Bernanke’s Financial Accelerator Principle Suggests For More Rate Cuts

``A weak banking system grappling with non-performing loans and insufficient capital or firms whose creditworthiness has eroded because of high leverage or declining asset values are examples of financial conditions that could undermine growth.”- Ben S. Bernanke, The Financial Accelerator and the Credit Channel

So with financial markets and some economic indicators pointing towards emergent signs of deflation, this ultimately leads us to the probable responses of US monetary authorities from which the direction of global markets will be anchored.

The question remains: Will Mr. Bernanke & Co face the music and save the US dollar by allowing deflationary trends to permeate and segue into a full blown recession or will they undertake measures to prevent the economy from falling off the cliff by utilizing its monetary tools?

We have long argued that the US Federal Reserve is sensitive to financial markets more than the economy [see sensitive August 13 to 17 edition, US FEDERAL RESERVE Is Financial Markets Sensitive!].

Our thoughts has been that given the Paper Money US Dollar standard from which the world operates on, the US Federal Reserve will do everything it can to sustain the present monetary system, which has given Americans an undue advantage over the rest of the world by simply issuing promises to pay (dollar notes) in exchange for goods or services. Hence for us, the Fed’s unstated mandate is to forefend its main constituents (banking system) from a collapse. Forget moral hazard, it’s all about perpetuation of the system.

We have also shown in the past that since Central Banking has been introduced in the US in 1913, the Purchasing power of the US dollar continues to approach ZERO, a natural predisposition of all paper currencies, see August 20 to 24 edition [see In Defense of the Philippine Stock Exchange From Political Correctness].

The plight of the purchasing power of the US dollar not only reflects on the impact of the cumulative inflationary policies but also of the historical responses by the US Federal Reserve when confronted with a financial or economic crisis, where the tendency has been to sacrifice the US dollar at the altar of the Paper Money-US dollar Standard.

So aside from the need to rescue its major conduits to sustain the system, the Fed likewise recognizes the overwhelming dependence of US households on financial assets to sustain their consumption patterns, which further buttresses the case for more intervention.

We are here to discuss not on the merits but on the proposed action and potential effects to the markets. As we always say, markets reflect on policies imposed.

And this bailout would come in the form of various monetary tools that the FED possesses such as injecting liquidity or manipulating interest rates to possibly even intervening directly in the financial markets. And such is the reason why a contingent executive committee, commissioned by EO 12631 in March 18, 1988, called as the Working Group on Financial Markets exists, or otherwise known as the Plunge Protection Team.

“Helicopter Ben” was the moniker Mr. Bernanke garnered following his November 21, 2002 speech Deflation: Making Sure "It" Doesn't Happen Here advocating the use of unconventional tools to fight deflation at all costs.

In a recent speech (June 15, 2007) entitled “The Financial Accelerator and the Credit Channel” by Fed Chairman Ben Bernanke, it appears that our thesis has gotten even more validation.

From Mr. Bernanke (highlight ours), ``…financial conditions may affect shorter-term economic conditions as well as the longer-term health of the economy. Notably, some evidence supports the view that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator." Moreover, a fairly large literature has argued that changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission.”

Figure 4: St. Louis Federal Reserve: FED Funds Futures

In figure 4, from the Saint Louis Federal Reserve Fed futures have placed a rate cut of about 25 basis points this coming December.

So what this means?

Despite the hawkish tone of “no further cuts” from Fed Governor Randall Kroszner and St. Louis Fed President William Poole, the continuing stress in the financial markets will most likely spur the FED to cut in the next meeting (December 11) otherwise risk a meltdown in almost all asset classes.

Mr. Bernanke’s Financial Accelerator principle reveals of the incentives by the FED to support the financial markets. Hence, we are likely to see them slash another 50 basis points, especially if the US equity markets regresses back to its August lows or even activate emergency cuts prior to the meeting if the slump deepens or a crisis turns into full blown turmoil. Goldman Sachs’ Jan Hatzuis warning serves as an implicit signal to the Fed and to Treasury Secretary Henry Paulson (ex-Goldman Sachs CEO) of the need to insure their position. We do not believe this warning will be ignored.

