Poker Bluffing Booby Traps: PIMCO And The PIIGS

``…the state consists not only of politicians, but also those who make use of the politicians for their own ends; that would include those we call pressure groups, lobbyists and all who wrangle special privileges out of the politicians. All the injustices that plague "advanced" societies, are traceable to the workings of the state organizations that attach themselves to these societies.”-Frank Chodorov, Gentle Nock at Our Door

The mainstream is loaded with booby traps.

Without critical thinking it would be easy for anyone to get entranced or fall victim to the metaphorical enchanting ‘songs of the Sirens’, as in one of Odysseus’ tests in his voyage home to Ithaca.

PIMCO’s Bill Gross: Do What I Say, Not What I Do

Basically a major objection to an upside market is that policy reversals from central banks are likely to lead to a withdrawal of liquidity, thereby adversely affecting market outcomes.

Here are some examples:

Pimco’s Bill Gross: ``if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009. It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this “juice” was being squeezed into financial markets. If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy.”

From John Maudlin: ``The Fed is going to stop the music in March. There will be a scramble for the chairs. This is a huge experiment with no precedent.”

The World Economic Forum chimes in, ``The risks of a sovereign-debt crisis, asset-price-bubble collapse and a hard landing for the Chinese economy will be high on the agenda of global leaders convening in Davos, Switzerland, for the World Economic Forum this month…

``The report found a collapse in asset prices to be the most severe and likely risk, amid concerns that the weak dollar and low global interest rates could fuel a liquidity-driven, rather than debt-driven, bubble.”

Note: Either the journalist here misquotes the authority interviewed or the authority doesn’t understand that liquidity is driven by debt.

In contrast, Morgan Stanley analyst Manoj Pradhan argues that liquidity won’t get affected by the reversal of policies, (bold highlights mine, italics his)

``Barring a major policy error, the exit from ultra-low interest rates should not mean a removal of accommodative monetary policies. The GCB [Global Central Bank] is unlikely to move rates back to neutral in 2010 - and there appear to be no dissenters on this ‘vote'. As the experience of front riders in the monetary peloton has shown, sharp interest rate hikes when major central banks are still in expansionary territory creates headwinds via currency appreciation and reduced policy traction in asset markets. Very few of the smaller economies will be able to hike aggressively, given these headwinds and weak export sectors in 2010, while monetary policy in the larger economies will be constrained by the BBB recovery. Thus, the ‘AAA' liquidity cycle (ample, abundant, augmenting) is likely to remain largely intact in 2010. The slow exit to a relatively less expansionary stance and the arrival of a sustainable recovery will be a key combination that will support growth and asset prices, in the G10 and even more so in emerging markets.

David Kotok of Cumberland Advisors has what I think the better perspective,

``In our opinion, we think the Fed is now trapped.

``By becoming the buyer of last resort, the Fed has now impacted the markets in such a way that the very idea that it may withdraw has caused mortgage interest rates to rise. Markets aren't dumb, and they realize that rates will rise, for two reasons. First, if the supply of funds to Freddie and Fannie stops with the Fed's purchases, then home-mortgage interest rates will have to rise. Moreover, they will rise even further if the Fed starts selling its existing securities into the market. What this also means is that the interest-rate risk associated with any future increases in interest rates will be shifted from the private sector to the Fed and ultimately the taxpayer – and this risk will grow as the Fed begins to unwind its current low-interest-rate policy.” (bold emphasis mine)

In other words, like us, Mr. Kotok believes that markets have essentially been propped up by the Fed and “exiting” the market could prompt for unwarranted uncertainty and result to increased volatility. Hence, Mr. Kotok prescribes a more transparent and credible strategy to alleviate the ‘exit risks’, as well as, raising reserve deposits to mitigate any incidental upsurge of the risks of inflation.

It’s true that markets aren’t dumb, but they haven’t been negatively reacting to the alleged ‘exit risks’ either, which is due on March. Maybe it’s because the Fed still covertly supports the stock market [as argued in Politics Ruled The Market In 2009].And importantly, markets aren't representative of their actual state, instead they represent distorted markets from massive interventions.

Moreover, it would also be quite naïve to think that Fed Chair Ben Bernanke or the US Federal Reserve backed by its huge platoon of economists and the sundry of employed experts, aside from their extensive network of allies in Wall Street or in the academia, are nitwits.

What we are suggesting is that these concerns are apparently NOT out of bounds for the Fed officials or authorities including Mr. Bernanke.

They know it.

On the contrary, asset prices seem to exhibit the top concern in the scale of priorities for authorities. And this has been flagrantly echoed by the official from the World Economic Forum, `` a collapse in asset prices to be the most severe and likely risk”.

They see it.

In short, global officials appear to prioritize the asset market dimensions as we have been arguing for the longest time.

They’d most probably act on it.

Hence, the other way to read the insights from Wall Street mainstays as Bill Gross is that they’re engaged in a psy-war, or particularly reverse psychology.

Being a political entrepreneur, who have constantly benefited from policy maneuvers by their central bank, one can’t ignore that the current missive by Mr. Gross signifies as tacit appeal to Ben Bernanke for maintaining or even expanding current policies.

Mr. Gross seems to be an avid adherent of the recent Nobel Prize winner and Keynesian high priest Paul Krugman, who proposed last December that the Federal Reserve should buy $2 trillion MORE of assets to jumpstart credit!

