The Possible Implications Of The Next Phase Of US Monetary Easing

``In a free economy the principal cause of a cumulative deficit in a country's international payments is to be found in inflation. Reference to it has been already made. A sustained policy of inflation leads a gold-standard country to a cumulative loss of gold and finally to the abandonment of that system; then the national currency can freely depreciate. In a country whose currency is not convertible into gold, inflation leads to its continuous devaluation in terms of foreign currencies.” Michael A. Heilperin, International Monetary Economics

I have more proof that the next wave of inflationism will take place not because of the political exigencies to restore “export competitiveness” (a.k.a currency wars) or about the US unemployment woes, even if the latter has been used as justification for the coming actions, but to save the US banking system.

QE 2.0 And The Legal Face Of The US Mortgage Crisis

The US Federal Reserve through Mr. Bernanke in a recent speech said that “the risk of deflation is higher than desirable[1]” and that “Given the committee’s objectives, there would appear — all else being equal — to be a case for further action[2]”

So there seems to be a strong likelihood of Quantitative Easing (QE) 2.0 will take place during the next Fed meeting in November 2-3.

Yet, what’s wrong with the two illustrations? (see figure 1)

Figure 1: US Stocks Rallying Without Financials

Basically, the US stockmarket has been rallying absent the financials, the former leaders. The financials, as seen by S&P Financials (SPF: left window, bottom pane), have lagged and has been weighed by the banking index (BIX-left window, main chart)

The poor performance of the US banks can be traced to the next phase of the mortgage crisis.

Apparently the US mortgage mess has been transformed from a financial and economic issue into a major legal morass: The issue of property titles—where the complexities of the Mortgage Backed Securities (MBS), during the boom days, may have led to string of fraudulent actions which may have caused a “chain of broken titles”.

Gonzalo Lira has the details[3] but here is the kernel,

``A lot of the foreclosed properties might not have been foreclosed legally. The people evicted might still have a right to their old houses. The new buyers might not actually own the REO’s they bought off the banks. The banks could be on the hook for trillions of dollars, and in the sights of literally millions of lawsuits.”

The initial tremor has been a wave of foreclosure moratorium.

According to Chad Fisher of USA News[4],

``JPMorgan Chase has suspended foreclosures in 23 states while the company looks at 115,000 mortgage foreclosure files to find potential errors in its documentation. Ally Financial and Bank of America are looking for errors in files for all 50 states and suspending foreclosures. Goldman Sachs' Litton Loan Servicing, PNC Financial, and OneWest Bank began are checking their files, but Wells Fargo and Citigroup are holding their ground, stating that their affidavits are valid and sound...This time the states are banding together to stop foreclosures based on illegal affidavits submitted by mortgage companies in foreclosure proceedings.”

One risk is that banks may be required to buy back mortgage securities if they are the originators. This could put under further strain the banking industry’s capital position that could trigger another seizure in the banking system.

And perhaps QE 2.0 is meant to assume this role—to provide another subsidy to industry by acting as lender or buyer or guarantor of last resort.

Of course the foreclosure moratorium presents as another burden to the housing industry, which serves as another reason why QE 2.0 will, once again, be in operation.

As we have long said, this has much less been about the US economy, but about protecting the banking system, which has been the anchor to the de facto US dollar monetary system, from the risks of collapse.

The problem with mainstream media is that they have been focused on the aspects of currency wars, emanating from so-called imbalances, when the predicament is apparently internal: Incumbent unsustainable policies and their unintended consequences.

The Deadly Effects Of Competitive Devaluation

I’d like to add that the impact of the so-called “currency wars” will greatly depend on the degree of reaction by Emerging Market central banks relative to the inflationism applied by their contemporaries in the developed economies.

Since currency wars or “competitive devaluation” function as a subtle form of protectionism, which implies of multiple participants, the effect isn’t likely to be temporary or short term but a lasting one with disastrous results.

We are not new to this, according to Murray N. Rothbard[5], (bold highlights mine, italics original)

``Of course, the world had suffered mightily from fluctuating fiat money in the not too distant past: the 1930s, when every country had gone off gold (a phony gold standard preserved for foreign central banks by the United States). The problem is that each nation-state kept fixing its exchange rates, and the result was currency blocs, aggressive devaluations attempting to expand exports and restrict imports, and economic warfare culminating in World War II.”

The major difference is that countries then went off the gold standard and eventually returned to a modified US dollar-gold fix, known as the Bretton Woods system[6], while today we are operating plainly on a paper money US dollar standard. So essentially, the competitive devaluation being staged by today’s global central banks sails on unchartered waters.

Figure 2: Imports Then And Today

Besides unlike in the 30s, global trade was much less of a factor (see figure 2). And less global trade translated then to geopolitics that had been mainly based on nationalism.

Today, the world has been alot more trade oriented. And so far, the responses by emerging market monetary authorities have been benign, defensive and less confrontational.

For instance, Thailand reportedly will remove a 15% tax privilege accorded to foreigners on income from domestic bonds[7]. Also lately Brazil’s government will move to “to raise the country's Financial Operations Tax, known as IOF, on certain types of incoming foreign investment will be insufficient to resolve the country's problems with an appreciated local currency, Brazil's National Confederation of Industries, or CNI, said Tuesday[8].”

South Korea also joins the clamp down on foreign currency speculation by increasing probes on currency derivatives[9].

And to confirm our suspicions[10], Asian central banks have been heavily intervening on their respective markets to curb currency appreciation. According to a news report ``Authorities in the region were estimated to have bought a combined $23.2 billion via intervention from last week until Tuesday, according to traders estimated compiled by IFR Markets.[11]”

And signs are likely that reactive interventions also involves the domestic central bank (Bangko Sentral ng Pilipinas) in the slowing the appreciation of the Peso[12].