Besides many of these FED officials had been talking incessantly about “inflation” even prior to the first rate cuts but suddenly voted in favor of cuts during the past FOMC meetings which goes to show how these officials lack the credibility by saying one thing and doing another.

Like any politicians or bureaucrats, the FED will protect its interests.

The Politics Behind The Peso

``The moment we want to believe something, we suddenly see all the arguments for it, and become blind to the arguments against it."-George Bernard Shaw

Again we can’t help but emphasize on what the history says; in all 60 years where the Peso devalued from Php 2 to a US dollar until its peak of Php 56.4 (or about 96% loss) in 2005, our export industry has NOT gained a hefty market share enough to navigate or steer our economy into Nirvana, which has remained sluggish all throughout the past 6 decades, as we discussed in our August 20 to 24 edition [see In Defense of the Philippine Stock Exchange From Political Correctness].

The point being that the function of price as represented by currency changes alone has not been a beneficial factor to our export industry simply because OTHER variables has led to our lack of competitiveness, ergo the seeming price inelasticity of our exports.

Whereas even if the Peso falls to Php 100 to a US dollar, it is not guaranteed that our export industry will recover without adequate reforms in the areas which has impeded on our capacity to compete. Those arguing on the elasticity of our export industry are simply suggesting of short term solutions again, notably through government interventions-a cure worse than the disease-without asking how such wretched conditions emanated from in the first place.

This fallacious linear way of thinking, “falling peso is good for exports” can easily be debunked using with Zimbabwe as an example. Because of Zimbabwe’s hyperinflationary depression has resulted to an inflation rate of 6,598% in August 2007 (BBC), the value of its currency has dropped like a stone from a cliff, where its official rate is at Z$30,000 to a US dollar, but in the unofficial “black markets” are trading at (VOA) Z$1 Million to a US dollar! In effect, Zimbabwe, given such grotesquely skewed premise, should be the WORLD’S LEADING EXPORTER! Duh!

When reforms are made to reflect on the capacities to compete in the market, then prices come into play depending on the level of products produced and to which markets they are sold to, here the cost efficiency and productivity factors would play the leading roles. Hence, addressing these factors requires no short term solution where eventually currency markets should reflect on its true price levels.

As you have seen in Figure 4, the entire region has appreciated against the US dollar in relative terms. So if one argues about pricing in terms of currency adjustments, ALL Asian countries have generally seen their export pricing costs climb. This holds true for most of the rest of the world. So the argument of losing export market share is entirely out of context.

It is not the issue of the Philippines versus the US alone; in the global trade dynamics, it is the issue about the US dollar falling against most global currencies.

To likewise expose such misleading grounds, exporters can always hedge their exports via currency forwards, which if I am not mistaken are also offered by domestic banks. That is why financial markets need to generate more sophistication and deepening, so as to allow our investors alternative sources of financing or acquire additional capabilities to hedge their risks. A natural outcome of a well functioning market is for our industries to achieve increased efficiencies and heightened competitiveness.

Looking at the context of statistics, our external trade has been a less significant factor if based on our 2^nd quarter GDP’s computation, by expenditure at current prices (NSCB). Private consumption accounts for about 70% of the GDP, followed by capital formation 15% and government consumption 11%. Net exports (Exports- Imports) account for only .1% of the GDP. This means that both exports and imports are almost at parity with the exports having a slight edge (both 42% of GDP), hence the net exports.

Of course, what the market critics wants to say is that the government needs to protect these groups by intervening in the markets. And the unseen part is that intervening eventually translates to balance sheet losses by our (BSP) Bangko Sentral ng Pilipinas which would imply to future actions of selling assets to cover deficits. Exhausting all available assets for sale extrapolates to either incurring more debts or printing more money or increasing taxes, whose side effects would mean losing purchasing power over the longer horizon aside from again the loss of competitiveness.

