Why Mercantilists Are Wrong (Again)

The Chinese yuan may not be as undervalued as expected by present day mercantilists.

According to the Economist, (bold highlights mine)

The yuan may well still be undervalued but our index suggests American manufacturing should have less to fear from Chinese competition than it did five years ago. Until June 2009 appreciation was largely because of the stronger yuan. Since then it is largely because China’s unit labour costs have grown much faster than America’s. Employers in China’s coastal factories have suffered labour shortages and strikes. America’s factories have reported strong productivity gains as they have wrung more out of the workers that survived the recession (although those gains will be hard to repeat).

Of course, China and America do not trade only with each other. China’s big surpluses and America’s big deficits depend on the real exchange rate between them and all of their trading partners. But calculating that would require timely estimates of unit labour costs for all of China’s trading partners. That is a bit too laborious.

The Economist is correct to point out implicitly how wrong present day mercantilists unduly fixate on China’s currency as the main mechanism for global trade.

These mercantilists allude to trade imbalances as the root of all economic problems and thus recommend policies grounded on ‘restoring balance’ via curtailing trade or applying protectionism (tariff, and controls) or inflationism (currency wars)

Yet the mercantilist perspective deliberately neglects or disregards all other variables or factors which mistakenly presume that the world operates in a “ceteris paribus” or an imaginary two nation world of US and China. Yes, they love to fantasize a world beyond or outside of reality.

Contrary to the mercantilist orthodoxy, trades imbalances are NOT the problem. Instead trade imbalances account for as symptoms of evolving geopolitical and world economic conditions and patterns which had been brought upon by present policies.

One of which is the Triffin Dilemma, which according to the Wikipedia.org, is the paradox by which “the country issuing the global reserve currency must be willing to run large trade deficits in order to supply the world with enough of its currency to fulfill world demand for foreign exchange reserves”.

Another is globalization.

Importantly, trade imbalancess signify as outcomes from voluntary action and not of government mechanistically engaged in trade for no apparent reason at all.

It is individuals who buy or sell services even if it is done with other individuals abroad.

Yet the mercantilist logic goes:

If I frequent my favorite pizza parlor, whose food I savor, which means I repeatedly incur a deficit with the pizza parlor, then the pizza parlor should be forced by edict to obtain my services (as a stock market agent) even if they refuse to get involved in the stock markets in order to balance our trade. By doing so, my favorite Pizza Parlor would only serve to people who they are willing to balance out which alternatively means going out of business. This circular reasoning by the mercantilists is all patent nonsense.

Individuals conduct trade to fulfil specific needs. And the division of labor and comparative advantages channelled via voluntary exchange is what allows our needs to be met. Territorial or geographic boundaries does not change this perspective.

And forcing people to balance trade would result to REDUCED trades, which ultimately leads to impoverishment via higher prices, shortages, diminished of choice of available products, inferior qualities and etc.

Besides, contrary to conventional mercantilists expectations, exports ALONE do NOT make a country prosperous. This mercantilist perspective, which aims to increase ‘surpluses’ by fiat or protectionism, actually confuses wealth with money and have long been demolished by Adam Smith (bold highlights mine)

I thought it necessary, though at the hazard of being tedious, to examine at full length this popular notion that wealth consists in money, or in gold and silver. Money in common language, as I have already observed, frequently signifies wealth, and this ambiguity of expression has rendered this popular notion so familiar to us that even they who are convinced of its absurdity are very apt to forget their own principles, and in the course of their reasonings to take it for granted as a certain and undeniable truth. 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.

The two principles being established, however, that wealth consisted in gold and silver, and that those metals could be brought into a country which had no mines only by the balance of trade, or by exporting to a greater value than it imported, it necessarily became the great object of political economy to diminish as much as possible the importation of foreign goods for home consumption, and to increase as much as possible the exportation of the produce of domestic industry. Its two great engines for enriching the country, therefore, were restraints upon importation, and encouragements to exportation.

In short, wealth is acquired through capital accumulation via savings and investment and expressed through voluntary exchange.