And of course the overall effect of competitive devaluation is to raise the price of commodities (see figure 3).

Figure 3: Stockcharts.com: Commodity Inflation

So whether it Gold (Gold), Agriculture commodities ($GKX-S&P GSCI Agricultural Index Spot Prices), industrial metals ($GYX S&P GSCI Industrial Metals Index - Spot Prices) or energy products ($GJX-S&P GSCI Energy Index Spot Prices) we seem to be witnessing broadening signs of commodity inflation emanating from these collective policies. This is aside from the financial asset inflation in Emerging Markets.

Author Judy Shelton quotes Euro currency founder Robert Mundell in an interview[13],

``'The price of gold is an index of inflation expectations," Mr. Mundell says without hesitation. "The rising price of gold shows that people see huge amounts of debt being accumulated and they expect more money to be pumped out."

In explaining the failure of the Bretton Woods system, Mr. Mundell again in the same interview says

"The system broke down," he hastens to explain, "not because of fixed rates. Fixed exchange rates operate between California and New York . . . the system broke down because there was no mechanism to keep the world price level in line with the price of gold." (emphasis added)

In other words, sustained interventions and inflationism deflected or distorted the exchange ratio between money relative to gold which induced huge unsustainable imbalances that caused the monetary system to disintegrate.

Applying this to competitive devaluation, this implies that protectionism via the currency valve will only risks leading the world to inimical trade wars or shifting bubble cycles or hyperinflation/breakdown of the currency system.

So for a full scale currency war to take place, the effects are certainly not negligible.

In A Currency War No Nation Wins

It’s even equally ridiculous to hear mainstream proponents advocate currency wars as solution to global imbalances such as “China wants to impose a deflationary adjustment on the US, just as Germany is doing to Greece”[14].

On the first place no one is trying to deflate other nations directly for their own benefit. Policies are most shaped to conform with perceived interests of local entities that takes external interests as secondary objectives.

For instance, QE 2.0 appears directed at the banking system rather than promoting demand via export competitiveness via the currency channel.

Next, people and not nations are the ones who conduct trade and trade balances likewise reflect on this.

Another, currency values are not the sole factor that determines trade balances, there are many issues such as scale of capital, technology, infrastructure, cost of doing business through tax and bureaucratic regime, legal institutions, property rights, state of the markets and labor and many others that influence the business environment.

Fourth, it isn’t true China or Greece has been deflating (see figure 4).

Figure 4: Tradingeconomics.com: Inflation in China and Greece

The problems of Greece, for instance, reflect more on the rigidity of a relatively closed economy[15] and the overdependence on a welfare state than from its Euro anchor. I’d suspect that even if Greece were to operate on its former currency, the drachma, and allowed to devalue; the internal rigidities won’t miraculously bring them to an export giant as misperceived by the mainstream.

So I wouldn’t know what kind of world these analysts live in, but their narratives has been far from appropriate accounting for the facts. They would seem to be like snake-oil salesman.

Lastly, since inflationism is a subtle form of redistribution, i.e. from savers to spenders and from creditors to debtors, this will be beneficial only to a few but at the expense of society. Therefore, claims that the US will benefit from a currency war is unalloyed canard.

Doug Noland of the Credit Bubble Bulletin rightly observes[16],

``The U.S. cannot win the “currency war.” In reality, central bankers in China, Japan, Brazil, South Korea and elsewhere aren’t even battling against us. They have, instead, been waging war on the market. If foreign central bankers had not intervened and accumulated massive dollar holdings (international reserves up an incredible $1.5 TN in 12 months!) – in the process providing a “backstop bid” for both our currency and the Treasury market – it would be an altogether different market environment today.

``There will be no answer for global imbalances found by the U.S. “inflating the rest of the world.” The problem with inflationism is that one year of inflationary measures leads only to the next year of greater inflation.”

And I certainly agree that inflationism is an addictive agent. But like abuse of use of illegal substances, such actions will have long term deleterious implications.

QE 2.0 Should Boost Emerging Market and Asian Equity Assets

As we have long repeatedly argued, global policy divergences has been prompting for cross border capital flows that has been buoying emerging market assets including that of Asia (see figure 5).

Figure 5: US Global Funds: QE 2.0 Should Lift Asian Equities

And the transmission mechanism that would boost liquidity flows isn’t only from external sources but likewise reflected from domestic channels.

Some confirmation of our view from Morgan Stanley’s Joachim Fels and Manoj Pradhan[17]

``Economies with greater slack in their economies and less inflationary pressures will try to keep their currencies from appreciating, either through FX intervention or, to a lesser extent, via the use of capital controls. Intervention in FX markets will likely mean higher domestic liquidity (in the absence of tight credit controls like in China). In turn, the domestic economy is likely to expand and goods and risky asset prices are likely to be pushed higher. These EM economies should see a boom, and higher incomes, leading to an increase in the demand for US exports. Other EM economies, whose output gaps are too small for comfort or whose inflation is already a concern, could decide to let their currencies accelerate to a greater extent. Domestic expansion here would be more limited, so there would be not so much of an income effect; but US exports would still benefit again, this time from an improved price advantage thanks to EM currency appreciation.”

Figure 6: Tradingeconomics.com: Philippines Total Forex Reserves (ex-gold)

In the Philippines, as cross border capital flow surges, domestic liquidity has likewise been expanding, as the local central bank, the BSP, intervenes in the currency markets, aside from the ramifications of the artificially suppressed interest rates.

So in the environment of the alluring sweet spot of inflationism and concerted currency debasement, cash is likely the worst form of investment.