The desire to help a select group over a popularly themed perceived inequality over the short term means sacrificing the future for the benefit of a few.

The following excerpt reflects on the sentiment of domestic businessmen on the perceived factors which inhibits the country from attaining competitiveness (Businessworld), ``But from a list of 14 "factors for doing business," senior business executives in the poll selected corruption, inadequate supply of infrastructure, policy instability, an inefficient government bureaucracy, and "government instability/coups" as their five top concerns.

``Others include stiff taxes and complicated tax regulations, lack of access to financing, restrictive labor regulations, crime and theft, poor worker ethics, and inflation.” (highlight ours)

Our guess is that inflation which rank last seems so because it is the least understood among the lay people. However, generally stated, the frustrations emanate from again misdirected and distortive (inflationary) policies, which have been the main cause of our present plight. Yet ironically, these experts have been urging our officials to apply the same measures with which had caused them in the first place. It’s like giving an alcoholic his next bottle of gin.

Just take the account of remittances; bleeding hearts say that since remittances accounts for about 10% of the economy, it makes up a big portion of private consumption. And since it is a big part of our consumption it should be subsidized by a weak peso.

We wrote NSCB to ask for an estimated figure from which remittances contributes to this share. Apparently since I made the initial query two weeks ago and they have not responded, our guess is that they have no precise figure for such claims. Previously our requests were promptly responded for, not this one though.

The implication is while remittances do vastly help the GDP, rising currencies ex-Peso or a falling peso should help in the purchasing power of those who benefit or the supposed “majority”.

Again, the deceptive linear logic, “falling peso=greater purchasing power for OFWs=the better economy”, yet nobody says anything about higher future consumer prices, an offshoot to such policies.

First of all, if remittances account for 10% of GDP then apparently 90% of the other sectors are also there to deal with. When has the “popular” 10% been greater than the “unheralded” 90%?

Second, even assuming that the OFW’s beneficiaries constitute a big portion say a majority of our consumer spending power today, it is not spending that helps our economy but generating savings and channeling them into investments. The assumption that consumer spending has a multiplier effect is a dubious one. Even if we send half of our population abroad, if the country does not generate enough investments we are unlikely to improve and remain as we are today.

From Dr. Frank Shostak of the Ludwig von Mises Institute (emphasis ours),

``What gives rise to the expansion of real wealth is the expansion in the pool of real savings. It is real savings that funds the making of various capital goods i.e. tools and machinery. In short, it is real savings that sustain various individuals that are engaged in various stages of production. All that money does in all of this is to provide the facility of the medium of the exchange. It makes it possible for individuals to exchange goods and services. The services of money are not enhanced on account of its greater supply. If anything the increase in the supply undermines the services of money. After all when people’s demand for money rises they don’t want more money as such but rather more purchasing power, it is the increase in the purchasing power of money that makes goods and services more marketable. The increase in the supply of money only prevents an increase in the purchasing power of money from taking place.”

Third, all you have to do is look at the Peso for empirical evidence; has 60 years of devaluation and greater OFW exports resulted to a better economy??? I think the answer is quite evident for those who are wise enough to see the truth. Besides, OFW flows are likewise levered to global growth. In general, if global growth slows substantially so will the flow of OFWs and the remittances. Mexico’s remittance flows, which has been levered to the US economy, has started to slow (MSNBC).

Fourth, there is also the unseen implication of money flows, where under a falling peso, OFWs tended to delay remittances in the hope of garnering more “purchasing power”.

Investors are seen in the same light, under a falling peso, capital flight is the common option. People invest in the US dollar instead of the Peso investments. How can withholding money or investing in ex-Peso assets by resident investors benefit the economy?

If there is one domestic reason why we specialize in exporting labor, aside from globalization/demographic trends, is the belated effect of policy outcomes or the law of unintended consequences. It seems that we never learn.

