (JODI), an official source of oil production, consumption and export data.

The OPEC heavyweight saw production decline by 237,000 barrels per day (bpd) from three-decade highs of 10.047 million bpd in November, the JODI data showed on Sunday.

The draw-down was sharper for the actual amount exported, declining by 440,000 bpd, or 5.6 percent, to come in at 7.364 million bpd, the data also showed. The level would still be similar to exports after a steep ramp-up last June.

In its monthly report on February 10, the IEA put Saudi Arabia’s production number for December slightly lower at 9.55 million bpd, a disparity of 260,000 bpd versus the JODI data.

The actions of the Saudi Arabian government have profound implications.

Could it be that Saudi Arabia has been responding to the threat of Shale oil revolution? Recently Saudi halted a planned $100 billion expansion of productive capacity.

And considering that Saudi’s fiscal budget breakeven level stands at an equivalent of $90 oil, with current prices only marginally above the critical threshold, Saudi’s political stewards seem to anxiously sense of the growing risks to political stability or a threat to their grip on power. Hence the move to reduce oil production aimed at the preservation of the status quo or the incumbent welfare state.

Chart from Energy Insights

It could also be that Saudi’s reserve and production may also have reached a “peak”.

Last year, Wikileaks reported that cable correspondence by key officials from Saudi Arabia suggested that the kingdom may have bloated their estimated reserves by nearly 40%. Thus cuts in exports and production have merely been exposing the chicanery of oil politics.

The bottom line is that Saudi Arabia seems desperate to see higher oil prices.

So aside from production cuts, the bias for inflationary policies, the other alternative would be to promote a war on Iran using the obsession “with the need to prevent Iran getting nuclear weapons” as cover. The same applies to other autocratic Middle East oil producing welfare states.

Thus political languages conveyed by political authorities can be deceiving as they may not reflect on the realities intended.

As George Orwell warned,

Political language is designed to make lies sound truthful and murder respectable, and to give an appearance of solidity to pure wind

20 Signs of the Unsustainable US Nanny State

From The Economic Collapse Blog

The following are 20 signs that the culture of government dependence has gotten completely and totally out of control....

#1 If you can believe it, 48.5% of all Americans now live in a household that receives some form of government benefits. Back in 1983, that number was less than 30 percent.

#2 Way too many Americans believe that the government should just swoop in and solve all of their problems. For example, the plight of a single mother named Angel Adams made national headlines recently. Over the years her relationships with three different men have produced 15 children, and she was recently found living in a single motel room with 12 of those children.

As you can see in the video below, Adams is looking for the government to come in and rescue her. The following is what Adams told one reporter....

“Somebody needs to pay for all my children and my – for all my suffering. Somebody needs to be held accountable, and they need to pay.”

#3 The amount of money paid out to individual citizens by the government today is absolutely staggering. In 1980, government transfer payments accounted for just 11.7% of all income. Today, government transfer payments account for 18.4% of all income.

#4 According to a recent ABC News report, suicides in rural America are spiking, and experts say that cuts to Medicaid are partly to blame....

“Kathie Garrett, co-chairman of the Idaho Council on Suicide Prevention, says the problem has gotten only worse since the recession. "The poor economy and unemployment—those put a lot of stress on people's lives," she explains. To save money, people skip doctor visits and cut back on taking prescribed medications. Cuts in Medicaid have reduced the services available to the mentally ill.

"I personally know people who lost Medicaid who've attempted suicide," says Garrett.

#5 By the end of 2011, approximately 55 million Americans will receive a total of 727 billion dollars in Social Security benefits. In future years, this dollar figure is projected to absolutely skyrocket.

#6 When you total it all up, American households are now receiving more money from the U.S. government than they are paying to the government in taxes.

#7 It is being projected that the federal government will account for more than 50 percent of all health care spending in 2012.

#8 Back in 1965, only one out of every 50 Americans was on Medicaid. Today,one out of every 6 Americans is on Medicaid.