---

[1] Businessweek.com Bernanke Ponders ‘Crapshoot’ Amid Deflation Risk, October 15, 2010

[2] New York Times, Bernanke Weighs Risks of New Action, October 15, 2010

[3] Lira, Gonzalo The Second Leg Down of America’s Death Spiral, October 12, 2010

[4] Fisher Chad, 5 Things You Should Know About the Foreclosure Moratorium, US News, October 15, 2010

[5] Rothbard, Murray N. The World Currency Crisis, Making Economic Sense

[6] Wikipedia.org Bretton Woods system

[7] Businessweek, Bloomberg Thailand to Levy 15% Tax on Foreigners’ Bond Income, October 12, 2010

[8] Wall Street Journal Brazil Industry: IOF Tax Not Enough To Resolve Forex Problems October 5, 2010

[9] Wall Street Journal, Korea to Inspect Forex Positions at Banks, October 5, 2010

[10] See Currency Wars And The Philippine Peso, October 10, 2010

[11] Business Recorder, Taiwan dollar at two-year high, October 6, 2010

[12] Inquirer.net, Jan.-Aug. BOP surplus rises by 25% to $3.48B, September 20, 2010

[13] Shelton, Judy, Currency Chaos: Where Do We Go From Here?, October 16, 2010

[14] Wolf, Martin Why America is going to win the global currency battle, Oct 12, 2010

[15] See Greece And Economic Freedom, October 16, 2010

[16] Noland, Doug Inflationary Biases And The U.S. Policy Dilemma, Credit Bubble Bulletin PrudentBear.com

[17] Fels Joachim and Pradhan Manoj, QE-20, Morgan Stanley October 15, 2010

Greece And Economic Freedom

Greece is reportedly seeking to open her economy to more competition.

This from the Wall Street Journal Blog

Ms. Daimantopoulou, like other Greek ministers, is trying to figure out how to open up one of Europe’s most closed economies. State-owned universities can’t even hire foreign professors, she said, a practice she was trying to change.

She said Greece became more and more inward looking over the past 50 years because of the Cold War and the years of dictatorship. The economic collapse, and the rescue loans by the International Monetary Fund and European Union, make liberalizing the economy a requirement.

“Before, competition was always undermined,” she said. “We need healthy competition.”

Yes, they indeed need more economic freedom.

How Capitalism Saved The Chilean Miners

Daniel Henninger at the Wall Street Journal asserts that the successful rescue of Chilean miners as signifying victory for capitalism.

Mr. Henninger writes, (bold emphasis mine)

This profit = innovation dynamic was everywhere at that Chilean mine. The high-strength cable winding around the big wheel atop that simple rig is from Germany. Japan supplied the super-flexible, fiber-optic communications cable that linked the miners to the world above…

In an open economy, you will never know what is out there on the leading developmental edge of this or that industry. But the reality behind the miracles is the same: Someone innovates something useful, makes money from it, and re-innovates, or someone else trumps their innovation. Most of the time, no one notices. All it does is create jobs, wealth and well-being. But without this system running in the background, without the year-over-year progress embedded in these capitalist innovations, those trapped miners would be dead.

In short the technology, instruments and expertise used to save the trapped miners had been a product of capitalism.

This reminds me of the great classic, “I, Pencil”, from Leonard Read which states that market, using the pencil as example, is driven by spontaneous order: No no one exactly knows how to make the pencil in the entirety, yet people using division of labor, specialization and voluntary exchange concertedly allows the pencil to be produced and be used by us, the consuming public.

Here is an excerpt from Mr. Read, (bold highlights mine)

Actually, millions of human beings have had a hand in my creation, no one of whom even knows more than a very few of the others. Now, you may say that I go too far in relating the picker of a coffee berry in far-off Brazil and food growers elsewhere to my creation; that this is an extreme position. I shall stand by my claim. There isn't a single person in all these millions, including the president of the pencil company, who contributes more than a tiny, infinitesimal bit of know-how. From the standpoint of know-how the only difference between the miner of graphite in Ceylon and the logger in Oregon is in the type of know-how. Neither the miner nor the logger can be dispensed with, any more than can the chemist at the factory or the worker in the oil field — paraffin being a byproduct of petroleum.

Here is an astounding fact: neither the worker in the oil field nor the chemist nor the digger of graphite or clay nor any who mans or makes the ships or trains or trucks nor the one who runs the machine that does the knurling on my bit of metal nor the president of the company performs his singular task because he wants me. Each one wants me less, perhaps, than does a child in the first grade. Indeed, there are some among this vast multitude who never saw a pencil nor would they know how to use one. Their motivation is other than me. Perhaps it is something like this: each of these millions sees that he can thus exchange his tiny know-how for the goods and services he needs or wants. I may or may not be among these items.

Capitalism is almost always the unheralded and unappreciated hero, for incidents like the successful rescue of Chilean miners, but has undeservingly served as the scapegoat for failures of the political order.

Is Social Cooperation A Product of Evolution?

Some people mistakenly think that social cooperation is merely a product of evolution.

They seem to forget that if evolution is about the “survival of the fittest” then men would always be at war perennially with each other. And societal advancement at current conditions would not have occurred as people would have lived off from each other through violence (war and plunder).

Yet there is no compelling reason for people to simply co-opt outside free trade. Altruism and or political submission (Social Darwinism) cannot be held as sustainable conditions for progress.

Murray Rothbard has seen through such Social Darwinist nonsense. He writes,

``For the Social Darwinist erroneously saw history and society through the peaceful, rose-colored glasses of infinitely slow, infinitely gradual social evolution. Ignoring the prime fact that no ruling caste in history has ever voluntarily surrendered its power, and that therefore Liberalism had to break through by means of a series of revolutions, the Social Darwinists looked forward peacefully and cheerfully to thousands of years of infinitely gradual evolution to the next supposedly inevitable stage of individualism.”

