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.

Poker Bluff: The Exit Strategy Theme For 2010

Many have used the strong showing of 2009 to advert that 2010 would be the year of “exits”. I don't buy it.

As in the game of poker, I’d call this equivalent to a policymaker’s Poker bluff.

Clear Divergence: Periphery Versus Core

This ‘exit strategy’ may be probably ring true for many emerging markets whose economies have been more responsive to the hodgepodge of policies designed to cushion the economies from downside volatility.

Again, the wide variance of performances of emerging markets relative to advanced economies validates our theory since the peak of the crisis where each nations would respond differently to the near uniform set of policies adopted, leading to divergent market and economic results.

And such patent discrepancies have led to earlier tightening policies of some nations. According to the Businessweek, ``Since Nov. 30, the central banks of Australia, Vietnam, Norway and Israel have raised interest rates, and signs the global recession is ending have spurred speculation the U.S. Federal Reserve will follow this year.”

On Thursday, China joined the roster of countries engaged in a rollback of easy money policies, the Businessweek quotes the Bloomberg, ``China's move to raise the cost of three-month bills will probably lead to the nation's first interest-rate increase in almost three years by September, a survey of economists showed.”

Figure 2: Economist: Decoupling in Government Debt and Growth

The Economist says that a major source of this growth discrepancy will likely emanate from the PONZI scheme employed by major economies to substitute lost ‘aggregate’ demand with leverage incurred by government to spur this ‘demand’.

From the Economist, ``Advanced economies, which aggressively stimulated demand and are forecast to experience weak GDP growth next year, contrast starkly with the G20’s developing countries. After some gentle fiscal stimulus, these countries are on track for strong growth next year. The IMF forecasts that gross government debt among advanced economies will continue to rise until 2014, reaching 114% of GDP, compared to just 35% for developing nations. With governments struggling to rein in their finances, rating agencies are becoming increasingly twitchy; rich countries such as America and Britain are fearful of losing their hallowed triple-A status.” (all bold highlights mine)

Of course 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]

However the more important factor revealed by the Economist in the terse article above is that the debt onus for advanced economies implies low productivity, cost of crowding out private investments, larger tax burden, greater risks of escalating consumer prices, higher than average unemployment rate, greater cost of financing debt, heightened sovereign risk premia and fiscal austerity measures that may entail a higher degree of political volatility.

Harvard’s Carmen Reinhart and Kenneth Rogoff seconds this view in a recent study,

``Our main finding is that across both advanced countries and 23 emerging markets, high debt/GDP levels (90 percent and above) are associated with notably lower growth outcomes. In addition, for emerging markets, there appears to be a more stringent threshold for total external debt/GDP (60 percent), that is also associated with adverse outcomes for growth. Seldom do countries simply “grow” their way out of deep debt burdens.”

Alternatively, this also raises the risks of an implosion in the fast emerging government debt bubble, which we will call as the Keynesian Debt Crisis-(since most of these debts were acquired in the context of the Keynesian ideology), one of the risks that could spoil our fun in 2010.

Nearly 90% of the world’s bond markets have been denominated in these four major currencies (Ivy Global Bond): the US dollar, the Japanese yen, British pound, dollar, and the euro.

This means that even if many emerging markets will tighten, it is the policies from the advanced economies that will likely have a greater impact on global capital flows.

And it is why we hypothesize that even if global policymakers pay lip service to the so-called “exit strategies”, what truly matters will be the policy actions by authorities in the face of the evolving activities in the marketplace, the real and the political economy.

Hence, it would be an immense mistake to parse on a single variable, e.g. unemployment, when there would be sundry factors in determining political action.

In other words, this means deducing political and economic persuasions or ideology of the incumbent officials, interpreting their underlying cognitive biases based on their speeches, interviews or official pronouncements, analyzing their interpretation of events and lastly appraising on the political influences of certain interest groups that may determine the prospective actions of policymakers.

The Underlying Incentives Of The Poker Bluff

So what factors could likely determine the direction of policy actions?

Interest Rate Derivatives. One must realize of the extent of sensitivity of global asset values are to interest rates.

Figure 3: BIS: Composition Of Global Derivatives

Interest rate derivatives account about 72% or $437 trillion of the notional $605 trillion as of June of 2009 according to the Bank of International Settlements.

Any unexpected volatility from so-called monetary rollback could amplify the risks of unnerving the markets. Thereby, policymakers would likely remain supportive of unorthodox actions like Quantitative Easing.

Hence, we see the recent measures by the Bank of Japan to impose their version of Quantitative Easing last December has catapulted the Nikkei to outperform [see The US Federal Reserve Experiments On Unwinding Stimulus As Bank Of Japan Engages in QE]. In addition, the Bank Of England remains with on track with its ₤ 190 billion of asset purchases and which is likely to increase to ₤ 200 billion (Edmund Conway, Telegraph) and possibly more.