#9 According to the Congressional Budget Office, the Social Security systempaid out more in benefits than it received in payroll taxes in 2010. That was not supposed to happen until at least 2016.

#10 The federal government is expected to "take care" of their workers far better than the private sector does. If you can believe it, the average federal employee in the Washington D.C. area brings in total compensation worth more than $126,000 a year.

#11 Last year, federal employees "earned" approximately 447 billion dollarsin total compensation.

#12 Spending by the federal government accounts for approximately one thirdof the GDP of the entire Washington D.C. region.

#13 The federal government spent more than 50 billion dollars on "housing assistance" in 2009.

#14 The U.S. government now says that the Medicare trust fund will run outfive years faster than they were projecting just last year.

#15 The total cost of just three federal government programs - the Department of Defense, Social Security and Medicare - exceeded the total amount of taxes brought in during fiscal 2010 by 10 billion dollars.

#16 Right now, there are more than 45 million Americans on food stamps. That means that approximately one out of every seven Americans is dependent on the federal government for food.

#17 The number of Americans on food stamps has increased 74% since 2007.

#18 Sadly, one out of every four American children is now on food stamps.

#19 In 2010, 42 percent of all single mothers in the United States were on food stamps.

#20 According to one study, "64.3 million Americans depended on the government (read: their fellow citizens) for their daily housing, food, and health care" during 2009.

The following chart from Heritage Foundation shows that by 2049, Medicare, Medicaid and Social Security will consume 100% of taxes.

This excerpt from Professor Higgs (previously at quote of the day) has been so relevant…

As the ranks of those dependent on the welfare state continue to grow, the need for the rulers to pay attention to the ruled population diminishes. The masters know full well that the sheep will not bolt the enclosure in which the shepherds are making it possible for them to survive. Every person who becomes dependent on the state simultaneously becomes one less person who might act in some way to oppose the existing regime. Thus have modern governments gone greatly beyond the bread and circuses with which the Roman Caesars purchased the common people’s allegiance. In these circumstances, it is hardly surprising that the only changes that occur in the makeup of the ruling elite resemble a shuffling of the occupants in the first-class cabins of a luxury liner. Never mind that this liner is the economic and moral equivalent of the Titanic and that its ultimate fate is no more propitious than was that of the “unsinkable” ship that went to the bottom a century ago.

The laws of economics will not allow for its persistence, whereas beneficiaries will revolt over any cuts.

The ultimate end of the welfare state extrapolates to chaos or dystopia.

Investing in the PSE: Will Negative Real Rates Generate Positive Real Returns?

Easy money also helps the fiscal position of the government. Lower borrowing costs mean lower deficits. In effect, negative real interest rates are indirect debt monetization. Allowing borrowers including the government to get addicted to unsustainably low rates creates enormous solvency risks when rates eventually rise. I believe that the Japanese government has already reached the point where a normalization of rates would create a fiscal crisis. David Einhorn

We are living in interesting times.

Negative Real Interest Rate as Stock Market Driver

In the Philippines, interest rates have considerably been below inflation rates.

Banks like the BPI[1], offers yields anywhere 2-2.75% for 364 days on their regular time deposit account, depending on the size of the account (as of November 15 to 21), whereas statistical Consumer Price Inflation rate has reached 5.2% last October[2].

Most people don’t realize that real money returns for the Peso has been negative or that savers have been losing money in terms of reduced purchasing power.

Curiously, inflation rates are even higher than the yields of domestic government bonds, from 1 to 10 years in maturity. This implies that bondholders of 10 years maturity and below are also getting squeezed from the current negative real interest rate regime (chart from Asian Bonds Online[3]).

Aside, the steep yield curve likewise induces borrow-short lend-long activities or maturity transformation which implies of higher future CPI rates as banks are incentivized to expand lending.

And since the yield curve has been steep even from last year, we are seeing credit activities ramping up.