In other words, many of the talking heads seem to operate like masquerading propagandists, whose overall agenda have been cosmetically dressed up or disguised as ‘analysis’.

In putting money where his mouth is, Mr. Gross’ PIMCO has actively been expanding its global equity exposure by incorporating emerging market specialists (‘pirated’ from the top notch Franklin Templeton firm) to its team.

According to citywire.co.uk, ``The group is also going on the offensive in the equity space, last month hiring leading global equity fund managers Anne Gudefin, Charles Lahr and Neel Kashkari from franklin Templeton to improve its level of expertise in the area.”

Moreover, PIMCO pared its holdings of US and UK debt and appears to have switched into Southeast Asia’s sovereign debts!

So if Bill Gross sees an ominous reckoning for 2010, ``If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy”, then why has he been aggressively expanding on his global equity-bond markets to even add Southeast Asian debts on his portfolio mix?

Apparently actions don’t match with rhetoric.

This category of bluffing appears to reinforce our thesis discussed last week. [see Poker Bluff: The Exit Strategy Theme For 2010].

The PIIGS Bogeyman

Another objection recently brought up has been the possible risks of contagion from Europe’s crisis affected PIIGS-most notably Greece, (as Ireland has reportedly been coping positively with present austerity policies).

I would place such “concern” in the same category of the Dubai Debt Crisis, as it would seem more of a political than of an economic/financial problem [see Why Dubai’s Debt Crisis Isn’t Likely THE Next Lehman].

Yet again this would seem to uphold my contention that today’s trend will be more on political bluffing aimed at perpetuating inflationary policies.

This fabulous excerpt from Danske Bank’s Fixed Income Research team (all bold highlights mine),

``Moody’s sent out a report on the European Sovereign outlook on Wednesday, in which they argue that countries such as Portugal and Greece could be facing a “slow death” as higher debt costs will cause the economies to “bleed” economic potential. Hence, a large part of the future public revenues would have to be spent paying off the debt rather than on welfare etc. Moody’s thinks that the risk of a “sudden death” is negligible, but warned that the countries have to act and do NOT have an open window indefinitely in order to restore public finances. Moody’s highlighted Greece, saying that it would have significantly less time than Portugal. Hence, if the forthcoming fiscal austerity plan from Greece is not considered to be sufficient, then Moody’s is very likely to downgrade Greece, and this will bring Greece closer to ECB’s temporary threshold of BBB-, as the other rating agencies will also act. Portugal tried to distance itself from Greece…

``Furthermore, the current rating threshold is only temporary and is valid until the end of 2010, and we do not think that Greece will have been able to stabilise its finances such that its rating will be at or above A-. The risk of Greece not being able to use its government bonds as eligible collateral was highlighted at yesterday’s ECB meeting. Here, Trichet said that ECB “would not change its collateral rule for the sake of any particular country”, although on the question as to whether Greece or any other country could leave the Euro area, Trichet replied that "I do not comment on absurd hypotheses".

What’s the article been saying?

For Greece, it means ‘Heads I win, Tails you lose’, a bailout is in order. Just look at Trichet’s statement, the dice is loaded for a Greece rescue.

Why?

Because the European Central Bank (ECB) is likely to suffer more from the ripples of a withdrawal (unlikely expulsion) which appear likely to risk materially undermining the political and monetary significance of the European Union.

More proof?

The ECB has recently issued a report on the prospects of a withdrawal or expulsion from ECB based on the LEGAL aspects,

Here is the Wall Street Journal Blog (all bold emphasis mine), ``Written by the ECB’s legal counsel, it notes that “recent developments have, perhaps, increased the risk of secession (however modestly), as well as the urgency of addressing it as a possible scenario.”

``It concludes that unilaterally withdrawing from the European Union “would not, as a matter of public international law, be inconceivable, although there can be serious principled objections to it; and that withdrawal from EMU without a parallel withdrawal from the EU would be legally impossible.”

``As for expulsion, “the conclusion is that while this may be possible in practical terms — even if only indirectly, in the absence of an explicit Treaty mechanism — expulsion from either the EU or EMU would be so challenging, conceptually, legally and practically, that its likelihood is close to zero.”

“Absurd hypotheses, legally impossible and close to zero” reverberates as strong political phrases which seem to reinforce our view that the obvious course of political action will be a bailout of Greece.

Yet even assuming the worst scenario that if Greece were to withdraw, considering its present financial and economic state, the most likely actions that she would undertake would be similar to the others-inflate by devaluing its resurrected currency, the drachma.

So it would be just a matter of WHO does the inflating, the ECB or Greece.

Of course the ECB bailout would come with the attendant ‘disciplining chastisement’ policies which mostly likely would signify melodious political leadership face saving soundbytes.

Besides, PIIGS sovereign debts account for only 38% of the Euro denominated Government Debt securities as of November 2009 as per the ECB. The biggest exposure would be Italy (20.16%) and Spain (12%) the balance spread between Ireland (1.506%), Portugal (1.91%) and Greece (2.43%).

Finally, if one were to argue that the hubbub over Greece should translate to a contagion, we should be seeing rising default risks in the credit standings of broader Europe (see figure 5)

Figure 5 Danske Bank: Smooth Credit Ratings Still Intact, Peak In Default Risks

Apparently this has not been the case, as seen in the iTraxx Europe CDS (left window) which consists of 125 investment grade companies, the iTraxx Crossover CDS (middle window) which comprises of 50 sub-investment grade credits and the default rates of Europe and the US (right windows) which appears to have peaked as measured by Moody’s and Danske Bank.