In truth, the undeserved obsession towards trade imbalances represent as selective perception and data mining applied by modern day mercantilists in order to justify all sorts of interventionism. They apply fallacious ‘cart before the horse’ reasoning.

Seen from the bigger picture trade deficits are part of the international transactions that can be seen from Balance of Payment (BOP) data where trade deficits are fundamentally offset by capital flows.

Professor Mark J. Perry points out that under double-entry accounting, debits have to equal credits, which applies to BOP accounting:

BOP = CURRENT ACCOUNT + CAPITAL ACCOUNT = CREDITS - DEBITS = 0

Professor Perry additionally writes,

The current account and capital account are the two main components of the U.S. Balance of Payments (BOP), which is a record of all international transactions for both: a) trade flows and b) capital flows in a given period. Every international transaction (e.g. export, import, U.S. investment abroad, foreign investment in the U.S.) is recorded on a double-entry accounting basis, so that each transaction involves both a debit and credit.

Professor Perry further notes that alarmism over deficits are unwarranted for the following reasons: (bold highlights mine)

1. There are no BOP deficits once we account for all international transactions, both for: a) goods and services, and b) financial transactions. For all of the one-sided coverage in the press about the "trade deficit," you would almost never even know that there is an offsetting "capital surplus" or "capital inflow." It's important for the general public to understand that trade deficits are offset by capital inflows on almost a 1:1 basis, resulting in a "balance of payments" for international transactions. When the public constantly hears about "trade deficits" without any understanding of the offsetting surplus, that economic ignorance allows politicians and special interest groups to exploit the general public, by advancing and promoting protectionist trade policies aimed to reduce the "trade deficit," or by refusing to approve trade agreements between Chile, Panama and Korea, etc.

2. The "trade deficit" generates so much negative coverage, that the significant advantages of capital inflows from abroad get frequently overlooked. Since 1980, the U.S. has attracted almost $8 trillion of foreign investment, which has provided much-needed equity capital that has allowed U.S. companies to start or expand, has provided much-needed debt capital that has also funded the expansion of American companies, along with providing debt capital for U.S. consumers in the form of mortgages, student loans, and car loans. Some of the $8 trillion of investment includes billions of dollars of Foreign Direct Investment, which has funded thousands of new projects in the U.S. (Toyota factories for example) and created hundreds of thousands of jobs.

This goes to show that “imbalances” serve more as political talking points meant to promote dogmatism than of observing factual operating circumstances.

Moreover what matters most is what mercantilists refuse to bring up in the imbalance debate: what seems to ail the US, isn’t China, but the entitlement mentality effected by the political leadership through inflationary policies (such as the recent housing bubble).

The negative effects of inflationism can be broken down into the following

-diverts resources to one that is not desired by the markets.

-crowds out the private sector

-generates systemic malinvestments.

-causes overvaluation in assets or the currency.

-misallocates the distribution of economic weighting towards areas preferred by government at the expense of the consumers.

-raises the costs of living.

-distorts corporate profitability and income streams

-raises the cost of doing business which translates to reduced competitiveness

-destabilizes the economy from the boom bust cycle which eventually leads to a consumption of capital.

The mercantalism-inflationist agenda does the opposite of what it intends to accomplish.

Applying real life examples, if the mercantilists-inflationists school is correct then Zimbabwe, North Korea, Cuba and Burma should have been the most prosperous countries (having been closed economies).

Ironically, the opposite is true, nations that have been economically free, are those whom have been prosperous.

Unfortunately reality isn’t what mercantilists are concerned with. Political religion is.

World Bank Chief Robert Zoellig: Bring Gold Back As Part Of The New Monetary Order

I never imagined how quickly developments have been shaping in the direction of my perspectives.

Here is what I wrote last Sunday

Global Central banks appears to be rediscovering gold as possibly reclaiming its role as money in a new monetary order. A new monetary order is not question about an if, but a when…

Those who obstinately relish the bias that gold is nothing but a barbaric relic will likewise suffer from taking on the wrong positions. But they eventually will succumb to the shifting expectations as with many monetary authorities today. The reflexive process of having prices influence fundamentals has clearly been taking shape.