Expanding GSE Operations. In the US, a day before Christmas eve, as everyone had been partying, the US government via the US Treasury stealthily lifted its financing cap on the Government Sponsored Enterprise of Fannie Mae (FNM) and Freddie Mac (FRE) [Wall Street Journal].

Essentially, this places the GSE debt on the US balance sheets, which technically has been operating on “implied” guarantees. Some analysts see that the ambiguity of the US position has led to foreigners to become risk-averse and avoid purchases of these securities.

Hence, the US treasury hopes that by making “implicit” guarantees as “explicit”, it would reduce the pressure on US Fed to bolster the US housing market via Quantitative Easing, and make GSE assets more attractive.

Remember about 9 out of 10 mortgages transacted today have been consummated by these GSE entities, thereby by opening the checkbook to absorb more tainted assets and in the absence of the resumption of foreign interests, the alternative view is that the Fed could increase its scope of quantitative easing programs.

Of course by incorporating the aforementioned GSE debt on the US balance sheets, recorded US liabilities will rise and exert pressures on its sovereign credit ratings.

The point is, US housing market, even faced with some semblance of recovery, remains heavily sensitive to interest rates movement which will likely compel authorities to tweak with financial markets and remain policy easy.

Policymaker’s Economic Ideology. Ben Bernanke is known as an expert of the Great Depression from which his views on monetary policy has been oriented towards the Milton Friedman model, i.e. to provide generous liquidity during an economic recession. The illustrious Mr. Milton Friedman in an interview with Radio Australia said, ``So in our opinion, the Great Depression was not a sign of the failure of monetary policy or a result of the failure of the market system as was widely interpreted. It was instead a consequence of a very serious government failure, in particular a failure in the monetary authorities to do what they'd initially been set up to do.”

And it is likely that from this monetary paradigm he sees the risks of an economic relapse from premature tightening as that in 1937-38. Hence Mr. Bernanke is likely to pursue what he sees as a triumphant path dependency policy of money printing.

Analyst Mike Larson says it best, ``Look at Chairman Bernanke’s background. Massive money printing is at the heart of his entire philosophy. He literally wrote the book on this subject — the book that’s now essentially the Fed’s operating manual on precisely how to print enough money to overwhelm almost any economic collapse.

``Bernanke believes in his heart of hearts that the Fed prematurely hiked rates in 1937, prolonging the Great Depression into 1938 and beyond. He’s convinced that that single, momentous blunder of history is what doomed the world to a nasty “double dip.” (emphasis added)

It’s also the reason why Fed Chair Ben Bernanke recently put the blame squarely on the shoulders of belated regulatory response as having caused the crisis and exculpated the low interest regime (Bloomberg).

By keeping the political heat off low interest rates, he hopes and intends to divert the public’s attention away from his primary tool to manipulate markets.

Ironically and bizarrely too, Mr. Bernanke used the Taylor Rule model to justify the exoneration of role of low interest to the recent crisis.

However John Taylor, a Professor at Stanford University and a former Treasury undersecretary, the creator of the popular model challenged and issued a rejoinder on Bernanke’s interpretation saying ``The evidence is overwhelming that those low interest rates were not only unusually low but they logically were a factor in the housing boom and therefore ultimately the bust.” (Bloomberg).

This goes to show that the fudging, twisting and the manipulation of the means (model or data) in order to come up with the desired end signify as a symptom of economic dogmatism, which operates regardless of the veracity of the implied causality.

Record Debt Issuance, Rollover and Interest Payments. We have pointed out that the US economy, while indeed has been manifesting signs of recovery, hasn’t been entirely out of woods.

The next wave of mortgage resets, which we identified as Alt-A, Prime mortgages, and commercial real estate, which follows the original strain-the subprime mortgages, are still putting pressure on the US real estate industry [as discussed in Governments Will Opt For The Inflation Route].

Moreover, many US States have been staggering from bloated deficits stemming from falling tax revenues in the face of bubble day spending budgets, probably this year will mark a series of bailouts from the Federal government [see Federal Bailout For US States In 2010?]

So together with huge fiscal spending slated for 2010 plus the rollover of maturing debts and the attendant interest payments, as previously discussed in Market Myths and Fallacies On The Dubai Debt Crisis, all these would translate to some $3.6 Trillion of financing required for the US for this year.

We said then,

``$1.9 trillion of debt required for refinancing + $1.5 trillion in additional deficits + $ .2 trillion in interest payments=$3.6 trillion of financing required for 2010! Since US and global savers (particularly Asia) are unlikely to finance this humungous amount, [other parts of the world will require debt financing too (!!)], the available alternative options appear to be narrowing-the Federal Reserve would have to act as the financer of last resort through the Bernanke’s printing press or declare a default. Of course, Bernanke could always pray for a “Dues ex machina” miracle.”

This means that to activate an “exit” mode by raising interest rates risks heightening the amount required for financing. That’s obviously is a NO CAN DO for the authorities.