Like in last week’s article, I wouldn’t be calling on their bluff. Neither should you.

Desperately Looking For Normal-In Pictures

Here is another demonstration of how massively disconnected the stock markets are with conventional fundamentalism (e.g. economy or earnings)-which is the reason why many "experts" have been utterly perplexed.

Russia's RTSI had been one of the top world performers for 2009 and produced 129% in local currency gains!


The conventional thought have been that stocks function as forward looking indicators for the economy with about a window of 4 to 6 months ahead.

Yet the Russian economy has wobbled ALL throughout last year as shown below from US Global Investors.


According to US Global Investors, ``Russian GDP contraction is estimated to decelerate to -5.3 percent in the fourth quarter compared to -9.8 percent in the third quarter. The beginning of economic recovery as well as the base effect means a substantial upside to 3-4 percent growth estimate in 2010."

The RTSI spiked by another astounding 8% this week!

More.

In our recent post, Venezuela's Path To Hyperinflation we noted that despite the recent crisis-massive devaluation and electricity rationing-Venezuela's stock market benchmark, the IBVC, soared by a whopping 10.85% this week!

Chart From Bloomberg

No, it isn't that Venezuela is immune or crisis proof.

Instead it is likely that we are witnessing accelerated signs of the demonetization process or the trajectory towards hyperinflation.

Bottom line: the common denominator appears to be massive inflationism and how these has mangled economic calculation and has thus resulted to unexpected volatility.

Global Political Freedom Backslides, Asia Improves

Speaking of freedom. It has generally been a bad news for global political freedom.

The Economist recently observed that recent trends reveal of a general deterioration of political freedom even prior to the crisis. This means that many countries have turned inwards.


From the Economist (all bold highlights mine)

``Political rights and civil liberties around the world suffered for the fourth year on the trot in 2009, according to the latest report published by Freedom House, an American think-tank. This represents the longest continuous period of deterioration in the history of the report. The number of electoral democracies dropped from 119 to 116, the lowest figure since 1995. Six countries were downgraded: Lesotho to partly free and Bahrain, Gabon, Jordan, Kyrgyzstan and Yemen dropped into the “not free” category. Around a third of the world’s population live in countries deemed not free, although over half of these live in China. In the Middle East and North Africa 70% of countries are not free. Still, freedom was on the march in 16 countries, notably in the Balkans, where Montenegro is now considered free, and Kosovo is partly free."

The chart below shows of the distribution pie of the world's political freedom according to Freedomhouse.org

And here is the 20 year trend of the global political freedom.

Notice that the surge of nations that assimilated political freedom was during the 90s. This coincides with, if not signifies as the aftermath of the fall of the Berlin Wall and India's liberalization.

And global political freedom appears to have climaxed during 2004-2005.

Nevertheless, as mentioned above, the marked declines had been accounted for by marginal emerging market states, so the loss in political freedom may not be as significant relative to economic contribution.

According again to Freedomhouse.org

(all bold highlights mine)

``In this year’s findings, five countries moved into Not Free status, and the number of electoral democracies declined to the lowest level since 1995. Sixteen countries made notable gains, with two countries improving their overall freedom status. The most significant improvements in 2009 occurred in Asia.

``The Middle East remained the most repressive region in the world, and some countries that had previously moved forward slipped back from Partly Free into the Not Free category. Africa suffered the most significant declines, and four countries experienced coups.

``This year’s findings reflect the growing pressures on journalists and new media, restrictions on freedom of association, and repression aimed at civic activists engaged in promoting political reform and respect for human rights.

“In 2009, we saw a disturbing erosion of some of the most fundamental freedoms—freedom of expression and association—and an increase in attacks on frontline activists in these areas,” said Jennifer Windsor, Executive Director of Freedom House. “From the brutal repression on the streets of Iran, to the sweeping detention of Charter 08 members in China and murders of journalists and human rights activists in Russia, we have seen a worldwide crackdown against individuals asserting their universally accepted rights over the last five years.”

In other words, despite the bad news there have been some noteworthy improvements.

And consistent with recent accounts that exhibits a trend towards adapting more economic freedom [see Asia Goes For Free Trade], Asia seem to defy withering concerns of political freedom.

Here is how political freedom in East Asia is classified (green -free, yellow partly free and blue-not free). Again from Freedomhouse.org

This implies that for political freedom (civil liberties and political rights) to flourish via representative governments requires economic freedom to similarly blossom.

Why?

The preeminent economist Milton and wife Rose Friedman provides the answer:

``Economic freedom is an essential requisite for political freedom. By enabling people to cooperate with one another without coercion or central direction, it reduces the area over which political power is exercised. In addition, by dispersing power, the free market provides an offset to whatever concentration of political power may arise. The combination of economic and political power in the same hands is a sure recipe for tyranny.

``The combination of economic and political freedom produced a golden age in both Great Britain and the United States in the nineteenth century. The United States prospered even more than Britain. It started with a clean slate: fewer vestiges of class and status; fewer government restraints; a more fertile field for energy, drive, and innovation; and an empty continent to conquer. . . .

