Marc Faber On Gold, Moral Hazard and Inflation

Marc Faber recently interviewed by Hera Research Newsletters: (all bold emphasis mine)

HRN: Is there a relationship between monetary expansion and the fact that the US economy depends so heavily on consumption?

Dr. Marc Faber: Basically, if you look at consumption as a percent of the economy and at housing activity, the excessive debt growth began essentially after LTCM and, I have to say, it was a huge mistake of the Treasury and Fed to bailout LTCM because it gave Market participants in the financial sector a signal that there is a Greenspan put, and later on a Bernanke put [1], with an even higher strike price and this resulted in excess leverage. So, if you have problems, the Federal Reserve will bail you out or the system will bail you out. That’s where I think the Federal Reserve acted irresponsibly—irresponsibly—that has to be said very clearly. They didn't pay attention to credit growth. Every central banker in the world pays attention to credit growth, but not in the US.

HRN: What would you recommend that the Federal Reserve do differently?

Dr. Marc Faber: The first action Mr. Bernanke should take is to resign. If I had messed up the system so badly, as he has done, I would have to resign. He has talked constantly about the Great Depression and what caused the depression but the problem is that he really doesn't understand what caused the depression, which was also excessive leverage at that time. I have to stress that in 1929 the debt to GDP ratio was of course minuscule in comparison what it is today. It was 186% of GDP but you didn't have Social security, Medicare and Medicaid and unfunded liabilities for Social Security and so forth. So, debt today, as a percent of GDP, is 379% and if you add the unfunded liabilities we are at over 800%. The Federal Reserve should pay attention to that.

HRN: With debt levels and liabilities so high, what solution is there for the United States?

Dr. Marc Faber: The solution is, basically, for the government to move out and not intervene in the economy. There are economists who will dispute that the Federal Reserve is partially responsible for the crisis and there are economists that will still tell you that debt doesn’t matter, that deficits don't matter and they want to continue to intervene in the free market constantly. To these economists I respond: What about Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB)? It was an intervention by the government into the housing market and into the mortgage market and the biggest bankruptcies—bigger than Citigroup (C) and all the banks—are Fannie Mae and Freddie Mac—government-sponsored enterprises. [1] The same economists will tell you that the government has to intervene and to these economists I say: Well, you have made so many mistakes already with interventions do you think that in the future your interventions will improve anything? Einstein defined insanity as doing the same thing over and over and expecting different results, but these economists and the Federal Reserve think that by more interventions with fiscal measures and more money printing they will improve things. No, they won’t. They will make things worse.

HRN: It seems the US is moving towards more government intervention into the free market rather than less.

Dr. Marc Faber: Yes. That’s why I’m very negative about economic growth in the US. It just won’t happen. Can the US economy grow at 2% per annum or, in the best case scenario, at 3% per annum with current policies? Yes, but it will create a lot of distortions. The best case for an economy that goes into a boom phase, in other words over consumption, is to bring it back into the trend line as quickly as possible. So when you have an excursion into a boom, what you need is a cleansing of the system and that may take a few years to happen in the US because the excesses were built up not just in the last 7 years between 2000 and 2007 but, over the last 25 years. So, to really bring the US back into sanity—into a healthy mode where the economy can grow—might take 5 to 10 years, but it won’t happen under the Obama administration.

HRN: Given the poor prospects for US economic growth, do you foresee a flight of capital from the United States?

Dr. Marc Faber: You would be out of your mind, with health care reforms and with the government interventions and the uncertainty about future taxes in the US, to even consider expanding in the US and this is a problem. I mean people say that loan demand is down because banks are not lending, but maybe nobody wants to borrow any money in the US and nobody wants to expand in the US but they are expanding in China, India, Vietnam, Bangladesh, Africa and Brazil. The business world is an international place today, and if you run a corporation, whether you employee 50 people or 10,000, you can choose where you invest your money in terms of capital spending. [2] Where do you want to expand factories? If I employed people in the US, I would rather think of reducing the 50 employees maybe to only 20.

HRN: Where should American investors put their money?

Dr. Marc Faber: Different people have different investment objectives but I made a presentation recently where I showed, that in terms of goods markets, the emerging world is now larger than the developed world and so I think people should have at least 50% of their money in emerging economies. With interest rates at zero and with the prospect that they will stay at zero, or below zero in real terms for a long time, I think cash is not particularly attractive. I think US government bonds are unattractive in the long run, although they may be attractive for the next three months. I would recommend to people to accumulate precious metals and invest in a basket of shares in emerging economies.

HRN: Are you saying you would consider buying gold even at today’s prices?

Dr. Marc Faber: Yes, I keep accumulating gold although in the next three months it may go down and not up, but maybe it won’t go down. To me, it doesn’t really matter if it goes down by 10% or 20% or whether it stays where it is. I think if in case gold came down 20% it would be because tightening of global liquidity and, in that scenario, equities wouldn’t do particularly well either [3].

HRN: You mentioned that cash is not attractive. What are the prospects for the US dollar?

Dr. Marc Faber: The dollar has been relatively weak in the last few years. It’s just that the other currencies are not much better. There has been a tendency for the dollar to weaken and certainly it has weakened against the price of oil, against the price of precious metals and raw materials and it's lost its purchasing power. There is no question about the fact that, today, if you have $100,000 you can buy less than 10 years ago or 20 years ago. Just look at the housing market. It has come down somewhat but a house is much more expensive than in 1980.

HRN: Can you comment on inflation versus deflation?

Dr. Marc Faber: In this whole inflation and deflation debate investors have to realize that in a system—say you have a room like this and then the money is dropped from helicopters into this room, it can flow into real estate; it can flow into equities; it can flow into precious metals; it can flow into the art market or it can flow out into other currencies or into commodities that the Federal Reserve doesn’t control [4]. They only control essentially how much money they will drop from the helicopters.

HRN: Is this an example of why central planning of the economy by the Federal Reserve isn’t effective?

Dr. Marc Faber: Yes. Exactly.

HRN: Do you think hyperinflation in the US is possible?