Moreover, the US won’t likely take the risks of a “failed auction” during its record Treasury sales this year, since this would likely send the interest and bond markets into a tailspin or a mayhem.

This means that as contingent plans we expect that the US Federal Reserve will remain as THE buyer of the last resort for the US treasury markets.

Devaluation as an unofficial policy. We have stated in numerous occasions [e.g. see Changing The Rules Of The Game By Inflation] how Ben Bernanke champions the mainstream view of oversimplifying economic problems by reducing (yes reduction ad absurdum) them into few variables. Hence by focusing on a few variables such as global imbalances, he sets forth devaluation as the key instrument for economic salvation- via his Helicopter “nuclear” option.

Again Mr. Bernanke in his Helicopter speech, ``it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation.”

Yes it’s a supreme irony for government to promote debt, yet fear its consequence-deflation.

It’s also worth repeating that the only way to achieve devaluation is through inflationism which is what Bernanke’s Zero Interest Rate policy, quantitative easing and host of other interventionism-in the form alphabet soup of programs to the tune of Trillions of spending and guarantees, have all been about.

As Ludwig von Mises wrote in Stabilization of the Monetary Unit? From the Viewpoint of Theory ``The valuation of a monetary unit depends not on the wealth of a country, but rather on the relationship between the quantity of, and demand for, money.”

The same ideology afflicts other policymakers as seen in Japan, England and most of the central bankers of the world.

Remember, inflationism is a form of protectionism, since it supports or protects the interests of some politically favorite sectors at the expense of the rest of the society.

In the case of the US, such collective ‘devaluation’ policies appear aimed at alleviating the untenable debt levels held by the banking industry.

Although the public seem to have been grossly misled by political demagoguery and politically colored experts who try to make believe the tomfoolery that devaluation is about exports (only 11% of the economy see Dueling Keynesians Translates To Protectionism?) or about jobs.

Of course, another mechanism of devaluation is the transferring of the resources from the real economy to the banking and finance industry.

Unfortunately for the gullible adherents, who seem to have lost any semblance of critical thinking and common sense enough to swallow hook line and sinker the hogwash that such political propaganda as the “truth”, “candidness” of the messenger and meant as “best” for the social order.

Hardly in the understanding that such political actions represent as ruse for a political end. Again from Professor von Mises, ``By deceiving public opinion, it permits a system of government to continue which would have no hope of receiving the approval of the people if conditions were frankly explained to them.”

Hence, the so-called “exit” program would be antipodal to the policy thrust to devalue the currency.

Political Influences On Policy Making. One unstated reason why companies like General Motors or Chrysler have been nationalized or significantly buttressed by the government is due to the payback of favors to a political constituent, particularly in this case the labor union.

Considering that labor had been a big contributor to Obama’s election, where according to Heritage Foundation, ``Big Labor spent an estimated $450 million on the 2008 election, and the SEIU alone put $85 million into the political campaign — almost $30 million just for Obama’s election”, many of Obama’s major policies appears to have been designed as remuneration for political ties.

This can be seen with the recent tariffs slapped against China, the infrastructure stimulus spending which forces contractors to hire labor union members, the latest $154 billion round of stimulus passed in Congress last December targeted at reducing unemployment, proposed taxes on stock trades to fund labor projects, mass unionization of the US government which now constitutes more than half or 51.2% compared to 17.3% in 1973 and many more.

Of course the other vested interest group as stated above would be the banking sector.

The point is- a higher cost of financing from a series of interest rate increases and monetary policy rollback will vastly reduce the Obama administration’s capacity to fund the pet projects of his most favored allies.

And going into the election year for the US Senate in 2010, greatly reduces this incentive especially that the popularity of Democrats has been on a free fall, as shown by recent Gallup polls, WSJ-NBC News, and Ramussen Reports

Finally, the Question Of Having To Conduct Successful Policy Withdrawals. This would be technical in nature as it would involve the methodology of how excess reserves, the alphabet soup of market patches, guarantees and commitments will be successfully scaled down.

For us, thinking that garbage would be bought back at the original “subsidized” price is no more than wishful thinking. Most of the so-called “plans: would be like having off balance sheet holdings.

Figure 4: BIS: Central Bank Balance Sheet and Spreads for the Crisis

Analyst Jim Bianco was spot on when quoted by Tyler Durden of Zero Hedge, ``We believe the proposal of this new tool signals the Federal Reserve is still flailing around trying to look busy so everyone is assured they have a plan.” (Bold highlight mine)

Bottom line: Interest Rate Derivatives, Expanding GSE Operations, Economic Ideology Record Debt Issuance, Rollover and Interest Payments, Devaluation as an unofficial policy, Political Influences On Policy Making and the Question Of Having To Conduct Successful Policy Withdrawals all poses as huge factors or incentives that would drive any material changes in the Federal Reserve and or the US government policies.

In knowing the above, I wouldn’t dare call on their bluffs.