``Ironically, the very success of economic and political freedom reduced its appeal to later thinkers. The narrowly limited government of the late nineteenth century possessed little concentrated power that endangered the ordinary man. The other side of that coin was that it possessed little power that would enable good people to do good."

In short, economic freedom and political freedom are two obverse sides of the same coin.

Economic Freedom And Natural Disasters: Haiti's Tragic Earthquake

Professor Don Boudreaux nails it.

While media have been fixated with the devastation of the recent earthquake in Haiti, which up to this writing has now tallied some 50,000 deaths, many have attributed the destructive loss of lives to many other peripheral causes, including the absurd ("pact with the devil").

What has hardly been mentioned is WHY Haiti's impoverishment had made her disproportionately vulnerable to human life losses in such natural calamities.

From Professor Boudreaux of Cafe Hayek says it best: [all bold emphasis mine]

``The ultimate tragedy in Haiti isn’t the earthquake; it’s that country’s lack of economic freedom.

``Registering 7.0 on the Richter scale, the Haitian earthquake killed tens of thousands of people. But the quake that hit California’s Bay Area in 1989 was also of magnitude 7.0. It killed only 63 people.

``This difference is due chiefly to Americans’ greater wealth. With one of the freest economies in the world, Americans build stronger homes and buildings, and have better health-care and better search and rescue equipment. In contrast, burdened by one of the world’s least-free economies, Haitians cannot afford to build sturdy structures. Nor can they afford the health-care and emergency equipment that we take for granted here in the U.S.

``These stark facts should be a lesson for those who insist that human habitats are made more dangerous, and human lives put in greater peril, by freedom of commerce and industry."

Let me add that the Philippines should be a more worthwhile in comparison.

We suffered from an even more destructive quake in July 16, 1990 which according to wikipedia.org registered 7.8 and resulted to an estimated 1,621 deaths

The Philippines has a per capita of $920.19 (ranked 106th according to nationmaster.com) almost double that of Haiti $480.52 (ranked 126th).

And by economic freedom, the Philippines is way up the list at 104th according to Heritage Foundation, compared to Haiti's 147th spot.

In short, capital or wealth generated from economic freedom has indeed been a key factor in reducing the risks of higher casualty toll from natural calamities.

As Ludwig von Mises wrote, ``It is fashionable nowadays to pass over in silence the fact that all economic betterment depends on saving and the accumulation of capital. None of the marvelous achievements of science and technology could have been practically utilized if the capital required had not previously been made available. What prevents the economically backward nations from taking full advantage of all the Western methods of production and thereby keeps their masses poor, is not unfamiliarity with the teachings of technology but the insufficiency of their capital."

Venezuela's Path To Hyperinflation

My prime candidate for the next episode of hyperinflation (which I mentioned here) has long been Venezuela.

That's because accelerating socialism, espoused by the dictatorship regime translates to profligate spending which generates intractable financial claims and economic inefficiencies (which impedes the capacity to pay the incurred liabilities) that has resulted to ballooning deficits.

And this translates to massive printing of money in order to fill or cover such shortfalls for the preservation of power by the incumbent political leader. In short, using the printing press as political tool.

So while hyperinflation is technically about sustained excessive money printing, the underlying incentives that beckons it is political.

The end result: the demonetization of money.

According to Professor Ludwig von Mises from his Stabilization of the Monetary Unit? From the Viewpoint of Theory,

``If people are buying unnecessary commodities, or at least commodities not needed at the moment, because they do not want to hold on to their paper notes, then the process which forces the notes out of use as a generally acceptable medium of exchange has already begun. This is the beginning of the “demonetization” of the notes. The panicky quality inherent in the operation must speed up the process. It may be possible to calm the excited masses once, twice, perhaps even three or four times. However, matters must finally come to an end. Then there is no going back. Once the depreciation makes such rapid strides that sellers are fearful of suffering heavy losses, even if they buy again with the greatest possible speed, there is no longer any chance of rescuing the currency. In every country in which inflation has proceeded at a rapid pace, it has been discovered that the depreciation of the money has eventually proceeded faster than the increase in its quantity.” [all bold emphasis mine]

Seen in the context of Venezuela, which massively devalued its currency last week, this from Wall Street Journal account, (hat tip Douglas French and Mises Blog) [bold highlights mine]

``President Hugo Chávez's decision to devalue Venezuela's bolivar and impose a complicated new currency regime may paper over some growing cracks in the economy, but it is also setting the stage for bigger problems down the road for the country's oil-rich nation and its populist leader.

``Over the weekend, there were signs that Mr. Chávez's slashing of the "strong bolivar" currency could create as many problems as it solves in Venezuela's economy, provoking a wave of anxiety that sent Venezuelans scurrying to spend cash they feared could soon be worthless.

``At Caracas's middle-class Sambil shopping mall, lines at cashiers reached 50-deep. Carmen Blanco, a 28-year-old accountant, waited to buy a 42-inch flat-screen television she doesn't need because she already has one at home.

``"It doesn't make any sense to keep my savings," Ms. Blanco said Saturday. "I'd love to see how things work in a normal country."

``On Sunday, Mr. Chávez vowed to fight speculation and price increases that could result from the devaluation, which raises the price of imports.

``Harried by recession and sliding popularity, Mr. Chávez on Friday weakened the bolivar to 4.3 per dollar from 2.15 in a bid to shore up government finances, which have been hit by weaker oil prices, and to stimulate economic growth ahead of key elections."