Dr. Marc Faber: The Federal Reserve doesn’t want to create a hyperinflation. I mean Mr. Bernanke may be incompetent, but he’s not an evil person per se. He just doesn’t have sufficient knowledge to be a central banker, in my opinion, and has misguided economic theories, but he’s not evil in the sense that he would not wish to debase the currency entirely. Clearly, if the US economy moves into a double dip recession and you have deflationary pressures reappearing, in the housing market, for example, and if the S&P drops from roughly 1,100 down to say 900, then I think further monetization will happen. I believe that because of the unfunded liabilities and the deficits of the US government, which will stay high for a long time; sooner or later there will be more monetization anyway [5].

It’s more a question of when it will happen rather than if it will happen. For sure it will happen but will it happen right away, say in September, or maybe only in two years time? Eventually, before everything collapses we’ll have an inflationary bout which may not be so strongly felt in consumer prices, as in stocks or housing or precious metals prices or in commodities like oil; or inflation could occur mostly in foreign currencies, in other words, in Asia where the currencies could appreciate.

My comments:

[1] Boom bust cycles have been amplified by the environment of moral hazard as consequence to repeated ‘bailouts’ or interventionism.

[2] In the era of globalization, US investors are most likely to arbitrage between domestic interest rates and potential returns on emerging markets, hence the US dollar carry trade.

Of course, one can’t discount that the deepening of international trade would attract capital to where it is best treated.

[3] Gold is a long term buy, regardless of short term fluctuations, predicated on government interventionism and the debasement of fiat currency system.

[4] We are in the sweetspot phase of inflationism.

[5] Addiction to the printing press as a way to resolve economic ailments will lead to unintended serous consequences.

US Dollar Carry Fuels ASEAN Stock Market Boom

Now my themes on the current market actions in the ASEAN markets appear to be gradually gaining acceptance among a few perceptive observers.

While I call it arbitrages from policy divergences, they call it US dollar Carry Trade. Point is policy divergences of developed economies and emerging markets have incentivized cross-border capital flows that has helped pumped up asset prices (asset inflation).

Here is a terse excerpt from Howard Simons... (bold highlights mine/charts Minyanville.com)

``If it seems like the cheap dollar is propelling Thai stocks higher relative to US stocks, it is. Now let’s duplicate the exercise with another one of 1997’s chalk outlines on the pavement, the Philippines.

``The song remains the same: Filipino stocks have been feasting on cheap dollars; just borrow the USD, lend the PHP, rinse and repeat. The Philippines actually get a twofer for our policies as the stimulus increases demand for Filipino expatriate workers throughout the region; their remittances are one of the top sources of export earnings for the nation.”

Carry trade is seen from the perspective of foreign money flows INTO the ASEAN markets. Of course, NOT all trades are foreign based. In fact, foreign money account for less than half of the overall trade. This implies that the other important half is the domestic business cycle at play.

What this points to is that those who insist that this run up is about economic success or political endorsement or positive micro fundamental developments will one day get a RUDE awakening.

For now enjoy the party!

Deflating The Mythical Powers Of Central Bankers

For those who believe that government officials can do magic, this should be a reality check.

Here is a list of major recent failures of central bank interventionism which Fortune’s Colin Barr commented as having “caused a kerfuffle, much to their citizens' dismay.”

From Mr. Colin Barr:

The Bank of Switzerland. It spent around $200 billion between March 2009 and this past June in a bid to hold down the Swiss franc's appreciation against the euro. How did that work out? The swissie appreciated 10% during that span anyway. "Those are some serious paper losses," said Popplewell. "You'd have to say their big picture strategy hasn't worked out."

The Bank of Japan. It has spent almost $800 billion since 1977 on currency intervention that "seems to have had little lasting effect" on the value of the yen, a 2007 report to Congress concluded. But try try again. And so it is that this month Japan intervened for the first time in six years in a move that was almost universally derided as doomed to fail – particularly since any Fed announcement of QE2-related action would likely send the dollar lower against all currencies.

The Central Bank of Brazil. It has wasted large sums in a forlorn bid to hold down the value of the real over the past year. But setting an example all central bankers are surely taking note of, Finance Minister Guido Mantega said last week the government won't let that stop it from making the same mistake over and over again. "We won't just stand here and watch this game," he said. But the moral of this story might be: Don't just do something, stand there.

Bottom line: Governments recklessly gamble away with OUR money yet FAIL to accomplish the intended goals!

Why Philippine Elite Schools Are Inclined Towards Statism

Recently a libertarian colleague frustratingly observed that elite Philippine schools appear biased towards socialism.

Before dwelling directly with this issue, we should first look at the bigger picture and ask whether Filipinos, in general, are inclined towards (classical) liberalism or socialism.

In observation of the major source of influences which shapes the public’s mindset—particularly, the context of TV and newspaper or mainstream media’s reports and opinions, combined with the influences of the Church (largely the Catholic Church), one may conclude that Filipinos seem largely predisposed with the notion of social democracy (socialism).

And this is why domestic politics has popularly but erroneously been seen as the elixir to prosperity: just put in the “right” people and everything will be fixed. Yet this prevailing mindset has led to the public’s undeserved fixation towards politics at the expense of enhancing productivity.

And conversely, this seems to be the reason why (classical) liberalism seems to be a strange and unpopular concept here.

And only with the help of the internet has the principle of individual freedom, upholding private property as means of production, freedom of contract and social cooperation (or peace) via free trade gradually spread to a handful of adherents.

And likewise given that the domestic education industry has been highly regulated in terms of the enforcing curriculum standards, education cycle (see How Bro. Armin Luisitro’s 12 Year Basic Education Cycle Will Benefit The Big League Schools), the obsession towards compulsory education (e.g. subsidies to private schools for underprivileged students- See Is There A Brewing Bubble In The Philippine Education System?) and in many other aspects, this only suggests that Philippine educational system could somewhat constitute as a form ‘indoctrination’ towards the acceptance of state absolutism.

Apparently this hasn’t escaped the elite schools.

But there seems more to this.

In my view the most important factor is what I would call this the insider-outsider dynamics.