From the BSP[4], (bold emphasis mine)

Growth in outstanding loans of commercial banks, net of banks’ reverse repurchase (RRP) placements with the BSP, accelerated in September to 21.7 percent from the previous month’s expansion of 19.8 percent. Meanwhile, the growth of bank lending inclusive of RRPs slowed down to 18.9 percent from 24.8 percent in August. Commercial banks’ loans have been growing steadily at double-digit growth rates since January 2011. On a month-on-month seasonally-adjusted basis, commercial banks’ lending in September grew by 1.0 percent for loans net of RRPs, while loans inclusive of RRPs fell by 2.0 percent.

Loans for production activities—which comprised 84.2 percent of commercial banks’ total loan portfolio—grew steadily by 22.9 percent in September from 21.5 percent a month earlier. Growth in consumer loans likewise accelerated to 17.9 percent from 13.4 percent in August, reflecting the rapid growth in lending across all types of household loans.

The expansion in production loans continued to be driven largely by higher lending to electricity, gas and water (which grew by 56.3 percent); manufacturing (24.2 percent); real estate, renting and business services (26.1 percent); wholesale and retail trade (29.8 percent); financial intermediation (32.8 percent); transportation, storage and communication (19.3 percent); and construction (17.6 percent). Moreover, with strong global demand driving growth in the mining and quarrying industry, loans to mining and quarrying more than tripled in September from a year ago, sustaining the three-digit growth rate since May 2011. Meanwhile, contractions were posted in lending to three production sectors, namely, health and social work (-4.9 percent), education (-10.0 percent), and agriculture, hunting and forestry (-3.5 percent).

From a mainstream economic viewpoint this will be seen as a good sign.

Theoretically low interest rate should reflect on the time preferences of individuals, where the preference to consume goods later rather than now (lower time preference) means that there should be an abundance of savings available for investments.

According to Mises.wiki[5]

The act of saving is a means through which man can achieve his ultimate goal, which is bettering his situation. Saving implies giving up some benefits at present - this is the price paid for the attainment of the end sought. The value of the price paid is called cost, and costs are equal to the value of the satisfaction which one must forego to attain the end aimed at.

The return on savings must be in excess of the cost of savings. If the costs are too high - if savings can’t better an individual’s life and well being - then saving will not be undertaken.

Consequently, the return on savings must be above the premium for man to agree to save. A positive time preference (i.e., the existence of a premium) precludes the natural emergence of a zero interest rate. Should a zero interest rate be imposed, this will abort all savings and lead to the destruction of the production structure. The premium of having goods now versus having them in the future is getting smaller with the increase in their stock. This, in turn, means that the required return on savings will be lower. An increase in the pool of funding sets the platform for lower interest rates.

Apart from time preferences, the purchasing power of money and business risk are important elements in the formation of interest. However, their importance is assessed in reference to the fundamental factor, which is time preference.

However as pointed out above a policy induced boom from manipulated interest rates distorts the production structure which will be misdirected towards investments in capital goods (higher stages of production) that leads to a bubble cycle (Austrian Business Cycle Theory—ABCT).

As I wrote last week[6],

Although I am not sure which sector should give the best returns over the short term, I am predisposed towards what Austrian economics calls as the higher order stages of production or the capital goods industries, which are likely the beneficiaries of the business cycle, specifically, mining, property-construction and energy, as well as financials whom are likely to serve as funding intermediaries for these projects.

Interestingly, even the relative performances by different sectors in the PSE seem to coincide or reflect on the distribution of credit growth as noted by the BSP.

For this week, except for Financial-Banking sector, the best gainers have been the mining index, followed by the industrial (mostly weighted on energy and utility companies) and the property sector. Here I am comparing apples to oranges because of the variances of time considerations between the PSE sectoral activities and loan portfolio growth in the real economy.

Yet the outperformance of the mining sector in the PSE can likewise be accounted for in the tripling of loans to the mining and quarrying industry.