And where does Mr. Chavez gets his ideas? Unfortunately from the stereotyped self-righteous protectionist mindset.

Again from the same WSJ article, (all bold highlights mine; comments added)

``In Mr. Chávez's favor, a weaker currency helps narrow a growing budget shortfall by instantly giving his oil-rich government more local currency to spend per barrel of oil exported by the state petroleum company, PDVSA. That is a key consideration with congressional elections looming in September.

[yes inflationism shifts spending power to the government and his allies at the cost of less spending power for the people-Benson]

``Mr. Chávez has watched his popularity slide amid corruption scandals, a shrinking economy, rising crime and shortages of food and electricity. Increased spending could boost Mr. Chávez's popularity.

[note: Venezuela is a major oil exporter-Benson]

``Mr. Chávez also predicted a weaker currency would breathe life into a domestic economy that depends on imports for everything from beef and milk to cars.

[this is an example of the currency magic wand mindset at work-Benson]

``The measure may buttress the banking system, which has been rocked by the closure of several institutions amid an embezzling scandal. Many Venezuelan banks head into the devaluation holding large stocks of dollars.

[governments almost always favors the banking system because it can help in the financing of its political goals-Benson]

``Holders of dollar-denominated bonds issued by Venezuela and PDVSA will be encouraged by the move. Devaluation narrows Venezuela's financing gap to around 3% of economic output from around 7%, said Boris Segura, a Royal Bank of Scotland economist."

``However, the devaluation does little to assuage the deeper problems plaguing the Venezuelan economy, economists say. Devaluation isn't enough to revive the domestic manufacturing base. Few investors are willing to brave Venezuela's maze of price caps, currency controls and the ever-present fear of nationalization."

[Here's the rub: the rubber finally meets the road, this is a vivid example where fallacious theories don't square with reality. The currency magic wand can't offset domestic policy distortions-Benson]

``Higher inflation from the move will also keep chipping away at the value of the bolivar, even at its new peg."

``What is more, by keeping a subsidized dollar rate for importing food, medicine and essential items, Mr. Chávez removes any incentive for Venezuelans to produce what they need most."

From Murray Rothbard in Mystery of Banking, ``But if government follows its own inherent inclination to counterfeit and appeases the clamor by printing more money so as to allow the public’s cash balances to “catch up” to prices, then the country is off to the races. Money and prices will follow each other upward in an ever-accelerating spiral, until finally prices “run away,” doing something like tripling every hour. Chaos ensues, for now the psychology of the public is not merely inflationary, but hyperinflationary, and Phase III’s runaway psychology is as follows: “The value of money is disappearing even as I sit here and contemplate it. I must get rid of money right away, and buy anything, it matters not what, so long as it isn’t money.”

We seem to be witnessing unfolding chaos from the demonetization process.

Another observation: It's been a common fallacious notion that stock markets respond negatively to intensified inflation.

In Venezuela, this hasn't been the case.

Perhaps this could be true depending on the degree of inflation.

But in cases where the state of money swiftly deteriorates, where its store of value comes into question or comes under severe strain, stock markets become haven from the demonetization process.

Why?

Again from Professor von Mises, ``If the future prospects for a money are considered poor, its value in speculations, which anticipate its future purchasing power, will be lower than the actual demand and supply situation at the moment would indicate. Prices will be asked and paid which more nearly correspond to anticipated future conditions than to the present demand for, and quantity of, money in circulation. The frenzied purchases of customers who push and shove in the shops to get something, anything, race on ahead of this development; and so does the course of the panic on the Bourse where stock prices, which do not represent claims in fixed sums of money, and foreign exchange quotations are forced fitfully upward."

And this has been the case of Weimar Germany and just recently Zimbabwe.

If present political trends won't reverse, then Venezuela would be another real time example of paper money based system that will evaporate soon.

Asia Goes For Free Trade

Here is what we wrote in Poker Bluff: The Exit Strategy Theme For 2010

``there are many other reasons to suggest why emerging markets seem to be on a secular trend to play catch up with advanced economies, particularly positive demographic trend, urbanization, high savings rate, low debt or systemic leverage, unimpaired banking system, rising middle class and most importantly a trend towards embracing economic freedom via more freer trade, investments, financial and migration flows [e.g. see Asian Regional Integration Deepens With The Advent Of China ASEAN Free Trade Zone]

We found this from the Investor's Business Daily, (all bold highlights mine) [hat tip: Professor Mark Perry]

``Largely ignored over the weekend, Jan. 1 signaled the arrival of the world's third-biggest free trade area. China and Asia's Tigers — the Association of Southeast Asian Nations — scrapped 7,000 different tariffs to form a $200 billion open market for about 2 billion consumers, one-third of the world's population.

``That's not the half of it. Jan. 1 also heralded another ASEAN free-trade pact with mighty India, ending tariffs on 4,000 products staggered through 2016. This deal will expand a $50 billion market for 1.5 billion consumers into something even bigger.

``ASEAN also signed off on free trade with Australia and New Zealand, tacking on another $50 billion market to expand for their 600 million consumers. It follows ASEAN's Dec. 1 agreement with Japan, which created a $240 billion market for 670 million. In addition, Thailand and South Korea completed the last step of 2007's ASEAN-Korea pact, finalizing expansion of the zone to a $72 billion market for 600 million.