Insiders, represent the symbiotic relationship between the economic elite and ruling political class while the outsiders are the average citizen.

In consideration of the operating framework of the domestic political economy, where the Philippines is considered economically less free, and where, to quote Joe Studwell in Asian Godfather: Money and Power in Hong Kong and Southeast Asia (bold highlights mine), ``business interest gain so close a control of the political system that they are unaffected by the changes of government that do occur (as in Thailand and the Philippines). In both instances politicians spend huge sums to maintain a grip on power that has some semblance of legitimacy. This can only be financed by through direct political ownership of big business or more usually, contributions from nominally independent big business that is beholden to politicians. Whichever, the mechanism creates a not entirely unhappy dependence of elites between politicians and tycoons”, the elite schools has served as THE breeding or training grounds into fostering and nurturing the union of this exclusive insider political-economic relationship.

In other words, the primary reason elite schools have been inclined towards statism is because they benefit from such relationship. They represent the status quo.

Think of the Presidents who came from the ranks elite schools, including the incumbent. Or think of the cabinet members or bureaucrats who emerged from such top rank schools throughout the past and present administrations.

In addition, think of all those “donations” made by “Godfathers (tycoons)” to the elite schools, after having financially benefited from “political concessions” (monopolies, subsidies, cartel, access to funding, and etc...).

It’s been a give and take for the elite schools and the privileged political and economic class.

This also means that for people aspiring to get assimilated with the privileged clique, the best chances to gain entry would be through the elite schools route, via networking or by establishing connections. And obviously the passport has costs—skyrocketing tuition fees!

This also implies that elite schools are likely to fight to maintain status quo by promoting statism, despite the oxymoronic rhetoric towards ‘good’ government.

However, not all of the graduates of the elite schools aspire to be part of the insider. And I am talking about myself and a handful of emerging local contrarian classical liberals.

That’s because the status quo political economy benefits some at the expense of the rest of the society by instituting inequality of political and economic power through arbitrary laws and regulations.

And classical liberalism hopes to disentangle this “inequality”—by giving everyone (or democratizing) the “equality” of opportunity to succeed.

At any rate, for my colleagues, Murray N. Rothbard offers the best way to disseminate the principles of classical liberalism...

This is why, by the way, strategically, if you're an Austrian, you shouldn't spend time trying to convert Paul Samuelson or Milton Friedman. These guys are not going to be converted: they're locked into their paradigm. You convert people who are just coming up, new people, people who are on the fence. Graduate students, these are the people you can convert. Don't waste your time trying to convert Samuelson or Friedman or whoever the other paradigm people are.

Distinguishing Luck From Skills In The Financial Markets

``Luck is far more egalitarian than even intelligence. If people were rewarded strictly according to their abilities, things would still be unfair—people don’t choose their abilities. Randomness has a beneficial effect of reshuffling society’s cards.”- Nassim Nicolas Taleb, The Black Swan

In a bullmarket everybody is said to be a genius. This also implies that there will be an explosion of participants masquerading as experts.

Many will be overwhelmed by the attribution bias, where success will be associated with skills rather than the general circumstance of the marketplace or in particular the rising tide or plain old lady luck.

Winnowing the quality of knowledge will thus be a very important factor for any serious investors.

Importantly, to avoid getting trapped into a false sense of security (overconfidence) we should learn how to discriminate between luck and skills.

Information needs to be processed for them to be qualified as knowledge. Yet knowledge is never equal and has individualized traits.

And knowledge becomes skills only when translated into actions. Yet in applying knowledge to actions, where luck is involved, is highly dependent on the classification of the activity.

Figure 1: Legg Mason: Distinguishing Luck and Skills

Some activities have greater influence of luck than the others, as illustrated by the chart in figure 1.

Legg Mason’s Michael Mauboussin elaborates,

“Skill is “the ability to use one’s knowledge effectively and readily in execution or performance.” You can think of skill as a process, or a series of actions to achieve a specific goal. Luck is “the events or circumstances that operate for or against an individual.” Luck, in this sense, is above and beyond skill.”

The more variables involved in the nature of activity, the greater luck interplays with action.

So how does one distinguish between luck and skills?

Through mean reversion.

Legg Mason’s Mr. Mauboussin explains[1],

``One point is worth making right upfront: the outcomes of any activity that combine skill and luck will exhibit reversion to the mean. More technically, an extreme outcome (good or bad) will be followed by an outcome that has an expected value closer to the mean. Reversion to the mean is a tricky concept, and the relative contributions of skill and luck shed light on its significance for various activities.”

This is true. Predicting the market would seem like a coin toss distribution (50-50%) since markets move only in two opposite directions.

What makes forecasting activities difficult is the sustainability of accuracy. And mean reversion is what Warren Buffett would analogize as “you would only find out who is swimming naked when the tide goes out.” When luck runs out experts riding on artificial steak of predictive successes will be exposed for its facade.

For instance, some people claim that they have predicted one or two circumstances wherein the market validated their perspective.

However, if we consider the batting average of their overall predictions, their performances may accrue to be even less than the coin-toss distribution. This means that like a broken clock, they can only be right twice a day. This implies that relying on their expert opinion as basis for securing knowledge for prospective investment actions may not be worthwhile, as they could yield inferior results given their poor forecasting probability. (A noteworthy example would be a prominent University professor who had been on embraced by the media as a guru even when his streak of forecasting appears to have been tainted by a wide margin of error.[2])

Another way to say this is that one can be right for the wrong reasons or what one may call as sheer coincidence. Here, the context of the prediction would be its substance.

Luck versus Skills

Knowing to distinguish between luck and skills are important for several reasons:

1. It serves as a way to institute measurement of tradeoffs among available actions. In other words, economic calculation based on each proposed action and its attendant opportunity costs. Of course one can’t be specific, but instead rely on estimates.

In addition, one must give room or margin of error to variability, randomness and diminishing returns in terms of establishing the prospective asymmetric outcomes.

2. It provides rational feedback mechanism for assumed circumstances. Hence, contingent actions can be devised, where one won’t get caught by nasty “surprises” like a deer freezing in fear when faced headlights.