Overall, the point is that the accelerating credit growth in capital good industries such as in mining, real estate and construction, power and financial intermediation appears to corroborate the boom bust process.

Another fascinating observation is that negative real interest rates may have altered the composition of trading activities seen during the current cycle in the Philippine Stock Exchange (PSE).

In the 2003-2007 boom cycle, foreign investors had largely been the dominant force in the daily trading activities at the PSE. Today, local participants appear to have wrested that role.

And the ascendancy of local investors seems to have provided resiliency to the Phisix during the recent shakeout.

The implication is that negative real interest rates may have driven many savers to speculate on the stock market to eke out positive real returns.

Yet if holding cash and near term bonds generates negative real returns then where to put one’s resources?

Every investment competes for your money. There will always be a tradeoff for any choices we make. Investments would mean a trade-off in terms of risk-reward and on relative assets.

Market Risk: Debating The Role of the ECB

There is no such thing as a risk free investment as inculcated to us by media, the academe or by mainstream institutions.

The concept of “risk-free” has been impressed upon us to justify the institutional rechanneling of private savings via the banking system into funding pet programs of politicians. And part of the process has been enabled by banking regulations such as the Basel Accord.

Yet such masquerade is presently being exposed by the markets. The bond spread of Italy and France (relative to the German Bund) has soared to record highs[7] as shown in the above chart (chartoftheday.com).

To add, the cost to insure liabilities of AAA credit rating France is now higher than the Philippines or compared to ASEAN-4[8]. This means that the credit standings applied by the government licensed or accredited credit rating agency cartel does not accurately reflect on the credit risks by developed economies plagued by the unsustainable welfare state.

And because financial markets have been defying whatever the EU governments has been imposing such as credit margin hikes[9] on Italian bonds and ban on short selling of Italian stocks[10], credit rating agencies appear as being pressured to downgrade the AAA credit rating of France[11].

The economics of the marketplace has been reasserting her ascendancy against welfare based politics.

Yet political impasse over the role of the European Central Bank as the “lender of last resort” has proven to be a seething issue that continues to unsettled financial markets.

While some key officials such as German Chancellor Angela Merkel[12], ECB’s Mario Draghi[13] and IMF’s John Lipsky[14] were allegedly against the carte blanche backstop role for the ECB, there has been a growing clarion clamor for the ECB to aggressively support the bond markets from France and from political personalities such as former German Chancellor Gerhard Schroeder[15], Portuguese President Anibal Cavaco Silva[16] and many more.

One popular analyst have even called the ECB’s role as either to “Print or Perish” for the Euro, which resonates with the popular call to inflate. Little do these inflation advocates realize that historical accounts of currency destruction have hardly been about the “deflationary spiral” but more about serial episodes of hyperinflations and or wars[17].

For the ECB to rapidly and intensify inflationism would be to “Print and Perish”.

Nonetheless, print and perish has been the name of the game for global central bankers.

But the supposed political stalemate over the ECB’s role appears as “smoke and mirrors” for me.

That’s because in reality, the ECB along with rest of major Central Banks except the US Federal Reserve has been scaling up their asset purchases as shown by the above chart[18].

Since 2008, major central banks have been ramping up asset purchases which makes today’s developments as unprecedented or entirely unique in modern history. So there hardly can be merit to claims that we are bound for “deflationary spiral” for as long as central banks continue to inundate the world with the liquidity approach to contain what truly are insolvency issues.

The ECB has reportedly an undeclared €20 billion weekly limit of bond purchases[19]. I would conjecture that rules, laws, regulations, policies or self-imposed limits change according to the convenience and the interests of politicians.

And recent reports suggest that European banks have been unloading heaps of sovereign debt issues.

So EU banks have been taking the opportunity to transfer their supposed “risk free” securities to the ECB in order to rehabilitate their balance sheets.