Finally some pertinent quips from US presidential aspirant Ron Paul on currency manipulation (from Mish Shedlock),

``[The answer] is inflate the currency. They don't say inflate the currency, they don't say debase the currency, they don't say devalue the currency, they don't say cheat the people. They say lower the interest rates.'"

``And you never tell them 'the only way you can lower the interest rate is to create more money'. I see this as the problem we don't want to talk about…

``We ignore the fundamental flaw and that is not only have we had a subprime market in housing, the whole economic system is subprime in that we have artificially low interest rates. This has been going on for 10 years or longer and now we are bearing the fruits of that policy… The real deception is when we distort the value of money, when we create money out of thin air…. So my question boils down to this: 'How in the world can we expect to solve the problems of inflation, that is the increase in the supply of money, with more inflation.” (highlight ours)

In essence most of the policy makers, political demagogues and anti-market experts have the all same solution to the very problem from which was created; inflate the system, distort the markets, benefit from it (by being a part of the bureaucracy or the special interest/parallel groups), feed the public with the scraps of money and cry inequality! That is what personality based rent seeking politics is all about.

As they say in France, “plus ca change, plus c'est la meme chose” or in English, the more things change the more they remain the same.

In Defense of the Philippine Stock Exchange From Political Correctness

Now when markets become an instrument for POLITICAL CORRECTNESS we are compelled to respond.

Where the allegation is…

In rising markets, the rich benefits with a miniscule “trickle-down-effect” to our economy…

In falling markets, the poor ‘non market participant’ gets clobbered by losses transmitted by changes in financial conditions…

While the rich is implied to remain “rich” or “unaffected” by the reversals of financial fortunes…

Of course, the obvious implication here is that the financial markets including the PSE becomes an agent of “inequality”, where gains are limited to a select few while losses ripple across the country.

First, our response on the issue of losses…

In absolute terms, a LOSS is a LOSS is a LOSS…regardless of economic status!

Let us put that in an OBJECTIVE perspective…

In 1997 as we previously described, the Phisix fell by 70% in the wake of the 1997 Asian Financial Crisis from 3,400 to about 1,000. Then, whether one’s investment was Php 100 million, 1 million or 10,000 pesos, in absolute terms a 70% write off is a loss of Php 70 million, Php 700,000, or Php 7,000 respectively!...

Regardless of how one views the RELATIVE VALUE of money or…

Regardless of the wealthy’s “reserve” status (besides how can we categorize or know about the depth of their vaults?).

What we want to emphasize is that, losses DO NOT DISTINGUISH between people attired in COAT AND TIE or those wearing only tattered SANDOS, SHORTS AND SLIPPERS. Anyway, should there be one?

Second, is the issue of categorization; how certain are we that the “wealthy” dominates stocks investing?

Are we talking of Peso investment volume per capita or the average net worth of the average investor? Does the PSE have a data on such demographic make up?

What's more, investing in the stock market is NOT an exclave reserve for the “rich” since a neophyte or practically anyone from any income stratum can buy stocks for less than P 10,000.

To suggest another angle, what if LOCAL INSTITUTIONS and not retail investors dominate the Peso volume of trades? How does one classify them? Are they still part of the cyclically “immune” much loathed “Elite” brigade?

How about FOREIGN MONEY, are they also part of the complicit team of “inequality drivers” too?

Anyway, RISING markets DOES have the tendency to attract a wide variety of investors, again regardless of social status (one can just look at China.)….

When lower income levels troop into the market, STATISTICALLY you can bring down the averages…oops, remember the Gaussian Curve?

Does a population of more retail investors AUTOMATICALLY EQUATE to “wealthy” class of investors dominating our stock market trades? Not necessarily I suppose...

What we are trying to painstakingly point out here is…unwarranted POLITICALLY COLORED sweeping conclusions have been punctured with a lot of observational biases…

Nicolas Nassim Taleb, in his book Black Swan, the Impact of the Highly improbable, calls this kind of cognitive bias as the ROUNDTRIP Fallacy….