3. It filters false premises or noise from relevant information or signals.

In pointing out that the predictions of cabdrivers were at no disadvantage with very intelligent persons, Nassim Taleb wrote[3], Cabdrivers did not believe that they understood as much as learned people-really, they were not the experts and they knew it. Nobody knew anything, but the elite thinkers thought that they knew more than the rest because they were elite thinkers, and if you’re not a member of the elite, you automatically know more than the nonelite.

In short biases (economic or political) can obscure anyone from adapting the appropriate balanced or a more open perspective.

Applied to the general failure of most experts to foresee the recent crisis, economist David Colander in his written testimony submitted to the Congress of the United States, House Science and Technology Committee writes[4], (bold highlight mine)

``One of J.M. Keynes’s most famous quotes, which economists like to repeat, highlights the power of academic economists. He writes, “the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.” (Keynes, 1936: 135) What this quotation misses is the circularity of the idea generating process. The ideas of economists and political philosophers do not appear out of nowhere. Ideas that succeed are those that develop in the then existing institutional structure. The reality is that academic economists, who believe themselves quite exempt from any practical influence, are in fact guided by an incentive structure created by some now defunct politicians and administrators.”

The comfort of the crowd (or appeal to popularity), sheer dependence on models and presumptuousness of knowledge (or in Hayek’s term Fatal Conceit) can lead people to mental blindness which may extrapolate to severe miscalculations and eventual losses.

4. Michael Mauboussin suggest that this is also a way to segregate outperformers and laggards, which he calls “framework for understanding whether there’s a “best” participant”

He writes[5],

Transitivity is a key concept in assessing the outcomes of one-on-one interactions. An activity has transitive properties when competitor A beats competitor B, competitor B beats competitor C, and competitor A beats competitor C. Activities dominated by skill tend to be transitive. In contrast, in an activity that is not transitive, competitor A beats competitor B, competitor B beats competitor C, but competitor C beats competitor A. This is the set up of the game rock, paper, scissors. In theory, there is no best strategy in rock, paper, scissors, and chance will dictate the winner of a game, or repeated games. (In reality, people are poor at behaving randomly. For example, in tournament play, competitors throw scissors only 29.6 percent of the time, 3.7 percentage points less than what randomness requires. 13) A number of sports show a lack of transitivity, in part reflecting the nature of match-ups.

5. Importantly, distinguishing luck from skill based action also provides a framework for managing expectations.

This is especially important because of the possibility of the contrasting nature inherent in the expectations of the agent and the principal (agency problem) which could generate tensions or conflicts.

Here Mr. Mauboussin gives a prudent advice,

``Stated differently, you want the investment professionals focused intently on finding opportunities with edge and building sensible portfolios. Career risk is also important. Investment managers seeking long-term excess returns will frequently have portfolios that are very different than the benchmark and that have high tracking error. If the time horizon of either the investment company or the clients is shorter than the time horizon necessary to see the fruition of the investment approach, even skilled managers risk getting fired.” (bold highlight mine)

So principals (investors and punters) and their agents (bankers, stockbrokers, analysts, fund managers) would need to have their expectations aligned so as to maintain harmonious relationship as well as optimize on the skill based advantages of their agents in generating above average relative returns, in spite of the vicissitudes of the marketplace.

Prediction Versus Entrepreneurial Action

For most participants, the timeframe horizon is so narrow such that they presume financial markets as being driven by popular events.

In most occasions they can be so emotionally overwhelmed that they would accept any information as having valid causal linkages to price actions. Others may be in not for the returns, but for the thrill and excitement of market gyrations (entertainment value). Some are enticed by their endemic gambling ticks.

In addition most mainstream analysis are predicated on projecting past performances into the future.

Nassim Taleb rightly points out on this blind spot[6]: when we think of tomorrow we do not frame it in terms of what we thought about yesterday or the day before yesterday. Because of this introspective defect we fail to learn about the difference between our past predictions and the subsequent outcomes. When we think of tomorrow, we just project it as another yesterday. (bold highlight mine)

The important point here is that the pattern seeking nature of most people including experts tends to neglect on the conditional asymmetries involved which led to the outcome of yesterday.

Thus, many experts will err in the belief that yesterday’s conditions will playout similarly tomorrow.

Also, plain vanilla predictions issued by experts can differ with entrepreneurial actions in the sense that analysts may have less stakeholdings in their forecasts.

In other words, experts may not have personal money involved on the markets and could be advancing the latent interests of their employers (institutions) or themselves (subscription services) rather than the interests of principals (ROI). Hence, flowing with the mainstream ideas essentially shields them from the accountability of underperformance—where any negative outcome would be ascribed to general misfortunes (reverse attribution bias).

Another difference is that where the probabilities or the frequency and the substance would serve as an imprimatur for predictive successes for prediction gurus, in the financial markets, it is the magnitude of the gains, arising from their prudent portfolio management that matters most for investors. That’s why understanding crowd psychology and the stages of the market cycles play a far more important role for any serious investors than just interpreting from economic or corporate fundamentals perspective. After all, markets are all about people, their expectations vented through their actions to fulfil certain needs.

Lastly and importantly, we should learn to accept and admit that luck will be playing a big role into shaping relative or absolute returns. It’s because the complexity of nature allows many unseen things or “randomness” to shape decisions, actions and events.

As Nassim Nicolas Taleb wrote in his best seller[7],

``Capitalism is, among other things, the revitalization of the world thanks to the opportunity to be lucky. Luck is the grand equalizer, because almost anyone can benefit from it. The socialist governments protected their monsters, and by doing so, killed potential newcomers in the womb.”

So yes, as an unabashed capitalist, I would certainly count on luck in shaping the performance of my portfolio.