``ASEAN's six freest members — Thailand, Indonesia, Singapore, Philippines, Malaysia, Brunei — even enacted a free-trade deal among themselves on Jan. 1, ending tariffs on goods sold to each other, freeing a $60 billion market for 500 million consumers.

``ASEAN wasn't the only one moving on free trade. Over the same weekend, India announced that three years of talks with South Korea were complete, uniting the third- and fourth-largest economies in the Far East. India's leaders said a one-year deadline for negotiating a pact with the European Union was set this week, too.

``All this points to something major: While the Obama administration has put its energy into trade wars with China, enacting punitive tariffs on steel, tires, nylon, paper, and other goods and has signed no new pacts in 2009, free trade is marching on without the U.S."

Here we have a clear case of policy divergence. Asia (most especially ASEAN) openly goes for free trade while the Obama regime seems backtracking on economic freedom.

Guess where capital will flow?

Lastly this goes in patent defiance to the mercantilist perspective that the world will go protectionist.

Reasons To Distrust Mainstream Economists

Here is why I wouldn't depend or trust (my life) on the opinions and (most especially) the forecasts of the mainstream economists.

(hat tip: Dan Mitchell of Cato.org) Why the miserable track record?

In my opinion here are the reasons:

One, model based prediction.

Most economists deem math models as representative of reality. They think that their models incorporate all the working variables required to represent market's action.

This is false, as Ludwig von Mises argued, ``The problems of prices and costs have been treated also with mathematical methods. There have even been economists who held that the only appropriate method of dealing with economic problems is the mathematical method and who derided the logical economists as "literary" economists."

Two, hostage to past performance and dogmatism.

Given their penchant to view reality as a construct of economic models, they become susceptible to fall for the "past-performances-determine-the-future" trap.

For instance, many have used the circumstances of the Great Depression as parallel paradigm to project the future given today's predicaments. They seem to forget that the Great Depression had been a product of the massive engagements of protectionism worldwide, and various anti-market and anti-foreign bias based policy interventions that have not emerged in the same degree today.

So mainstream protectionists, who impliedly have been 'clamoring' or 'desiring' to see a replication of the Great Depression paradigm, advocate similar mutually destructive policies just to have their convictions validated.

In other words, for such a clique, dogmatism precedes reality.

Unfortunately, the evolving technology based platform from which the world has been transitioning into (information age) has apparently served as major deterrent to the proliferation of such closed door-beggar thy neighbor policies.

In addition, much of the world through emerging markets, which have benefited from recent globalization trends, has been reluctant to jump into the protectionist cockamamie bandwagon.

This great quote attributed to Bertrand Russell encapsulates the surfeit of fallacies and myths seen in the profession,

``What a man believes upon grossly insufficient evidence is an index into his desires - desires of which he himself is often unconscious. If a man is offered a fact which goes against his instincts, he will scrutinize it closely, and unless the evidence is overwhelming, he will refuse to believe it. If, on the other hand, he is offered something which affords a reason for acting in accordance to his instincts, he will accept it even on the slightest evidence. The origin of myths is explained in this way.”

Three, political and vested interests.

The core of mainstream economics have been built around the ideas of John Maynard Keynes from which political institutions have warmly appropriated as their operating creed.

That's because Keynesianism is a proponent for big government, and inflation, in the words of James Buchanan,``The allocative bias toward a larger public sector and the monetary bias toward inflation are both aspects of, and to an extent are contained within, a more comprehensive political bias of Keynesian economics, namely, an “interventionist bias,” which stems directly from the shift in paradigm."

Unfortunately ideas and reality don't square, adds James Buchanan, ``The political process within which the Keynesian norms are to be applied bears little or no resemblance to that which was implicit in Keynes’ basic analysis. The economy is not controlled by the sages of Harvey Road, but by politicians engaged in a continuing competition for office. The political decision structure is entirely different from that which was envisaged by Keynes himself, and it is out of this starkly different political setting that the Keynesian norms have been applied with destructive results." (highlights mine)

In addition, the economic profession appears to have been "bought" or largely influenced by government.

For instance according to the Huffington Post, the US Federal Reserve ``doles out millions of dollars in contracts to economists for consulting assignments, papers, presentations, workshops, and that plum gig known as a "visiting scholarship."

In other words, many in the economic profession function as propaganda mouthpieces for the government.

Hence, the views of mainstream economists have been skewed by conflict of interests and hardly reflects on reality. This is what one might call the Agency Problem.

Here is a trenchant satire about mainstream economists...

``A mathematician, an accountant and an economist apply for the same job. The interviewer calls in the mathematician and asks "What do two plus two equal?" The mathematician replies "Four." The interviewer asks "Four, exactly?" The mathematician looks at the interviewer incredulously and says "Yes, four, exactly."

``Then the interviewer calls in the accountant and asks the same question "What do two plus two equal?" The accountant says "On average, four - give or take ten percent, but on average, four."

``Then the interviewer calls in the economist and poses the same question "What do two plus two equal?" The economist gets up, locks the door, closes the shade, sits down next to the interviewer and says "What do you want it to equal?"

Four, oversimplification of analysis.

Economic models and dependence on statistical aggregates allow economists to assume that people's action or reactions work in the same manner even in facing the same circumstances.

Unfortunately this isn't true, that's because everyone have different scale of values or priorities.