The flawed circular logic goes something like this, “the RICH profits from the STOCK MARKET, the STOCKMARKET is for the RICH”…

Or simply, the UNFAIRNESS of stereotyping!

Where the driver of my broker, invests in the market, I presume that he must also be “Rich”!

The third point is the issue of “market prompted inequality”.

For an economic class to assumingly reap the benefits from a collective activity it implies uniformity of actions, which is hardly the case.

One should realize that being rich and a rising market is NO guarantee of stock market investing success!

We should remember that every security yields a different price and varies in the degree of volatility…

Remember those “Greek” letters in “Alpha”, “Beta” and etc…

Then there are different perceptions and set of actions from different market participants on how to manage their portfolios…

Together these variables combine to facilitate the trades in the stock market.

But like every type of enterprise or even careers, there would always be winners and losers. Of course, rising markets are likely to produce more winners than otherwise and vice versa.

And this equation is UNIVERSAL to the investment spectrum…or in any other entrepreneurial endeavor….

Be it investments in tourism projects, schools, restaurants, computer shops, sari-sari stores, farming, or others.

Under ALL types of markets (financial or otherwise), the accurate anticipation of future events coupled with the corresponding action determines the success of an investor (regardless of economic status), unless the participant is a government sponsored entity such as the hybrid “sovereign wealth funds”.

``Like every acting man, the entrepreneur is always a speculator. He deals with the uncertain conditions of the future. His success or failure depends on the correctness of his anticipation of uncertain events. If he fails in his understanding of things to come, he is doomed. The only source from which an entrepreneur's profits stem is his ability to anticipate better than other people the future demand of the consumers. If everybody is correct in anticipating the future state of the market of a certain commodity, its price and the prices of the complementary factors of production concerned would already today be adjusted to this future state. Neither profit nor loss can emerge for those embarking upon this line of business.”- (highlight mine) Murray Rothbard, the Market, Man, State and the Economy

You see, under such conditions, even the “POOR”, which supposedly is a “victim” of the market fluctuations, can benefit from the stockmarket! One must remember, RISK TAKING IS ESSENTIAL TO WEALTH CREATION! In other words, markets provide the opportunities for ANY SOCIAL CLASS to benefit either from LUCK OR SKILLS, which in itself is a GRAND EQUALIZER.

On the other hand, to even entertain the thought of a “class struggle” presupposes the contrary; the “POOR” CANNOT BENEFIT from the markets. This seems to be dangerously discriminatory since it essentially DENIGRATES their capacity to think (anticipate) or even be lucky. So such assumption is UNDEMOCRATIC and sows the seeds of further INEQUALITY.

This leads us to the final point of our contention: The true source of Inequality.

Putting the blame on the markets for economic inequality is truly unfortunate and strays from the root of the issue.

As we have noted above, inflation is the core to society’s inequalities.

Again let me lengthily quote the illustrious economist Henry Hazlitt, in his book “What You Should Know about Inflation” (highlight mine),

``Inflation never affects everybody simultaneously and equally. It begins at a specific point, with a specific group. When the government puts more money into circulation, it may do so by paying defense contractors, or by increasing subsidies to farmers or social security benefits to special groups. The incomes of those who receive this money go up first. Those who begin spending the money first buy at the old level of prices. But their additional buying begins to force up prices. Those whose money incomes have not been raised are forced to pay higher prices than before; the purchasing power of their incomes has been reduced. Eventually, through the play of economic forces, their own money-incomes may be increased. But if these incomes are increased either less or later than the average prices of what they buy, they will never fully make up the loss they suffered from the inflation.”

``Inflation, in brief, essentially involves a redistribution of real incomes. Those who benefit by it do so, and must do so, at the expense of others. The total losses through inflation offset the total gains. This creates class or group divisions, in which the victims resent the profiteers from inflation, and in which even the moderate gainers from inflation envy the bigger gainers. There is general recognition that the new distribution of income and wealth that goes on during an inflation is not the result of merit, effort, or productiveness, but of luck, speculation, or political favoritism. It was in the tremendous German inflation of 1923 that the seeds of Nazism were sown.”