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[1] Mauboussin, Michael J. Untangling Skill and Luck, July 15, 2010 Legg Mason Management

[2] See Wall St. Cheat Sheet: Nouriel Roubini Unmasked; Lesson, October 22, 2009

[3] Taleb, Nassim Nicolas The Black Swan, The Impact of the Highly Improbable

[4] Colander David written testimony submitted to the Congress of the United States, House Science and Technology Committee, July 20, 2010 coordinationproblem.org, Read and React -- Colander's Testimony on Capitol Hill About Economics

[5] Mauboussin, loc. cit

[6] Taleb, Nassim Nicolas loc. cit

[7] Taleb, Nassim Nicolas loc. cit

Japan’s Currency Intervention, More Inflationism Ahead

``The whole world would then be able to inflate together, and therefore not suffer the inconvenience of inflationary countries losing either gold or income to sound-money countries. All the countries could inflate in a centrally-coordinated fashion, and we could suffer manipulation and nflation by a world government-banking elite without check or hindrance. At the end of the road would be a horrendous world-wide hyper-inflation, with no way of escaping into sounder or less inflated currencies.” Murray N. Rothbard on the Keynesian ideal “Bancor”

How the heck would you expect financial markets to falter with all the new stuff being worked out by major global central banks?

Let us put it this way, Japan has declared a war on her rising currency the Yen[1], which has been erroneously blamed by her government for their domestic economic malaise, by intervening in the currency markets.

This means that the Bank of Japan would have print money to sell yen in order to buy US dollars. And they have commenced on this operation just as China have begun to slow their purchases of US securities[2] —perhaps to accommodate for an appreciation of China’s yuan.

And as we have repeatedly predicted, economic ideology, path dependency and the prevailing low interest rates will prompt governments of major economies to use their respective printing presses to the hilt, in the assumption that money printing has little impact on the economy or the markets.

Policymakers are shown as exceedingly short-term oriented or with little regards to the possible consequences from their present actions.

And their academic and mainstream apologists have provided intellectual support, in the belief that by intervening in the currency market, or by the destroying their currency, they will the save the world. This is a delusion. Never has it been the case where prosperity had been attained by the destruction of one’s currency.

This is no more than a redistribution scheme by the Japanese government aimed at bolstering her exporters (17% of the Japanese economy as of 2007[3]) at the expense of the rest of the domestic economy in order to revive the old model where the US functioned as the world’s major consumption growth engine.

This interventionism could likewise be aimed at maintaining the low interest regime in the US in order to support the US banking system.

Or possibly, this could even signify as a clandestine three cornered coordinated operation with China, as China appreciates her currency by reducing purchases of US assets. Meanwhile, Japan takes over China’s role as the major accumulator of US securities, given the existing fragility of the US banking system.

Implications of the Japanese Yen Interventionism

Japan intervened in the currency markets in 2004. However the conditions of the past would be dissimilar today. Back then, the US was inflating a housing bubble, today, inflationism has been aimed at shoring up the local banking system.

Another, one possible reason Japan had not engaged in rampant inflationism during Japan’s lost decade could due to her cultural idiosyncrasy and a declining population, where Japan had wanted to maintain the value of Yen’s purchasing power. And this has been misconstrued as deflation[4].

Yet we see two problems with Japan’s interventionism.

First, the culture of savings of the Japanese will be jeopardized as the Yen is depreciated against real goods and services, rather than against the US dollar.

This isn’t likely to translate into new investments nor will this approach succeed to reinvigorate the economy. Instead, it could prompt for more capital outflows into commodity and peripheral markets.

Second, since the US has been inflating by keeping the US Federal Reserve’s balance sheet bloated, this means that Bank of Japan would not only have to print money but extensively print money WAY AHEAD of the US given the conservative position of the Bank of Japan’s balance sheet (BoJ) [see left window figure 2].

Figure 2: Competitive Devaluation And Record Gold Prices (chart courtesy of Danske Bank and Stockcharts.com)

Competitive Devaluation And Record Gold Prices

So in effect, we now have a three way competitive devaluation among the currencies of major economies, or a race to the bottom which includes the US dollar, the British Pound, and the Japanese Yen.

Thus, almost instinctively the gold market has responded to such development by exploding to new nominal record highs in US dollar terms (right chart-top window).

Priced in the Yen, Gold has likewise polevaulted as the BoJ made official her government’s interventionism in the currency market.

Slowly but surely rising gold prices continue to reflect on the growing cracks in the fiat paper money standard. Eventually the paper money system crumble like experiments in the past.

So as major economies devalue their currencies, we are likely to witness a monumental shift in the search for alternative “store of value” in the commodity markets and in the asset markets of the peripheral “emerging” economies as the ASEAN.

Figure 3: The Previous BoJ Interventionism and the Nikkei 225 (chart courtesy of Danske Bank and yahoo finance)

Japan’s previous interventionism failed to accomplish its goals (see figure 3), it took other factors to fire up a rally in the US Dollar-Japan Yen pair such as the American Jobs Creation Act Of 2004[5] which included a limited period of tax reduced incentives for multinationals who were enticed to repatriate overseas earnings, and others.

So whether this signifies as a standalone operation or a covert three way joint action among China, Japan and the US, the likelihood of the success of BoJ’s actions will likely be limited—unless Japan will aggressively take on more risk by exposing its system to the risk of hyperinflation.

In the past, such interventionism had coincided with the rising Nikkei (right window). With the degree of interventionism likely to be stronger than 2004, we should expect much of these easy money to flow into various assets.

So global bubble cycles are likely to get amplified.

Again all these add up to fly in the face of deflation exponents.

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[1] Japan Times, Government acts to drive down yen, September 15, 2010

[2] Wall Street Journal Blog, Don’t Worry About China, Japan Will Finance U.S. Debt, September 15, 2010

[3] Google public data, Exports as % of the Economy, World Development Indicators

[4] See Japan’s Lost Decade Wasn’t Due To Deflation But Stagnation From Massive Interventionism, July 6, 2010

[5] Investopedia.com American Jobs Creation Act Of 2004

Quote of The Day: Principles of Free Trade

A fantastic quote from Professor Don Boudreaux,

The principles of free trade demand that no government punish its own citizens with trade restrictions. Ever. Even if another government, such as China’s, harms its citizens by forcing them to pay tariffs or subsidies, the principles of free trade demand that our government nevertheless refrain from inflicting like harm on us.