The only sustainable way for people to attain lasting social cooperation is via division of labor and specialization through voluntary exchange.

To quote Henry George, (bold emphasis mine)

Civilized nations, however, do not use their armies and fleets to open one another's ports to trade. What they use their armies and fleets for, is, when they quarrel, to close one another's ports. And their effort then is to prevent the carrying in of things even more than the bringing out of things—importing rather than exporting. For a people can be more quickly injured by preventing them from getting things than by preventing them from sending things away. Trade does not require force. Free trade consists simply in letting people buy and sell as they want to buy and sell. It is protection that requires force, for it consists in preventing people from doing what they want to do. Protective tariffs are as much applications of force as are blockading squadrons, and their object is the same—to prevent trade. The difference between the two is that blockading squadrons are a means whereby nations seek to prevent their enemies from trading; protective tariffs are a means whereby nations attempt to prevent their own people from trading. What protection teaches us, is to do to ourselves in time of peace what enemies seek to do to us in time of war.

And obviously deepening free trade around the world has caused greater access to more products at more affordable prices, which has led to longer lifespan (see above chart), more conveniences, diffusion of knowledge, advancement in technology that has increased connectivity and productivity.

Of course perhaps one of the unseen benefit has been the reduced scale of international wars.

In other words, free trade has raised the world’s standard of living (even if measured in per capita GDP).

Evolution cannot be the principal driver of societal advancement because man emerged from a hostile (predator-prey) environment.

And the nasty and belligerent experiences by our forebears seem to have been hardwired into people’s intuitive aversion to free exchange.

As Paul Rubin eloquently explains,

There are two aspects of our evolved psychology that help explain beliefs about trade. First, humans tend towards zero-sum thinking. That is, we do not intuitively understand the possibilities of economic growth or the benefits of trade in achieving it.

Our ancestors lived in a static world with little intertribal trade and virtually no technological advance. That is the world our minds understand. This doesn't mean that we can't grasp the crucial concept that trade benefits both parties to a transaction--but it does mean that we must learn it.

Positive-sum thinking doesn't come naturally. By analogy, we learn to speak with no teaching, but we must be taught to read. Understanding the mutual benefits of exchange is like reading, not speech.

Second, we evolved in a hostile world. Our ancestors engaged in constant conflict with neighbors, much like present-day chimpanzees. We developed strong in-group and out-group instincts, and for many aspects of behavior we still have such feelings.

These feelings are benign when applied to something like rooting for local sports teams, but are more harmful when applied to international trade. They are most harmful when they generate actual warfare. Yet the metaphor of a "trade war" shows how close to the surface harmful instincts are.

These two sets of beliefs interact to explain our natural (mis)understanding of trade. We believe that the number of jobs is fixed (a result of zero-sum thinking) and that as a result of trade these jobs go to foreigners, whom in a deep sense we view as enemies. Both beliefs are incorrect, but both are natural. And in many cases politicians are only too eager to capitalize on these beliefs to be re-elected.

In short, the anti-trade sentiment is rooted fundamentally from archaic or primitive martial instincts than from rational arguments based on people’s growing acceptance of trade as means to achieve social cooperation.

Awhile back, I recall a socialist colleague mentioned a popular axiom—that “money makes the world go around”.

I said that this misleads, because money isn’t wealth, but only a medium of exchange. And what makes wealth truly go around is trade. Without trade money is useless.

Aside from wealth, the deepening of trade also means people are learning to get past our evolutionary instincts of bellicosity, aggression and hostility.

Thus, free trade not only enriches society but also is the principal way to achieve lasting peace and order.

Global Debt Concerns Overwhelmed by Liquidity

Here is a nice update on sovereign default risk prices from Bespoke Invest

They write,

default risk has fallen the most for Japan, China, Australia, Chile, and South Korea since July 2nd. It has risen for just four countries -- Egypt, Portugal, Ireland, and the US. Yep, the US has seen default risk rise 15.7% since the start of July, even as the equity market has performed well. Germany has the lowest default risk of all the countries shown.

Of the four high-risk states highlighted, Illinois currently has the highest default risk at 275 bps, followed closely by California at 269 bps. New York and New Jersey are both just above 200 bps.

Flushed with liquidity, most of the world has seen a decline in concerns over debt as measured by their respective credit ratings.

However, we seem to be seeing a different scenario in the US, where creeping default risk concerns have coincided with buoyant equity market.

It’s quite obvious that massive interventions (and expectations thereof) in the financial markets have distorted market signals.

Yet, how much government interventions can keep up with this “sweet spot” mode would something to behold about, most especially that liquidity flows have began to permeate into the commodity markets.

Eventually something has to give.

For the meantime, party on.

World’s Richest Women

Here is another interesting development, the world’s richest women are mostly Chinese.

According to the Economist,

ZHANG YIN, who made her money in the paper industry, is the wealthiest businesswoman in the world, according to Hurun Report, a Chinese magazine. Its ranking of the 20 richest self-made women (those who earned their money) combines its own findings with those ofForbes and the Sunday Times. Over half of the women in the top 20 are of Chinese origin, perhaps because of a communist ethos of gender equality, perhaps because previous generations of Chinese left so little wealth to be inherited. The richest non-Chinese is a Spaniard, Rosalía Mera, one of three on the list to have made her fortune in fashion.

Certainly signs of changing times.

Globalization And World Hunger

One very important positive development is that despite the global boom bust cycles, global hunger has been falling.