Here is from Monday’s news (Reuters)… [bold highlights mine]

The world's largest economies should consider gold as an indicator to help set foreign exchange rates, the head of the World Bank said on Monday in a proposal that threw open the acrimonious currency debate days before a summit of G20 nations.

Writing in the Financial Times, World Bank President Robert Zoellick called for a new monetary system to replace the floating rates adopted in 1971 known as Bretton Woods II…

The former U.S. trade representative, who served in several Republican administrations including Treasury, said the new system "is likely to need to involve the dollar, the euro, the yen, the pound and (a Chinese yuan) that moves towards internationalisation and then an open capital account".

"The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values," he added.

The geopolitical pressure for a monetary reform possibly anchored on gold appears to be mounting.

Quote Of The Day: Germany’s Export Strength Comes From Competitiveness And Not Surpluses

My quote of the day comes from Germany’s Finance Minister Wolfgang Schäuble (Wall Street Journal)

Germany's exporting success is based on the increased competitiveness of our companies, not on some sort of currency sleight-of-hand. The American growth model, by comparison, is stuck in a deep crisis…The USA lived off credit for too long, inflated its financial sector massively and neglected its industrial base. There are many reasons for America's problems—German export surpluses aren't one of them.

Some public officials get it right.

QE 2.0: It’s All About The US Banking System

``But the administration does not want to stop inflation. It does not want to endanger its popularity with the voters by collecting, through taxation, all it wants to spend. It prefers to mislead the people by resorting to the seemingly non-onerous method of increasing the supply of money and credit. Yet, whatever system of financing may be adopted, whether taxation, borrowing, or inflation, the full incidence of the government's expenditures must fall upon the public.” Ludwig von Mises

It’s time for a little gloating.

Last week we noted how global financial markets would likely respond to two major events that just took place in the US this week.

Globalization Versus Inflationism

We noted that while the outcome of the US elections would matter, it would be subordinate to the US Federal Reserve’s formal announcement of the second phase of the Quantitative Easing or QE 2.0.

Nevertheless we mentioned that in terms of the US Midterm Elections, still the odds greatly favoured a rebalancing of power from a lopsided stranglehold by left leaning Democrats towards the conservative-libertarian right that could result to what mainstream calls as “political gridlock”.

Such stalemate would thereby reduce the chances of government interventionism, which should have positive implications for both the markets and the US economy[1].

Figure 1: The Drubbing Of Keynesian Policies (USA Today[2])

Of course, what the surveys earlier conveyed had been merely translated into actual votes-Americans largely repudiated the highhanded Keynesian spend and tax policies adapted by the Obama administration. This also signifies as a decisive defeat for President Obama’s illusory “Change we can believe in”.

Except for the Senate which had only 37 seats, out of the 100, contested, Republicans swept the House (239-188) and the Governorship position (29-18). Yet, even in the Senate, the chasm in the balance of power held by the Democrats had been significantly narrowed (from 57-41 to 51-46).

To rub salt into the wound, even President Obama’s former seat at Illinois was won by a GOP candidate[3], Mark Kirk.

The burgeoning revolt against interventionist Keynesian policies has likewise been an ongoing development in Europe[4].

And as we have repeatedly been pointing out, two major forces have been in a collision course: technology buttressed globalization (represented by dispersion of knowledge and the deepening specialization expressed through free trade) and inflationism (concentration of political power).

The rising tide against Keynesianism, which translates to a backlash from these two grinding forces, can be equally construed as a manifestation of an evolving institutional crisis or strains from traditional socio-political structures adjusting to a new reality.

As Alvin and Heidi Toffler presciently wrote[5],

``Bureaucracy, clogged courts, legislative myopia, regulatory gridlock and pathological incrementalism cannot but take their toll. Something, it would appear will have to give...