Free trade is the principle that people should be free to spend and to invest their money as they see fit. Period. That principle is in no way contingent upon its acceptance or rejection by other governments.

Exactly.

Another way to say it is that TWO wrongs DO NOT make a right. And this the most common logical fallacy employed by superficial thinking naive protectionists.

OPEC 50th Birthday: 50 Years of Oil Price Manipulation

It’s been 50 years since governments around the world have been manipulating the oil price market.

This from the Economist,

OPEC, the cartel of oil producers, celebrates its 50th anniversary on September 14th. The organisation was founded in 1960 with the explicit purpose of manipulating oil prices by controlling supplies. It has generally proved successful. OPEC controls around 80% of the world's proven reserves and over 40% of the world's production among its 12 member states. The Gulf states that dominate OPEC have the biggest reserves and lowest costs, so can most easily turn the taps on and off when required to keep prices high. Despite the slow return to health of a sickly world economy, oil fetches a lofty $75 a barrel, which Saudi Arabia, OPEC's most influential member reckons is "ideal".

One should note that the cartel, which has been responsible for 40% of the world’s production, holds also 4/5 of the proven reserves. This means that the cartel isn’t limited only to oil production but also in the access to oil reserves for production. Limiting access to production means restricting available supplies.

Of course, the production cartel (OPEC) hasn’t been the only factor. Otherwise the prices of oil would have steadily trekked upwards over the last 50 years.

That’s because there is another cartel involved: the US Federal Reserve, whom represents today’s de facto US dollar standard system.

Monetary inflation by the US Federal Reserve has produced boom bust cycles in oil prices. The US Fed’s loose money policies has been instrumental in the huge price swings in the price of oil by artificially stimulating demand during the boom days, which subsequently resulted to the ensuing busts.

Bottom line: Unseen by the public has been the 50 years of manipulation by different government sponsored cartels that has vastly eroded our purchasing power and has prompted for intensive volatility in the world’s economic trends.

50 years of government “greed” at the expense of the people.

Ironically, the public sees things the opposite way.

Does Importation Drain The Wealth Of A Nation?

This has long been a fallacy used by mercantilists to advance protectionism which had been demolished by classical economics led by Adam Smith.

In short, the answer is NO.

First, accounting equations does NOT replace the essence of human actions.

Where GDP=private consumption + gross investment + government spending + (exports-imports), the impression derived from exports minus imports is that imports signify a drag to the economy.

This is plain nonsense. Exports and imports are activities of individuals who engage in voluntary exchange. And no one would willingly undertake trade if there are no perceived benefits from it.

And this also applies to people trading with one another from different countries. To quote Professor Don Boudreaux, “Consumers’ nationalities are economically irrelevant.”

Second, trade is NOT a zero sum game.

It is not what Michel de Montaigne (1533–1592) calls as “no profit can possibly be made but at the expense of another” from which Professor Ludwig von Mises calls as the Montaigne fallacy.

Trade is voluntary exchange via division of labour. We trade for the purpose of attaining things or services which we cannot provide to oneself, and in exchange, provide things or services that we have which the others want.

Trade isn’t mechanistic. It arises from individual choices and preferences.

Third, money should NEVER be confused with wealth.

As Adam Smith in the Wealth of Nations wrote, (bold emphasis mine)

Some of the best English writers upon commerce set out with observing that the wealth of a country consists, not in its gold and silver only, but in its lands, houses, and consumable goods of all different kinds. In the course of their reasonings, however, the lands, houses, and consumable goods seem to slip out of their memory, and the strain of their argument frequently supposes that all wealth consists in gold and silver, and that to multiply those metals is the great object of national industry and commerce.

Exactly. This especially for people who argue from the basis of their political religion.

And the principal aim of trade isn’t to accumulate money, but to benefit from the exchange of goods and services.

Again Adam Smith,

The importation of gold and silver is not the principal, much less the sole benefit which a nation derives from its foreign trade. Between whatever places foreign trade is carried on, they all of them derive two distinct benefits from it. It carries out that surplus part of the produce of their land and labour for which there is no demand among them, and brings back in return for it something else for which there is a demand. It gives a value to their superfluities, by exchanging them for something else, which may satisfy a part of their wants, and increase their enjoyments.

Fourth, money in a free market is self-regulating and that interventionism will NOT prevent outflows...

Again Adam Smith,

The quantity of every commodity which human industry can either purchase or produce naturally regulates itself in every country according to the effectual demand, or according to the demand of those who are willing to pay the whole rent, labour, and profits which must be paid in order to prepare and bring it to market. But no commodities regulate themselves more easily or more exactly according to this effectual demand than gold and silver; because, on account of the small bulk and great value of those metals, no commodities can be more easily transported from one place to another, from the places where they are cheap to those where they are dear, from the places where they exceed to those where they fall short of this effectual demand...

When the quantity of gold and silver imported into any country exceeds the effectual demand, no vigilance of government can prevent their exportation.

Finally those who preach mercantilism DO NOT argue for the benefit of the entire society but argue for the interest of a select few.

According to Jacob Viner in the Studies in the Theory of International Trade [1937]

The mercantilist literature, on the other hand, consisted in the main of writings by or on behalf of “merchants” or businessmen, who had the usual capacity for identifying their own with the national welfare. Disinterested exposition of trade doctrine was by no means totally absent from the mercantilist literature, and in the eighteenth century many of the tracts were written to serve party rather than self. But the great bulk of the mercantilist literature consisted of tracts which were partly or wholly, frankly or disguisedly, special pleas for special economic interests. Freedom for themselves, restrictions for others, such was the essence of the usual program of legislation of the mercantilist tracts of merchant authorship.

Restricting trade is a way to impoverishment.

Philippine Phisix In A Historic Breakaway Run!