Besides, reality means more options (or complexity) than what most economists presume (who assume laboratory conditions).

Yet economists are merely human beings and are thus subject to cognitive frailties. This means they can be swayed by mental shortcuts 'heuristics' or impulse based decision making or analysis derived from the agency problem incentives.

The only difference is that they can they can embellish their statements or studies with technical economic gibberish. As Nassim Taleb of the Black Swan fame says, ``Let us remember that economists are evaluated on how intelligent they sound, not on a scientific measure of their knowledge of reality."

Lastly, Hubris.

Many economists believe that their proficiency in math models and or economic theories privileges them with a clear edge over the rest of humanity that they resort to pedantic moralization of the world's problems accompanied by their sanctimonious prescriptions to such problems.

This is a practice of conceit aside from the cognitive folly known as overconfidence.

As Friedrich von Hayek warned in his Nobel Laureate speech, ``To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm. In the physical sciences there may be little objection to trying to do the impossible; one might even feel that one ought not to discourage the overconfident because their experiments may after all produce some new insights. But in the social field, the erroneous belief that the exercise of some power would have beneficial consequences is likely to lead to a new power to coerce other men being conferred on some authority. Even if such power is not in itself bad, its exercise is likely to impede the functioning of those spontaneous-ordering forces by which, without understanding them, man is in fact so largely assisted in the pursuit of his aims."

In short, be aware of the hazards from the pretentious knowledge peddled by the mainstream.

Bottom line: Not because most in the economic profession cannot be trustworthy doesn't mean that everyone is.

One way is to examine the incentives that prompts for an economist or expert to argue his point. The other is to keep an open mind to diversified ideas.

And that's why it is recommended that everyone develop their own 'independent' judgment by learning the ropes, since economics encompasses all fields related to human social interactions.

An apt quote from Professor Joan Robinson of Cambridge University, ``The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists."

Asia And Emerging Markets Should Benefit From The 2010 Poker Bluff

``What gave the west the edge over the east over the past 500 years? My answer is six “killer apps”: the capitalist enterprise, the scientific method, a legal and political system based on private property rights and individual freedom, traditional imperialism, the consumer society and what Weber probably misnamed the “Protestant” ethic of work and capital accumulation as ends in themselves. Some of those things (numbers one and two) China has clearly replicated. Others it may be in the process of adopting with some “Confucian” modifications (imperialism, consumption and the work ethic). Only number three – the Western way of law and politics – shows little sign of emerging in the one-party state that is the People’s Republic. Niall Ferguson, The decade the world tilted east

So what does the Policymaker’s poker’s bluff mean for Asian and Philippine asset markets, aside from emerging markets?

Widening Interest Rate Spread and the Carry Trade Arbitrage.

If Asian and emerging economies begin to tighten as we expect them to, and if we are correct about the implied devaluation policies by major economies as the US, Japan and the UK, then currency carry trade arbitrages will not only likely expand, but balloon.

This means we can expect foreign money to flood into these markets possibly triggering an asset meltup, meaning outperformance in stocks, currency and bonds.

Naturally, this won’t go in a straight line, and possibly be intermittently forestalled by internal policies to stanch flows such as capital controls similar to one imposed by Brazil.

Great Growth Story.

Asia and major emerging markets as noted above, having learned from the recent past crisis and having to embrace more globalization friendly policies particularly in trade, investment, finance and labor, will likely lure more funds given the relative its advantages-which means low debt, higher productivity, urbanization, demographic dividends and lower cost of living will likely magnify in the growth story.

Figure 5: Bloomberg: Goldman’s Call of Decade-Buy BRICs

An example would be Goldman’s Buy of the decade as shown in figure 5.

Policy Response and the Bubble Cycle.

Low systemic leverage and the largely uncontaminated banking system have responded “positively” to present policies that rejuvenated the markets and the economy.

As a reminder, manipulation of interest rates work similar to price controls, it leads to false signals which brings about massive distortions of the production and capital structure and gets magnified by people irrationality or in responding to the “bandwagon effect”.

As Henry Hazlitt explains, ``The credit expansion does not raise all prices simultaneously and uniformly. Tempted by the deceptively low interest rates it initially brings about, the producers of capital goods borrow the money for new long-term projects. This leads to distortions in the economy. It leads to overexpansion in the production of capital goods, and to other malinvestments that are only recognized as such after the boom has been going on for a considerable time. When this malinvestment does become evident, the boom collapses. The whole economy and structure of production must undergo a painful readjustment accompanied by greatly increased unemployment.”

Excessively low interest rates are the seeds to any bubble cycle which means that central bank policies have been a serial bubble blowing phenomenon.

And for this cycle, Asia and emerging markets are ripe as prime candidates for the next bubble.

Commodity Theme.

While we have greatly focused on the monetary aspects of commodity demand, there is also the policy and real economy facets that boosts the commodity dynamics.

This means that the traction generated by the recent policy actions could exacerbate a massive demand for commodity related investments and or speculation, following two decades of underinvestment.

Of course, the economic evolution where emerging markets outgrow advance nations would like spur heightened consumption.

Since commodity investments take time to materialize, the lag between the rapid growth in demand and availability of supply will be reflected on prices.

Redefining Markets And Asia’s Emerging Consumer Economy.