``All across the board –at the level of families firms industries national economies and the global system itself—we are now making the most sweeping transformation ever in the links between wealth creation and the deep fundamental of time itself. (italics mine)

For now, the forces of globalization appear to be the more influential trend.

Validated Anew: QE 2.0 Is About Asset Price Support

However, as we also noted, Keynesianism hasn’t entirely been vanquished[6]. They remain deeply embedded in most of the political institutions represented as unelected officials in the bureaucratic world. Importantly, they are personified as stewards of our monetary system.

Here is what I wrote last week[7],

``The QE 2.0, in my analysis, is NOT about ‘bolstering employment or exports’, via a weak dollar or the currency valve, from which mainstream insights have been built upon, but about inflating the balance sheets of the US banking system whose survival greatly depends on levitated asset prices.

Straight from the horse’s mouth, in a recent Op-Ed column[8] Federal Reserve Chair Bernanke justifies the Fed’s QE 2.0,

``This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion. (bold highlights mine)

Once again I have been validated.

The path dependency of Ben Bernanke’s policies has NOT been different[9] from his perspective as a professor at Princeton University in 2000 when he wrote along the same theme.

``There’s no denying that a collapse in stock prices today would pose serious macroeconomic challenges for the United States. Consumer spending would slow, and the U.S. economy would become less of a magnet for foreign investors. Economic growth, which in any case has recently been at unsustainable levels, would decline somewhat. History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse. (bold emphasis mine)

Figure 2: stockcharts.com: Global Equity Markets Explode!

The net effect of QE 2.0 has been almost surreal.

Global equity markets (DJW), as expected, skyrocketed to the upside from the higher than expected $600 billion or $75 billion a month (for 8 months) of US treasury long term security purchases that the Federal Reserve will be conducting with new digital dollars. Markets reportedly estimated the QE program at $500 billion[10].

And the Federal Reserve made sure in their announcement that $600 billion will not be a limiting condition. The FOMC said that they “will adjust the program as needed to best foster maximum employment and price stability”[11].

It’s simply amazing how the Fed’s QE 2.0 transmission mechanism has been worldwide. Whether in Asia (P1DOW-Dow Jones Asia), Europe (E1DOW-Dow Jones Europe) or Emerging markets (EEM-iShares MSCI Emerging Markets Index), the story has all been the same—markets breaking out to the upside.

I’d like to add that such bubble blowing policies has NOT been limited to the Federal Reserve.

Immediately after the Fed’s announcement, the Bank of Japan voted unanimously to support the domestic stock market by engaging on their own version of QE that would include “exchange-trade funds linked to the Topix index and Nikkei Stock Average, and Japanese real-estate investment trusts rated at least AA, the bank said. It said it would begin buying Japanese government bonds under its new program next week.[12]” (bold emphasis mine)

Add to these the inflation of global central banks international reserve position to the tune of $ 1.5 trillion over the past 12 months[13].

Hence the consequences of massive inflationism are likely to be fully felt yet in the markets.

The False Premise: Aggregate Demand Story

The substantiation of our analysis isn’t limited to Bernanke’s statements alone. Markets have likewise bidded up the major beneficiaries of the QE 2.0 program—the banks and the financial industry (see figure 3).

Figure 3: Financial Industry: From Laggards to Leaders (charts from US global Investors and stockcharts.com)

The mainstream wisdom goes this way: Money printing does not create inflation. With low inflation, printing money is, therefore, needed to generate demand that would spur inflation. This form of circular reasoning[14], which characterizes Keynesian economics, is what is sold to public as rationalization for the current policy. The mainstream sees it as an aggregate demand problem that can only be addressed by money printing.

The mainstream fails to see that there is NO such thing as a free lunch or that prosperity cannot be conjured or summoned by the magic wand of the printing presses.

All these so-called technocratic experts refuse to learn from history or deliberately distort its lessons, where debasing money has always been meant to accommodate for the political goals or interests of the ruling class.

Yet monetary inflation eventually crumbles to nature’s laws of scarcity for the simple reason that it is unsustainable. Printing of money does NOT equate anywhere to the same degree as producing goods and services. Printing of money can be limitless, while production of goods and services are limited to the available scarce resources.