``Genius is the act of solving a problem in a way no one has solved it before. It has nothing to do with winning a Nobel prize in physics or certain levels of schooling. It's about using human insight and initiative to find original solutions that matter. Genius is actually the eventual public recognition of dozens (or hundreds) of failed attempts at solving a problem. Sometimes we fail in public, often we fail in private, but people who are doing creative work are constantly failing. When the lizard brain kicks in and the resistance slows you down, the only correct response is to push back again and again and again with one failure after another. Sooner or later, the lizard will get bored and give up.” Seth Godin

After this week’s remarkable and historic breakout by the Philippine Phisix to a fresh all time nominal record highs, we should be having our victory lap.

Another Sweet Vindication

Sorry I can’t help but vent this pleasant and pleasurable feeling of total exoneration: I TOLD YOU SO!

That’s because it’s been years since my analysis and forecasts have been met by various incredulous expressions of scepticisms from almost all quarters.

And it’s not just the breakout that matters; it has been the operational process of the domestic and global financial markets which seems to have aligned in near precision with our analytical methodology predicated mostly upon a combination of non-mainstream theories: Austrian economics, Public choice theory, Hyman Minsky’s Financial Instability hypothesis, George Soro’s reflexivity theory, Alvin Toffler’s “Knowledge Economies”, behavioural finance (Nassim Taleb) and other theories on psychology (e.g. PTSD, Pavlov’s experiment).

Given the momentous force that had accompanied the recent breakout, wherein a whopping 9.44% of accrued gains had been established over the last two weeks, one should expect to see a reprieve over the coming week/s.

We don’t know of the scale of the pause, whether it should signify a substantial correction or a mere consolidation. But we know one thing: no trend goes in a straight line, and that the upcoming countertrend should signify as an opportunity to accumulate than for exit.

As we have previously pointed out, not all bullmarkets are like[1]. As the growing conviction phase of the bubble cycle deepens, as represented by the recent buyside calls of “Golden Era”[2], one should expect to see heightened volatility in market actions which means more frequent explosive moves.

Timing the markets, unless one is very lucky, could translate to lost opportunities, as sharp losses can equally translate to even swifter recoveries.

As a side note, attribution bias, or claiming skills as reasons for ‘trading’ successes, will predominate the coming atmosphere. This especially will be amplified for retail participants, but unknowingly for most, they would be just plain lucky, as the rising lifts most if not all boats.

In a bullmarket, as an old saw goes, everyone is a genius.

Peso Remains A Buy, Politicizing Market Success (Peso Bond Float)

Figure 1: Yahoo/Bloomberg: Milestone Phisix, Lagging Peso

The difference in today’s secular bullmarket compared with the past (1986-1997) is that this time the Phisix (right window) will be accompanied by a rising Philippine Peso. Lately the Peso has apparently lagged (left window).

In late 2007 where the Phisix made a new high, the Peso likewise belatedly caught up and peaked in January of 2008 (Php 40 to a US dollar).

And perhaps we can expect the same trailing performance by the Peso as foreign fund flows (compounded by immigrant and OFWs) into local assets magnify the demand for the Peso.

Meanwhile, the monetary accommodation by the US government and other developed economies will enlarge relative supply scale of the money supplies in favour of ASEAN and Asian currencies.

Importantly, the sustainability of the relative outperformance between asset prices of developed economies and that of the ASEAN (or emerging Asia) powered by the divergences of monetary policies will prompt for more inflows into the region.

And one of the glaring example of the unfolding of such dynamics has been the recent success by the $1 billion Peso bond float.

Yet like always, unfortunately events like this will always be tainted with political colour, as political personalities speedily associate these events with populism.

As we have argued this administration has been so image conscious, such that it would seem that the elections have never ended. To impute the successful bond float to “landslide vote of confidence[3]” for the new administration is no less than PR work meant at propping up imagery of the administration, even if the relevance of the purported linkages were less than half true or constitutes a logical fallacy.

Figure 2: AsianBondsonline.adb.org[4]: Size and Composition of Emerging East Asian Local Currency Bond Markets

The alleged “vote of confidence” does not consider the larger spectrum which would show that the region’s local currency bonds markets have been vastly improving (see figure 2).

In fact, the Philippines have lagged our Asian neighbours and falls below the average performance of the total Emerging Asia, (perhaps even if we add the latest US $1 billion float).

So on a relative scale, the vote of confidence on the Philippines isn’t that impressive, because investors have voted with more confidence on the markets of Thailand (which ironically just experienced a nasty city-wide riot[5] last May), Indonesia and has only been at par with Malaysia.

Given the above picture, I would dare argue that even under the past unpopular regime, the bond issuance would have had a similar magnitude of “warm” reception.

That’s because in a world where prices have been distorted by government’s manipulation of the interest rate (price of time), people conjure up all sorts of excuses, valid or not, just to chase for yields. In short, as the reflexivity theory would say, prices shape opinions.

Yet politicians are quick to grab credit for any actions as their own doing even if these are unrelated, unsupported or has little correlations.

And evidence from the above exhibits that politics have had little effect on the supposed “vote of confidence” of the latest Philippine bond float (or even applied to Thailand).

Another reason why the Philippine Peso has lagged has been due to domestic politics[6]. Particularly that of the politics of OFWs, and secondarily, of the exporters.

So yes, the Peso remains a buy and should be expected to appreciate towards the 40-levels by the yearend, barring any unforeseen circumstances (e.g. war on Iran) and unless our central bank will match the US Federal Reserve in inflating the system (our tail risk).

Unlikely A US Double Dip Recession

These sanguine forecasts are likewise predicated on the conditions that there will be NO double dip recession in developed economies, as a recession will likely drain liquidity in the global financial system despite the proclivity of central banks to counteract such dynamics by flooding the system with money.

Unless we can see further proof where domestic liquidity can get insulated from a liquidity drain abroad, it would be imprudent to bet against “convergence”, which apparently have been the hallmark of globalization.

And a recession is NOT inevitable for earlier reasons cited[7] plus some additional inputs:

1. Global central banks have placed under their stringent sponsorship the banking industry.

Unlike the Great Depression where collapsing banks had a domino effect throughout the economy, today global central banks led by US has backstopped their banking system (specifically creditors) with trillions of taxpayer money. This signifies as a pyrrhic short term victory whose enormous costs would certainly emerge sometime in the future.