According to the Economist, (bold highlights mine)

“TWENTY-NINE countries suffer from “alarming” levels of hunger, most of which are in sub-Saharan Africa, according to a report published on Monday October 11th. The “Global Hunger Index” (GHI) gives developing countries scores based on three indicators: the proportion of people who are undernourished, the proportion of children under five who are underweight, and the child mortality rate. The worst possible score is 100, but in practice, anything over 25 is considered “alarming”. Scores under five, meanwhile, are indicative of “low hunger”. Since 1990 the overall level of the index has fallen by almost a quarter (though the data do not cover the period of the global recession beginning in 2008). Two-thirds of the 99 countries counted in 1990 have reduced their populations' hunger levels. Kuwait, Malaysia, Turkey and Mexico have been the most successful, cutting their scores by over 60%. Those where hunger has increased include North Korea, Comoros and Congo. Congo's GHI score fell by over 60%, the worst of any country.”

Since 1990, after China and India opened her doors to embrace capitalism, world trade has exploded.

And this has been one of the main reasons for the vast improvement in poverty levels as measured by the hungry index.

Besides, the best performing countries, as noted by the Economist, can be observed as in the higher strata of economic freedom based on the Heritage Foundation’s Index (2010), specifically, South Korea ranked 31st, Mexico 41^st, Kuwait 42^nd and Turkey 67^th, while the worst performers in terms of the hunger index are those least free or at the tailend of economic freedom index—Comoros 165^th, Republic of Congo 169^th, Democratic Republic of Congo 172^nd and North Korea 179^th.

This goes to show how free trade and economic freedom democratises wealth.

Stephen Roach: Quantitative Easing Won't Work

In a recent CNBC interview, Morgan Stanley's Stephen Roach says that the world has been focused on the wrong problem, and that what ails the so called "imbalances" is principally about savings.

He also adds that currency fix is not going to work and is a result of bad economics and political propaganda.

In addition he says that capital controls are the wrong way to go about. And that quantitative easing will not work because it does not deal with root of the problem-savings.

Currency Wars And The Philippine Peso

``One cause for hope of an early agreement is that many of the illusions concerning the advantage of drifting currencies and competitive depreciation have been dissolving under the test of experience. Great increases in export trade have not followed depreciation; the usual result of anchorless currencies has been a shrinkage of both export and import trade. Again, the fallacy is beginning to be apparent of the idea that a currency allowed to drift would finally "seek its own natural level." It is becoming clear that the "natural" level of a currency is precisely what governmental policies in the long run tend to make it. There is no more a "natural value" for an irredeemable currency than there is for a promissory note of a person of uncertain intentions to pay an undisclosed sum at an unspecified date. Finally, it has been learned that competitive depreciation, unlike competitive armaments, is a game that no Government is too poor or too weak to play, and that it can lead to nothing but general demoralization.” Henry Hazlitt, From Bretton Woods To World Inflation

The Federal Reserve’s prospective Quantitative Easing 2.0 has now triggered an impassioned debate among international policymakers over the risks of currency wars.

Today, policy divergences among developed and emerging markets, which have been spurring capital flows that has boosted asset markets of emerging markets, has prompted for such worries.

Brazil’s minister Guido Mantega fired the first salvo[1] to accuse advanced economies of adapting “beggar-thy-neighbour” policies that could harm international trade.

Currency wars or competitive devaluation simply implies inflationism applied by governments in order to “boost jobs by bolstering exports”. This has been a long held mercantilist-protectionist approach, which had been debunked[2] by classical economist as Adam Smith, but seemingly being adapted by today’s leading authorities, perhaps out of desperation.

As the Wall Street Journal editorial writes[3],

``The growing danger today is currency protectionism—what students of the 1930s will remember as competitive devaluation or "beggar-thy-neighbor" policies. As economic historian Charles Kindleberger describes in his classic "The World in Depression," nations under domestic political pressure sought economic advantage by devaluing their national currency to improve their terms of trade.

``But that advantage came at the expense of everyone else. "As with exchange depreciation to raise domestic prices, the gain for one country was a loss for all," Kindleberger writes. "With tariff retaliation and competitive depreciation, mutual losses were certain."

Here is my take on the currency episode:

First, I don’t see the Federal Reserve as attempting to attain “export competitiveness” by taking on the currency devaluation path.

The Federal Reserve’s action, as well as the Bank of England, seems to be more directed at surviving the balance sheets of their respective banking systems which has been buoyed by earlier dosages of QE.

Therefore, as said above, dodgy assets that are still held by the banks would need further infusion of credit to maintain their subsidized price levels.

Second, it is political season in the US with mid-term elections coming this November. Hence, political talking points have been directed against free trade to signify attempts to shore up votes by appealing to nationalism and to economic illiterates, following the growing unpopularity with Obama administration and the Democratic Party.

This has been underscored by the recent passage of the China currency sanction bill[4] at the US House. Yet this bill isn’t certain to be passed by the Senate, which will most likely be after elections.

Third, while the currency bill has been seen as directed towards “forcing” China to revalue what most don’t know is that technicalities matters. As lawyer Scott Lincicome writes[5],

``But none of that changes the fact that, if it became law, this particular legislation probably won't have a big effect on things, at least in the near term.”

Why?

Because, according to Mr. Lincicome, ``The change in language... gives the administration 'a way to say no' to U.S. industries and could signal to China that Washington isn't looking to declare a trade war over currency practices."

In politics, it is usually a smoke and mirrors game.

Lastly, global policymakers appear to be cognizant of the dangers of applying protectionism and the nonsensical approach by mercantilist policies.

The IMF has cautioned against currency friction and has volunteered to act as a “referee”[6] to settle trade disputes emerging from such strains.

Importantly, emerging market authorities have been quite sensitive into maintaining open trade channels.