And the desire for the ECB to take on a more aggressive role can be seen through the implied missives from this New York Times article[20],

The dynamic of falling bond prices also undermines the capital position of the banks, since they are among the biggest holders of government bonds in many countries. As those assets plunge in value, banks cut back on lending and hoard capital, increasing the likelihood of a recession.

All these money printing won’t be sucked into a financial black hole, as they will have to flow somewhere.

Yet despite the current turbulence, I think that the current volatility may be ignoring such dynamic.

As a final note, if events in the Eurozone should turn out for the worst, the local and ASEAN economies may not be immune from such disruption, which may affect the region’s stock markets.

As Gerald Hwang of the Matthews Asian Fund writes[21],

Asian fixed income markets can have heavy foreign participation in both bonds and bank loans. The amount of participation from European banks is noteworthy in light of their exposure to European debt and the probability of shrinking balance sheets in the near future. European bank lending into Asia is greater than U.S. bank lending in the region; therefore, weakness in European bank balance sheets may tighten the financing environment for Asia’s borrowers more so than similar weakness in U.S. banks.

While European banks do have material exposure on Asia, I wouldn’t call less than 25% as substantial enough to possibly rock the boat. But again this depends on general market sentiment. Also, any tightening of credit conditions by Euro banks may be used as an opportunity by non-European banks to expand their market share.

Market Risk: US ‘Sequester’ Spending Cuts Will Be a Nonevent

The Philippine Stock Exchange’s Phisix has been up 2.41% on a year-to-date basis and has outperformed the majors and other Emerging Market contemporaries. But it is important to point out that such outperformance has still been dependent on the ebbs and flows of global markets, particularly the US (SPX).

Over the past weeks, we seem to be seeing renewed weakness in Europe (STOX50), China (SSEC) and US S&P 500 (SPX).

So far the stock markets of the Eurozone has, I think, already priced in an economic recession given the current bear market status. The Stoxx50 is still 19% down from the February 2011 high. Yet should the ECB intensify the asset purchases or inflationism we should see European stocks pick up.

Further, I think that US stock markets will likely steer the global markets rather than that of the EU. This means that an ascendant US markets should likely bolster the bullish case of the Phisix and of the ASEAN-4 and vice versa.

Yet another worry being promoted by some of the bears is the brewing gridlock by Congressional super committee over spending cuts that would result to sequester rules or automatic spending cut.

The Wall Street Journal editorial says that such concerns are exaggerated[22],

Under the sequester rules, roughly half of the spending cuts would come from defense and homeland security, and the other half from domestic programs such as roads, education, energy and housing. An automatic cut from every federal agency is far from an ideal way to write a budget, because it sets no priorities and largely exempts the major entitlements like Medicare and Medicaid.

But the sequester does have the virtue of imposing reductions in spending that Congress rarely agrees to on its own. The Congressional Budget Office estimates domestic programs would take a 7.8% cut, while defense programs would get sliced by 10%. Medicare spending, mostly payments to providers, would fall by 2%. This would yield $68 billion in savings in 2013, and more savings in future years by ratcheting down the baseline level of spending.

Given the spending increases of recent years, those cuts are hardly excessive. Domestic programs received a nearly $300 billion windfall under the 2009 stimulus, so a sequester would take back a little more than one-fifth in 2013. Total domestic discretionary spending doubled to $614 billion in 2010 from $298 billion in 2000. Even if there were a 10-year $1.2 trillion "cut," total discretionary spending would still rise by $83 billion by 2021 because those cuts are calculated from inflated "current services" projections.

Essentially, the $1.2 trillion sequester spending cuts will be spread over 10 years, and as mentioned above will be apportioned mostly towards defense, homeland security and domestic programs which hardly tackles on welfare entitlement programs.

The sequester or automatic spending cuts extrapolates to a cut on the rate of growth spending rather than real or actual cuts as shown above[23].

This only means that risks from the supposed political gridlock won’t be anywhere as disastrous as portrayed by political fanatics.