Since one the relative advantage of these economies have been scalability, whose rubric consist of more than half of the world’s population, what makes for the lost high value sales from the recession affected advance economies would probably be replaced by price sensitive massive volume based markets from Asian and the emerging economies.

Even Japanese exporters appear to be recognizing such reality [see Japan Exporters Rediscovers Evolving Market Realities].

In other words, global trade will likely be reconfigured, not because of mercantilist policies but of the shifting nature of consumer demands; this time brought about by the rapidly growing consumer dynamics of Asia and the emerging markets.

Leapfrogging The Industrial Age As A Candidate For Technology Ascendancy.

One of the major flaws by the mainstream is to ignore the tremendous contribution of technology in the form of increased information flows and enhanced efficiency of today’s marketplace.

Their outlook appears fixated on the industrial age paradigm even when they knowingly use the computers and the web to conduct exchanges and socially connect. Yet, ironically, they preach policies that would regress to medieval ages. These are the modern day Luddites.

Nevertheless, they are likely to be grossly mistaken. That’s because Asia has had a wide experience as an outsource agent for the western world, where it has learned to compete in the realm of technology.

Many Asian companies have recently embarked on technology value added ventures that today challenges the supremacy held by the West, see our post Asian Companies Go For Value Added Risk Ventures.

They appear to have taken advantage of the recent recession and utilized their inherent strengths or competitive advantages (access to capital, free cash flows, more liberal markets, etc.) to expand while the western peers reel from the recent setback. This is a dynamic we’ve discussed during the peak of the crisis [see Phisix and Asia: Watch The Fires Burning Across The River?]

J. Michael Oh of Matthews Asia describes of the Asia’s quest to leapfrog to the information age,

Figure 6 Matthews Asia: Fastest Growth In Internet Usage Is In Asia

``Over the years, Asia has given birth to many great technology companies but the region has also become its own dominant market for various consumer technology products including personal computers. Asia now boasts the world’s largest Internet user community, accounting for more than 40% of the world’s usage and last year, China surpassed the U.S. as the world’s largest Internet market, with more than 300 million users. Yet, China’s Internet penetration is only at approximately 22% compared to about 72% for the U.S. When China reaches the 70% penetration level, its Internet community will be larger than the combined population of all G7 countries.”

In short, technology based market competition will likely engender high productivity and generate wealth and would favor economies that would intervene less in discovering the fast evolving consumer desires.

Enhancing The State Of The Financial Markets.

One of the advantages of the West is that it has deep and sophisticated markets that allow her to efficiently channel savings into different investment needs.

This story appears to be changing.

While the recent crisis has led to more regulation, administrative control of employees (payroll), and the stifling of competition in the West, emerging markets appear to be drawing from their latest experience and trying to emulate Western market standards.

According to John Derrick of the US funds, ``Regulators in Beijing have approved a variety of investment products and strategies that are commonplace in mature stock markets: margin accounts for trading, stock index futures and short selling.

``A trial period will come first, so it’s not yet clear when the millions of investors in China will be able to execute a short sale or buy stocks on margin. But just the decision to move forward on this front indicates that the government recognizes that its highly liquid markets are ready for more sophisticated strategies.”

China, aside from trying to expand investment instruments for its retail sector has also opened its version of the Nasdaq board last year (New York Times).

In other parts of Asia, Hong Kong has positioned to compete for a Swiss-style trading hub for the gold bullion market (marketwatch), Singapore has opened a new commodity derivatives exchange the SMX (Financial Times) and likewise would offer its version of the dark pool (Asian Investor). The Philippines is reportedly considering a commodity exchange.

One must also consider the immense growth potentials for the pension, health and insurance industries, which is largely underdeveloped relative to the West, the overdependence on the banking system for corporate and business financing and the underutilization of the capital markets and the low penetration level of population engaged in financial institutions among emerging economies,

All these aspects- Widening Interest Rate Spread and the Carry Trade Arbitrage, Great Growth Story, Policy Response and the Bubble Cycle, Commodity Theme, Redefining Markets And Asia’s Consumer Economy, Leapfrogging The Industrial Age As A Candidate For Technology Ascendancy and Enhancing The State Of The Financial Markets-greatly depends on economic policies that allow for a greater freedom of commerce.

For as long as present dynamics continue in these directions we can remain confident over the long term investment prospects in Asia and in select emerging markets.

Short Word On Risks

Finally, speaking of risks, the character of the 2008 crisis had been vastly different than the next crisis, that’s simply because the drivers of the past bubble-Wall Street firms, Fannie Mae, Freddie Mac, the FHLB, the massive securitization marketplace, derivatives, and the hedge funds-haven’t been much into play, except for some, like the GSEs, dispensing their on support roles, while the bank as trader model appears to have given lift to the US financials.

But generally, the underperformance of the US markets signifies the changing composition of today’s reflation game which has obviously evolved from the core (advanced economies) to the periphery (emerging markets and commodity themes) amidst the backdrop of vastly inflating government liabilities (pls revert to figure 4-right pane).

In short, today’s central banks appear to attain a pyrrhic short term victory; it took huge amounts of deficits and money printing activities to achieve stabilization of credit flows see figure 4, left pane. This likely implies future risks ahead which means that anything that could spike interest rates of debt afflicted deficit laden nations- a sovereign bond Keynesian debt crisis or a currency crisis or a failed auction or spiraling inflation.

For the moment and perhaps for 2010, these risks don’t look imminent, yet.