Yet it would be a folly for the mainstream to declare victory on what is clearly a short-term panacea. Paying the Piper will be different from what the mainstream expects.

2. Globalization continues to progress.

In contrast to the Great Depression, collapsing banks, protectionism and regime uncertainties via a slew of massive regulatory obstacles caused a standstill and a decline in trade and investments. This is hardly today’s picture.

During the height of the recent crisis, marked by the Lehman bankruptcy, the near seizure of the US banking system rippled throughout the global banking system. However, many entities persisted to trade and channelled them via barter[8] and local currency[9]. And this empirically disproved the mainstream notion that the crisis was one of the failures of aggregate demand. Thus, the mainstream had been caught unaware of the 2009 “recovery” which was likewise supported by the Fed’s (Quantitative Easing) printing press.

Importantly, while the banking system of crisis affected areas like the US have resulted to large scale deterioration in the credit conditions as the crisis culminated, there appears to be material improvement over some aspects of the credit markets as previously discussed[10]. It is likely that the credit markets in the US could finally be responding to the yield curve dynamics which cyclically has had a 2-3 year lag period[11].

Another feature of globalization has been the financing dynamics outside of the banking system, or in particular the explosive growth of the bond markets.

According to Bloomberg[12],

``Global high-yield bond sales are poised to exceed 2009’s record issuance as the riskiest companies take advantage of plunging borrowing costs and investor demand to refinance debt.”

So while the permabears continue to tunnel onto the credit growth as a reason to argue for another recession, the complexities brought about by globalization is certainly keeping them on the wrong side of the fence.

Finally, in contrast to conventional wisdom, credit isn’t the foundation growth, savings is.

As the great Professor Ludwig von Mises wrote[13],

The only source of the generation of additional capital goods is saving. If all the goods produced are consumed, no new capital comes into being.

Figure 3: Deutsche Bank[14]: The Rising Impact Of Asia On The Global Economy

Flushed with savings, emerging markets have not optimized the utility of savings into investments due to their underdeveloped state of the markets (see figure 3). However, globalization appears to be reconfiguring this role as markets are liberalized to accommodate on foreign investments.

Yet of course, artificially suppressed interest rates have been also been a major factor into generating policy “traction” or having to accelerate such dynamics.

And for as long as interest rates will remain at über-accommodative levels in developed economies, emerging markets, like the Philippines, should generally be expected to outperform compared to the debt hobbled counterparts in developed economies.

3. More signs of transition to the Information Age.

The transition to the information age is no more than an extension of the highly competitive and increasingly diversified markets brought about globalization that has spurred massive technological innovation.

Most experts still use industrial age metrics to measure economic activities, which has increasingly become obsolescent. To analogize, the mainstream still think in terms of analog instead of digital, even when many of them increasingly use digital instruments to transact or engage in commerce or conduct many activities in their lives.

In the US, since the adjustment process from a bubble economy to a rediscovery phase takes a longer period, especially in the light of a growing specialization of trade patterns, government intervention only delays these rediscovery phase.

Nevertheless, signs of such transitions have become manifest as seen in the growing mismatch between job availability (high skilled) and manpower supply (labor exposed to malinvestments) as we have pointed out earlier[15].

It isn’t necessarily that there has been a paucity of jobs, but in many instances, the skills required for specialized jobs have been inadequate or have been in a mismatch. And this has mainly been due to the distortive effects from previous inflationary policies that has caused massive misdirection of use in terms of labor and resources. And currently, interventionist policies (unemployment benefits, Obamacare, prospects of higher taxes et.al.) have proven to be an obstacle in the retooling process required for their labor force to adapt to the new reality.

Additionally the latest trade data shows that capital spending has led the economic growth of the US, which has mostly been seen in the industrial machinery and computer exports sectors.

As this Wall Street Journal article illustrate[16],

``While capital projects abroad, especially in emerging economies, are designed to expand production capacity, U.S. businesses are spending to modernize existing facilities and to boost productivity in their work force. Business spending on equipment accounted for one-third of gross domestic product growth in the first quarter and almost all of second-quarter GDP growth.

``The increased foreign demand, coupled with spending here in the U.S., is why business equipment is leading economic growth. U.S. output of business equipment jumped 11.7% in the year ended in July, compared with a 7.7% gain for all manufacturing production.

So specialization, division of labor and comparative advantages highlight substantial part of the economic conditions in the US.

In short, for the mainstream there is alot more for them to chew on, which apparently they refuse to do.

---

[1] See How To Go About The Different Phases of The Bullmarket Cycle, August 23, 2010

[2] See The Rationalization Phase Begins: ‘Golden Era’ Equals The ‘New Paradigm’?, September 8, 2010

[3] Inquirer.net Peso bond sale nets $1B, September 11, 2010

[4] AsianBondsonline.adb.org, Asian Bond Monitor: Summer Issue Bond Market Developments in the First Quarter of 2010

[5] See Politics And Markets: Bangkok Burns Edition, May 20, 2010

[6] See Global Policy Divergences Favors A Rising Peso, August 22, 2010

[7] See Why Deflationists Are Most Likely Wrong Again, August 15, 2010

[8] See What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis, February 1, 2009

[9] See Emerging Local Currencies In The US Disproves The 'Liquidity Trap’, February 16, 2010

[10] See The Road To Inflation, August 29, 2010

[11] See Influences Of The Yield Curve On The Equity And Commodity Markets, March 22, 2010

[12] Bloomberg.com, Treasury 10-Year Note Yields Climb to One-Month High on Economy, September 10, 2010

[13] Mises, Ludwig von The Anti-Capitalistic Mentality by Ludwig von Mises, Section 4

[14] Lanzeni Maria Laura Lanzeni The Rising Impact Of Asia On The Global Economy June 2010

[15] See US Unemployment: It’s Partly About Skills-Jobs Mismatch, August 10, 2010

[16] Madigan Kathleen, Trade Data Show Importance of Capital Goods Wall Street Journal Blog, September 10, 2010