Poland’s central bank governor Marek Belka in an interview with Wall Street Journal[7] delivers a jarring statement against mercantilism.

From Mr. Belka, (bold emphasis mine)

``All those wars produce a lack of stability, and the warring parties forget the basic point. The bottom line is devaluations and appreciations change your competitive position temporarily but they don’t change your competitive position for good. If you want to strengthen your competitiveness by devaluing your currency, this is a sign of despair, this isn’t a policy. I am worried because this destabilizes the global economy and it does not lead to rebalancing, something we all long for.”

We just hope that global policymakers remain steadfast in support of freer trade than engage in inflationism which is no less than veiled protectionism.

Nonetheless, as far as the subtle competitive devaluation has been an ongoing concern, we should expect the local currency, the Philippine Peso to benefit from a far larger scale of interventionism from advanced economies as United Kingdom and Japan, whom like the US, has been engaged in “quantitative easing”.

Figure 5: Yahoo Finance: Philippine Peso Versus Quantitative Easing Economies (ex-US)

This means that the Peso is likely to appreciate against the British Pound and could likely reverse its long term decline against the Japanese Yen as Japan expands her battle against alleged deflation, which for me is no more than promoting the nation’s export sector at the expense of the rest.

Relatively speaking, the Peso is in a far better position than both of the above and most especially against the US dollar given the current conditions.

---

[1] BBC.co.uk Currency 'war' warning from Brazil's finance minister, September 28, 2010

[2] See Does Importation Drain The Wealth Of A Nation?, September 13, 2010

[3] Wall Street Journal, Beggar the World Monetary instability is a threat to the global recovery October 1, 2010.

[4] BBC.co.uk US House passes China currency sanctions bill, September 30, 2010

[5] Linicome Scott, House Passes Currency Legislation; Whoop-Dee-Freakin-Doo, September 29, 2010

[6] Marketwatch.com, IMF moves to referee currency debate, October 9, 2010

[7] Wall Street Journal, Poland’s Central Bank Governor Belka on Currency Wars, October 9, 2010

Interest Rates As Key To Stock Market Trends

``Credit expansion can bring about a temporary boom. But such a fictitious prosperity must end in a general depression of trade, a slump.” Ludwig von Mises

As we have long reiterated, the main driver of the financial assets isn’t economic growth nor is it about earnings but mainly about monetary inflation and credit.

Well it appears that the prominent mainstream research company McKinsey Quarterly somewhat shares our view (see figure 3)

Figure 3 McKinsey Quarterly[1]: Watch For Credit Conditions

Tim Koller of McKinsey writes that the stock markets are not reliable economic indicators of the economy (left window), ``While the equity markets may not predict economic trends well, their depth does provide investors with liquidity, so they generally continue to function smoothly even in difficult times.”

And importantly, Mr. Koller identifies credit conditions as the chief mover of the economy and of the financial markets: ``The credit markets are where crises develop—and then filter through to the real economy and drive downturns in the equity markets. Indeed, some sort of credit crisis has driven most major downturns over the past to 40 years.” (see right window of chart)

And four common patterns of credit crisis cycles can be observed: yield curve inversion and the freezing up of the debt markets, marketplace illiquidity, bandwagon effect on the industry participants and enlarged risk appetite out of the expectations that governments will provide support (moral hazard problem).

And naturally the common symptoms of a blossoming bubble would be loose lending standards, unusually high leverage and what Mr. Koller calls as “transactions without value” or euphemism for outrageous valuations, which are rationalized as the new paradigm.

Interest Rate Manipulation Fuels Imbalances

In reality, credit conditions are hardly shaped by free markets, otherwise boom bust conditions would largely be limited in scale and in duration. Instead, as a major policy tool used by central banks, interest rates are mainly used to perpetuate boom conditions, mostly based on political considerations.

As the great Professor Ludwig von Mises described of the Business or Trade cycle fostered by central bank manipulation of interest rates[2],

``The creation of these additional fiduciary media permits them to extend credit well beyond the limit set by their own assets and by the funds entrusted to them by their clients. They intervene on the market in this case as "suppliers" of additional credit, created by themselves, and they thus produce a lowering of the rate of interest, which falls below the level at which it would have been without their intervention. The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought "profitable" if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found "profitable" and can be initiated.”

In short, artificially tampering of interest rates leads to an unnecessary pile up in systemic leverage along with massive malinvestments which also drives up valuations of securities or assets to extreme levels.

Of course the market psychology here is to rationalize such actions as being warranted to the prevailing conditions, when they genuinely account for “flaws in perception” as billionaire George Soros rightly identifies[3], or a false sense of reality brought about by distorted incentives.

Yet in order to maintain these lofty levels would require constant infusion of fresh credit at far larger scale than the former.

Figure 4: Economic Slowdown and Quantitative Easing (chart from Danske Bank[4])

We seem to be seeing this episode playout today with renewed clamor[5] and the growing expectations by the mainstream for the US Federal Reserve to implement Quantitative Easing 2.0 on escalating fears of a global economic relapse (see figure 4 right window) by further pushing down interest rates.

Market expectations of the realization of the Federal Reserve’s QE 2.0 have thrashed the US dollar (left window), even as US treasury yields fall!

Even the resurgence of Ireland’s debt woes have failed to bolster the US dollar relative to the Euro. The rising Euro seems to validate our earlier prediction in contrast to mainstream expectations, but appears to have overshot our target[6].

So we have now a phenomenon outside or opposite to what had occurred in 2008, where a rally in US treasuries coincided with a rally in the US dollar.

And this should be a prime example of how past performances or patterns do NOT repeat.

Unravelling Of The Business Cycle

However, artificial suppressed rates can last only for so long.