``An inflation tends to demoralize those who gain by it even more than those who lose by it. The gainers become used to an "unearned increment." They want to keep their relative gains. Those who have made money from speculation prefer to continue this way of making money instead of working for it.”

In other words, subsidies, bailouts (which includes the market’s expected FED cuts (!) or Bill Gross’ suggestion for Fiscal Policy rescue package or Willem Buiter’s proposal for the Fed to act as a “market maker of last resort”), social welfare, wars, price control, dole outs (aids, grants, etc…), taxes or other redistributive programs fundamentally TRANSFER RESOURCES FROM PRODUCTIVE TO NON-PRODUCTIVE activities are inflationary in nature, because they tend CONSUME capital.

Burned capital signifies “SUNK COSTS” from which taxpayers would have to shoulder at the end of the day, despite the other ephemeral options of borrowing and printing money.

Figure 6: American Institute for Economic Research: US Dollar’s Purchasing Power

Figure 6, courtesy of the American Institute for Economic Research reveals of what inflation does to the public—the LOSS OF PURCHASING POWER or it lowers the standard of living for its citizenry!

As an example, the US dollar’s purchasing power plunged by 95% since the FED came to being in 1913 that’s according to the US Bureau of Labor and Statistics. You can check on website’s INFLATION CALCULATOR via the provided link…where $100 today has the same buying power of only $4.75 in 1913!

Figure 7: BSP: Peso-US dollar Rate: The Peso’s Anguish

In the same context, see figure 7, the Philippine Peso’s foreign exchange value relative to the US dollar fell from 2.733 in 1960 to 51.3143 in 2006 (BSP-thanks Vina)! During the same period, the US dollar’s purchasing power lost 85%, which even AMPLIFIES the loss of the Peso’s Purchasing Power! Yet in contrast to the claims where a LOWER PESO will help jobs or the public simply has not been supported by evidence.

By logic, we should have been one of the top exporting countries by now if PRICE ALONE, as reflected by the currency, had been the key measure of success…but where (see Figure 8)?

In practice, as any entrepreneur knows, price, while important, is NOT the only factor that shapes business transactions. Consider labor cost, China’s export might is often attributed to its low labor cost, but this is not entirely accurate, because Africa has even cheaper labor costs, so they should have been the export leaders, but not- because they suffer from other aspects of impairment such as the lack of infrastructure to security to governance concerns which increases the cost of doing business.

So after four decades of peso devaluation which area of trade have we then topped? Yes, you guessed it right again…human exports! Why? Because of our depressed standards of living as a consequence to the enormous purchasing power gap relative to the developed world prompted the LARGE SCALE EXPORT OF OUR CITIZENRY instead of goods of services! Essentially, an arbitrage of income disparities even in the Labor markets!

Figure 8: Yardeni.com: Exports Benefit from Lower Peso?

On the other hand, instead of the increased market share and profits via efficiency and productivity gains aided with lower prices, as our neighbors, what we saw is the opposite: MOUNTING HOMEGROWN INEFFICIENCIES aggravated the loss of competitive edge for our enterprises, which reduced our standards of living, discouraged productive risk taking ventures which thereby brought about the present outbound migratory trends.

The financial markets are to blame? In all 47 years until today, the domestic financial markets remain a small segment of the economy (see below: Stock Market: Boon or Bane to the economy?).

So, again despite the tremendous loss of purchasing power transmitted via the declining PESO-US dollar exchange during the past 47 years, why is it our economy remains uncompetitive and still mired in poverty?

In effect, the issue of inequality is LARGELY an OFFSHOOT to persistent government interventionist activities and does NOT emanate from the markets. The markets or financial conditions simply reflect on such policies, whether internally generated or from external influences.

To quote Milton Friedman anew, “There is no FREE LUNCH”.