Unknown to many, printing of money is subject to the law of diminishing returns (getting less for every extra output or a law affirming that to continue after a certain level of performance has been reached will result in a decline in effectiveness[15]) and law of diminishing marginal utility (general decrease in the utility of a product, as more units of it are consumed[16]).

And it is why repeated experiments with paper money throughout the ages of human affairs have repeatedly failed[17]. And I don’t see why the grand US dollar standard experiment today as likely to succeed either. The QE programs fundamentally reflect on the same symptoms of any degenerating or festering de facto money regime. We should expect more QE programs to happen.

Yet the aggregate demand story is basically premised on debt. To promote aggregate demand is to promote debt. Debts either incurred by the private sector or by governments in lieu of the private sector. While productive debt and consumption debt are hardly distinguished, consumption debt is promoted. Savings are disparaged as economically harmful. And the promotion of debt is the essential or critical element to fostering bubbles.

Figure 4: World Bank: Banking Crisis Since the 1970s

Hasn’t it been a wonder that since the closing of the Bretton Woods gold-dollar window in 1971, bubbles became a permanent fixture worldwide?

Yet, the public hardly can see through who the major beneficiaries from the debt based aggregate demand story. Obviously, it is the banking and the financial industry as they represent as the major funding intermediaries or financiers to both the private sector and importantly to the government.

And the banking system had been structurally incented to hold (or buy or finance) government debts into their balance sheets as they have been classified as less risky assets and thus requires less capital in accordance to the Basel Accord[18].

During the last crisis the unholy alliance of the central banking-banking industry cartel had been exposed as seen by the trillions worth of bailouts by the US Federal Reserve[19].

Yet the politicized nature of central banking (everywhere) obviously leads to cartel structured relationships, as survivability depends not on profitability based on market forces, but from the privileged conditions bestowed upon by the political strata.

And the QE 2.0, which I argued as having been unmoored from the prospects of the US or global economy, but rather aimed at safeguarding the balance sheets of the banking system has successfully boosted the prices of financial equity benchmarks, such as S&P Bank Index (BIX), the Dow Jones Mortgage Finance Index (DJUSMF), the S&P Insurance (IUX) and the Dow Jones US General Financial Index (DJUSGF), all along the lines of Bernanke’s design.

The industry that had miserably lagged[20] the recent stock market recovery in the US has in one week suddenly outclassed the rest.

Of course people who argue about the success or failure of policies frequently look at the effects depending on the time frame that support their bias.

For instance, policies that induce bubbles will benefit some participants, during its heydays. Hence, policy supporters will claim of its ‘success’ seen on a temporary basis as the bubble inflates. Yet overtime, an implosion of such bubbles would result to a net loss to the economy and to the markets. The overall picture is ignored.

And the same aspects would also apply to those arguing that the Fed’s rescue of the banking system has been worthwhile. They’re not. The benefits of a temporary reprieve from the recent crisis envisages greater risks of a monumental systemic blowup. If Fed policies had been successful, then why the need for QE 2.0?

So for biased people, the measure of success is seen from current activities than from the intertemporal tradeoffs between the short term and long term consequences of policies.

In other words, yes, the QE 2.0, which constitutes the continuing bailout of the US banking industry, seems to successfully inflate bubbles, mostly overseas. But at the end of the day, these bubbles will result to net capital consumption, if not the destruction of the concurrent monetary regime.

The next time a major bubble implodes there won’t likely be free lunch rescues as these will be limited by today’s massive debt overhang.

The Effects of QE 2.0: Promotes Poverty And A Shift To A New Monetary Order

Of course while the equity price performance of the US financial industry stole the limelight the next best performers have been the Energy and the Materials Index.

In other words, as I have long been predicting, the accelerating traction of the inflation transmission channels are presently being manifested in surging prices of commodities and commodity related equity assets aside from global equity markets.