Since resources are scarce and where interest rate manipulation essentially diverts massive amount of resources and labor into unproductive speculative activities, the increased demand for resources are eventually reflected on the price levels.

The current run-up in most prices of commodities[7] seem to be manifesting symptoms of the Austrian business cycle theory at work.

Eventually the whole artifice unravels with a bubble bust or with a destruction of the currency system if central banks persist to inflate.

Again Professor von Mises,

``This upward movement could not, however, continue indefinitely. The material means of production and the labor available have not increased; all that has increased is the quantity of the fiduciary media which can play the same role as money in the circulation of goods. The means of production and labor which have been diverted to the new enterprises have had to be taken away from other enterprises. Society is not sufficiently rich to permit the creation of new enterprises without taking anything away from other enterprises. As long as the expansion of credit is continued this will not be noticed, but this extension cannot be pushed indefinitely. For if an attempt were made to prevent the sudden halt of the upward movement (and the collapse of prices which would result) by creating more and more credit, a continuous and even more rapid increase of prices would result. But the inflation and the boom can continue smoothly only as long as the public thinks that the upward movement of prices will stop in the near future. As soon as public opinion becomes aware that there is no reason to expect an end to the inflation, and that prices will continue to rise, panic sets in. No one wants to keep his money, because its possession implies greater and greater losses from one day to the next; everyone rushes to exchange money for goods, people buy things they have no considerable use for without even considering the price, just in order to get rid of the money....

``If, on the contrary, the banks decided to halt the expansion of credit in time to prevent the collapse of the currency and if a brake is thus put on the boom, it will quickly be seen that the false impression of "profitability" created by the credit expansion has led to unjustified investments. Many enterprises or business endeavors which had been launched thanks to the artificial lowering of the interest rate, and which had been sustained thanks to the equally artificial increase of prices, no longer appear profitable. Some enterprises cut back their scale of operation, others close down or fail. Prices collapse; crisis and depression follow the boom. The crisis and the ensuing period of depression are the culmination of the period of unjustified investment brought about by the extension of credit.

Therefore, it has been long contention of mine that the interest rates and market psychology working as a feedback loop mechanism ultimately sorts out the phases of the business cycle.

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[1] Koller, Tim A better way to anticipate downturns, McKinsey Quarterly

[2] Mises, Ludwig von The Austrian Theory of the Trade Cycle

[3] Soros George, The Alchemy of Finance p.58

[4] Danske Bank, Currency Debate Heats Up, October 8, 2010

[5] Los Angeles Times Blog More Fed help for economy now just a matter of time October 8, 2010

[6] See Buy The Peso And The Phisix On Prospects Of A Euro Rally, June 14, 2010

[7] See Commodity Inflation, October 8, 2010

Political Spin On The Philippine Economy And An Overextended Phisix

``Now we see these qualities displayed by virtually all politicians in democracy: the constant need for status and recognition. The ends — compensating for an inferiority complex — justify whatever Machiavellian means. Because democracy is open to any and all who can get themselves elected, either through connections, personality, or personal wealth, it is a social system where leadership positions become a hotbed for sociopaths. Maslow's self-actualizing man won't have an interest in politics. But those stuck on the need for esteem are drawn to it like flies to cow pies.”- Doug French

The bullmarket has been relentless.

In the context of the Philippine Phisix, it has been a steamy 13.45% gains in 5 consecutive weeks that has produced a stupendous year-to-date return of 38.8%!

Economic Takeoff Mumbo Jumbo

Again this has nothing to do with the Philippines allegedly in an economic takeoff[1] emanating from the so-called public’s belief in the effective deliverance of the incumbent political leadership.

This messianic thinking is no more than political spin anchored on current events used to grab credit for popularity ratings (votes on issues or endorsements) and for self-esteem purposes[2].

Governments cannot generate wealth by picking on Juan’s pocket in order to give to Pedro. Shifting resources away from productive activities to non-productive activities diminishes wealth creation. There is little or no value added from coercive (tax based) reallocation of resources. In a world of scarcity, prosperity cannot emerge from “something out of nothing”.

Wealth is generated by capital accumulation, or the act or process of increasing the supply of capital goods, whereby capital can only be accumulated by producing more wealth than is consumed, i.e. savings[3]. And this can only occur when more risk-taking, profit-and-loss and market price sensitive entrepreneurial activities are allowed to legitimately flourish.

Political redistribution of scarce resources only leads to inefficiency, wastage, corruption, inflation and capital decumulation. So claims of economic takeoffs can only take place by an intensive reduction of politicization of the economy and by liberalizing economic activities in favour of the entrepreneurs.

The other way to say this it is that—in a world of tradeoffs, political power has to pave way to economic power for capital accumulation to progress. We can’t have both.

Applied to politics, you either expand political power via socialism or enhance economic power via capitalism or the market economy. And the latter is something political leaders won’t intuitively succumb to, unless forced at hand by the natural laws of economics.

Proof?

The proposed P 1.645 trillion National Budget for 2011 supposedly would include a doubling of the Pork Barrel[4], a bonanza for lawmakers.

This simply means more government spending on political pet projects, which are unproductive and not demanded by the markets (think basketball courts[5]), and whose implied effects translate to higher taxes, higher cost of doing business, rising cost of goods and services, high unemployment, and importantly increasing incidence of corruption from arbitrary dispensation of resources and further restrictions to civil liberty.

The election mantra of a corruption free government is gradually being revealed as no less than a drivel, despite the public’s current blind faith over the prospects by the incumbent administration.

So with these added obstacles to entrepreneurship growth, how does one expect the domestic economy to takeoff?