For the US markets, the reaccelerating growth of money supply should filter into and continue to provide support to her stock markets and the economy.

This week, the US economy posted strong growth which apparently surprised the mainstream[24]. Of course we understand this to be inflation boosted growth.

Barring any unforeseen events, I think this momentum should continue.

A Short Note On Commodities

Commodity markets experienced intensified downside volatility last week which many blamed on the Euro crisis.

While the Euro crisis may have aggravated sentiment, my guess is that these have been largely related to the liquidation process being undertaken by the trustee committee handling bankruptcy of MF Global Holdings who incidentally filed papers to set up the required accelerated filing of claims a day before the selloff[25].

Gold oil and copper simultaneously fell the following day.

I earlier noted that this should be expected[26] last week but apparently has been deferred until this week.

And I think that once the proceedings culminate, the upside trend for the commodity markets should resume.

Bottom line: Negative real interest rates and expanding balance sheets of major global central banks will impact asset prices differently. Nevertheless such dynamic will continue to provide support to the Phisix-ASEAN equity markets and the commodity markets.

On the other hand, unless a massive collapse occurs, political developments particularly in the Eurozone should spice up market actions.

So my guess is that the current domestic environment of negative real interest rates should bode well for investors of the PSE.

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[1] BPI Expressonline Regular Time Deposit (Peso) November 15 to November 21, 2011

[2] Tradingeconomics.com Philippine Inflation rate

[3] AsianBondsOnline Philippine Government Bond Yields

[4] bsp.gov.ph Bank Lending Growth Expands Further in September, November 11, 2011

[5] Wiki.mises.org Saving and the Interest rate

[6] See Phisix-ASEAN Equities: Awaiting for the Confirmation of the Bullmarket, November 13, 2011

[7] Telegraph.co.uk Spread between French and German bonds hits record, November 9, 2011

[8] See Chart of the Day: France ‘Riskier’ than the Philippines, ASEAN, November 17, 2011

[9] Reuters.com MONEY MARKETS-Italian banks risk becoming dependent on ECB, November 10, 2011

[10] Reuters.com Italy to ban naked short-selling on stocks, November 11, 2011

[11] Guardian.co.uk Debts in France threaten top credit rating, November 15, 2011

[12] Bloomberg.com Merkel Rejects ECB as Crisis Backstop in Clash With France, November 17, 2011

[13] Washington Post, ECB leader Mario Draghi rebuffs calls for greater central bank role, November 19, 2011

[14] CNBC.com IMF’s Lipsky Backs Merkel Over ECB Powers November 18, 2011

[15] Reuters.com German ex-chancellor sees ECB steps in "last resort", November 18, 2011

[16] Bloomberg.com ECB as Lender of Last Resort Will Resolve Debt Crisis for Portugal’s Silva, November 12, 2011

[17] Hewitt Mike The Fate of Paper Money, January 5, 2009 DollarDaze.org

[18] Danske Bank, Bank of Japan on hold, still sees substantial downside risks November 16, 2011

[19] Reuters.com ECB has secret 20 billion euro bond-buying limit: report November 18, 2011

[20] New York Times Europe Fears a Credit Squeeze as Investors Sell Bond Holdings, November 18, 2011

[21] Hwang Gerald Capital Flows: Asia's Quiet Revolution Asia Insight November 2011 Matthews International Capital Management, LLC

[22] Wall Street Journal Editorial The Sequester Option, November 18, 2011

[23] Mitchell Daniel What Matters More to Republicans, Defending Taxpayers or Expanding Government?, November 18, 2011

[24] See Strong Performance of the US Economy Surprises the Mainstream November 19, 2011

[25] See MF Global Holding’s Liquidations and the November 17th Commodity Prices Rout, November 19, 2011

[26] See Client Accounts Transfer from MF Global Holdings may trigger Market Volatility Next Week, November 5, 2011