While this should benefit equity owners and producers of commodity related enterprises, aside from the financial sector, those who claim that inflationism is justifiable and a moral policy response to the current conditions are just plain wrong. Such redistributive policies to the benefit of the banking sector come at the expense of the underprivileged.

What is hardly apparent or seen is that the current government structured inflation indices have been vastly underreporting inflation.

Yet surging agricultural and food prices would not only harm a significant percentage of financially underprivileged by reducing their money’s purchasing power but also promote poverty in the US and elsewhere.

Figure 5: Food Expenditures By Income Level

Tyler Durden of Zero Hedge quotes a JP Morgan study[21], (bold emphasis mine)

When the Fed considers the possible consequences of a falling dollar resulting from QE2, it should perhaps focus on food and energy prices as much as on traditionally computed core inflation. First, the food/energy exposures of the lower 2 income quintiles are quite high (see chart). Second, the core CPI has a massive weight to “owner’s equivalent rent”, which suggests that the imputed cost of home occupancy has gone down. Unfortunately, this is not true for families living in homes that are underwater, and cannot move to take advantage of it (unless they choose to default and bear the consequences of doing so). Due to the housing mess, there has perhaps never been a time when traditionally computed core inflation as a way of measuring changes in the cost of things means less than it does right now.

Figure 6: ADB[22] Asia’s Share of Food Expenditure to Total Expenditure

And as said above the effects are likely to hurt the underprivileged of the emerging markets more than the US.

So inflationism or QE 2.0 poses as a major risk to global poverty alleviation and prosperity, a blame that should be laid squarely on these policymakers and their supporters.

Of course as the ramifications of inflationary policies worsen, the subsequent scenario would be for political trends to shift towards holding the private sector responsible for elevated prices and for ‘greed’ in order to institute more government control and inflationism.

As the great Ludwig von Mises once wrote[23],

``They put the responsibility for the rising cost of living on business. This is a classical case of the thief crying "catch the thief." The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices. While the [the government] is busy annoying sellers as well as consumers by a flood of decrees and regulations, the only effect of which is scarcity, the Treasury [and the Fed] go on with inflation”

Here free trade will likely give way to protectionism; that is if public remains ignorant of true causes of inflation and if the world would stubbornly stick by the US dollar as preferred global medium of exchange.

Of course Asian nations were hardly receptive to the unilateral actions by the Federal Reserve. The conventional recourse in dealing with QE 2.0 has been via currency appreciation, tightening of domestic liquidity by raising bank reserves or increase policy rates or lastly ‘temporary’ capital controls. So far some countries as South Korea have threatened to impose some variation of capital controls.

Yet we should expect the world to shift out of the US dollar regime once inflationism becomes rampant enough to pose as a meaningful hurdle to national economic development and global trade. The Bloomberg quotes China’s Central Bank adviser Xia Bin[24],

``China should counter the U.S. through regional currency alliances, speeding international use of the yuan and seeking stability in exchange rates through the Group of 20, which holds a summit next week”

A currency from a political economy that engages in significantly less inflationism, has deep and developed sophisticated markets, has a convertible currency and hefty geopolitical exposure is likely to challenge the US dollar hegemony, whether this would be the yuan (which for the moment is unlikely) or the Euro, only time will tell.

Of course, we can’t discount gold’s role in possibly being integrated anew in the reform of the monetary architectural system.

Figure 7: Virtual Metals[25]: Central Bank Gold Holdings and Sales

Global Central banks appears to be rediscovering gold as possibly reclaiming its role as money in a new monetary order. A new monetary order is not question about an if, but a when.

Once as net sellers, central banks seem to be transitioning into potential net buyers.

So again, our peripheral insight seems being validated with the ongoing process of shifting expectations by authorities on the functions of gold.

As I pointed out last year[26], gold is presently seen by an ECB official as a form of economic security, risk diversification, a confidence factor and an insurance against tail risks. Once these factors become well entrenched, a store of value role would likely be the next step. And more QE’s would only serve to push gold towards such a path.