What we are certain of is that the personal economies of politicians and their affiliates or cronies will indeed takeoff. P1.645 (estimated $37 billion) or 22% of the $161 billion (nominal dollars[6]) Philippine economy is certainly alot of money being channelled or transferred from the private (productive) sector to unproductive institutions and to political agents. And surely, these massive diversion of resources, will NOT serve to the wellbeing of the general public. Instead, more will suffer from the unforeseen and indirect effects of these redistributive actions.

Applied globally, political redistribution has its limits, as recent crisis has evinced.

And this grand experiment of the paper money (US dollar) standard seems to push redistribution to its near limits as global government debt has reached over $39 trillion[7] or about 63% of the $61 trillion GDP[8].

It’s a ticking time bomb that has been camouflaged by today’s concerted efforts by central banks to flood the world with liquidity. Eventually, the pressure valve will give way. It has been this way throughout history, which means that this is a cycle which we must pay heed to.

As George Santayana who once admonished, ``Those who do not learn from history are doomed to repeat it”. We certainly cannot stop history from repeating but we can take steps to protect ourselves.

Expect Normal Profit Taking From Overextended Markets

Of course, seen the political standpoint, but looking at the bigger picture, it’s not only us whom are on a takeoff.

It’s the ASEAN or Asian emerging markets (see figure 1) aside from many emerging markets outside Asia that has been booming.

Figure 1: Bloomberg: ASEAN Bourses Takeoff

The Philippines (green line), Indonesia (yellow) and Thailand (orange) have been in a tight race for the top after successfully breaking past their most recent highs. Only Malaysia has lagged but remains on the positive.

On a year to date basis the gains of these bourses have been spectacular, with the three frontrunners posting over 30% returns.

Nevertheless, there appear to be signs of exhaustion strains from the recent breathtaking run.

And it would be ridiculous to expect the ongoing boom to streak endlessly as any overstretched gains are likely to result to the opposite action-a crash. We must remember that even in the financial markets Newton’s third law of motion[9] somewhat applies, where “To every action there is always an equal and opposite reaction”.

While I do not expect a major retrenchment in the global equity markets, a correction has long been overdue especially for the turbocharged emerging markets as ours.

And if there are any supposed signs of providence, last week’s market actions in Indonesia and Thailand could signify as pacesetters.

But any correction shouldn’t be construed as justification to raise cash balances. Rather, they should be used as entry point for those who have missed the ride or for those hoping to capitalize on the opportunities of the ASEAN-Phisix bullmarket.

What we can expect of is that any correction may unlikely be a broadmarket dynamic as last seen in the bearmarkets of 2007-2008. Instead, we should expect rotational of activities from outperformers to the laggards during the countercyclical phase.

I am not a seer who can give you the exactitudes of the potential retrenchment. Anyone who claims to do so would be a pretender. But anywhere from 5-15% from the recent highs should be reckoned as normal.

Yet, one cannot discount the potentials of a swift recovery following the corrective process. This is why trying to “market timing”, in this “growing conviction” phase of the bullmarket, could be a costly mistake.

From our standpoint, profit taking should be expected over the interim, but the main drivers of the current rally seem well entrenched enough to seemingly ensure that our markets (and those of our neighbours) are eventually headed higher in spite of the illusory political attribution and rhetoric.

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[1] Philstar.net Noy: RP ready for takeoff, October 8, 2010

[2] See The Corrupting Influence of Political Power, October 9, 2010

[3] Greaves, Percy Jr. Mises Made Easier, Mises.org

[4] Inquirer.net, ‘Pork’ in budget doubled, October 9, 2010

[5] See Philippine Sports: The Craze For Basketball And The Lack Of Interest In The World Cup, June 12, 2010

[6] Wikipedia.org Economy of the Philippines

[7] See Global Debt Time Bomb, October 8, 2010

[8] Google Public Data, World GDP

[9] Wikipedia.org Newton's laws of motion

The Corrupting Influence of Political Power

Remember J. J. Tolkien’s The Lord of the Rings where “One Ring to rule the other Rings of Power” changed the behaviour of those who got hold of the powerful exotic ring by making them addicted to power.

Well, this has empirical basis.

According to Cato’s Julian Sanchez, (bold highlights mine)

The humor site Cracked rounds up some serious social science on the psychological effects of power and authority. The results are sobering—if not entirely surprising. When people in experimental environments were made to feel as though they were powerful—either by recalling actual instances for their lives or by being placed in simulated positions of power for a few hours—researchers found that they became less compassionate, less prone to take the perspective of others, more able to lie without feeling guilty about it, and more prone to consider themselves exempt from the rules and standards they righteously insist apply to others. What’s striking is how quickly and easily the experimenters elicited dramatic behavioral differences given that (unlike people who actively seek power) their “powerful” and control groups were randomly chosen.

Simply said, entities who acquire political power would most likely see a shift in perspectives and in attitudes. In short, ideology or platform becomes a secondary issue to ego.

And this is one reason why public image seems to be a foremost concern for politcos. Aside from the need to get re-elected they see popularity as feeding on their bloated self-esteem.

And applied to politics, this seems like a prominent reason why the public’s romanticized expectations of “changes” from new leadership usually ends up in frustration—the public fails to account for the risks of individual character shifts of the political leaders when assuming power.

Again Mr. Sanchez,

It’s useful to keep this in mind because, while the overwhelming lesson of the last half century of social psychology is that situational influences can easily swamp the effect of individual differences in character, our political rhetoric takes scant account of this. Political campaigns focus heavily on questions of “character”—which especially in the case of “outsider” campaigns should be of limited predictive value....The remedy is, invariably, to replace them in positions of power with better people from the other team. These social science results suggest that this is unlikely to work: The problem is power itself.

Lord Acton was right, "Power tends to corrupt, and absolute power corrupts absolutely.”