Those who obstinately relish the bias that gold is nothing but a barbaric relic will likewise suffer from taking on the wrong positions. But they eventually will succumb to the shifting expectations as with many monetary authorities today. The reflexive process of having prices influence fundamentals has clearly been taking shape.

With gold prices at $1,390 mainstream economists like celebrity Nouriel Roubini[27], who last year debated savvy investor Jim Rogers and declared “Maybe it will reach $1,100 or so but $1,500 or $2,000 is nonsense”, must be squirming on his seat for the likelihood to be proven wrong once again.

---

[1] See US Midterm Elections: Rebalancing Political Power And Possible Implications To The Financial Markets, October 31, 2010

[2] USA Today, 2010 Elections: Live Results

[3] Politico.com Roland Burris will serve in November, November 5, 2010

[4] See An Overextended Phisix, Keynesians On Retreat And Interest Rate Sensitive Bubbles, October 25, 2010

[5] Toffler, Alvin and Toffler, Heidi Revolutionary Wealth Random House p.40

[6] See Trick Or Treat: The Federal Reserve’s Expected QE Announcement, October 31, 2010

[7] Ibid

[8] Bernanke, Ben What the Fed did and why: supporting the recovery and sustaining price stability, Washington Post, November 4, 2010

[9] Bernanke, Ben A Crash Course for Central Bankers, Foreign Policy.com or wikiquote Ben Bernanke

[10] Macau Daily Times Asian markets rise, dollar falls, November 5, 2011

[11] Board of Governors of the Federal Reserve System, November 3, 2010 Press Release

[12] Marketwatch.com Bank of Japan holds steady, details asset plans, November 4, 2010

[13] Noland, Doug QE2 Credit Bubble Bulletin, Prudent Bear.com

[14] See Thought Of The Day: The Keynesian Circular Thought Process, June 22, 2010

[15] Wordnetweb.princeton.edu law of diminishing returns

[16] Wiktionary.org law of diminishing marginal utility

[17] See Surging Gold Prices Reveals Strain In The US Dollar Standard-Paper Money System, November 1, 2010

[18] See The Myth Of Risk Free Government Bonds, June 9, 2010

[19] See $23.7 Trillion Worth Of Bailouts?, July 29 2010

[20] See The Possible Implications Of The Next Phase Of US Monetary Easing, October 17, 2010

[21] Durden Tyler, How Ben Bernanke Sentenced The Poorest 20% Of The Population To A Cold, Hungry Winter, Zerohedge.com November 5, 2010

[22] Asian Development Bank: Food Prices and Inflation in Developing Asia: Is Poverty Reduction Coming to an End? April 2008

[23] Mises, Ludwig von The Truth About Inflation

[24] Bloomberg.com Asians Gird for Bubble Threat, Criticize Fed Move November 4, 2010

[25] Virtualmetals.co.uk The Yellow Book September 2010

[26] See Is Gold In A Bubble? November 22, 2009

[27] See Jim Rogers Versus Nouriel Roubini On Gold, Commodities And Emerging Market Bubble, November 5, 2009

Should We Chart Read Market Actions From QE 2.0?

``We can chart our future clearly and wisely only when we know the path which has led to the present." - Adlai E. Stevenson

Now we know that no trend moves in a linear fashion.

Yet we cannot be heavily reliant on chart actions to determine the “overbought or oversold” conditions from which to base our positions.

In any major trend (bear or bull cycles), overstretched markets or securities can last for an extended period.

Besides, chart actions greatly depend on patterns from past performances in the probabilistic assumption of a recurrence. The operating word is here probability.

But charting does NOT incorporate the prospective stimulus-response and action-reaction by the public to the ever fast evolving highly fluid environment nor does charting impute exactly similar conditionalities from which decisions had been shaped. This is despite some successful repetition of patterns.

For instance can charting say to what degree the markets will react to a sustained QE? The answer is NO.

And it is from such dimensions that I accurately debunked earlier claims by perma bears of the supposed repetition of the Great Depression, through the alleged similarities in the unfolding of chart patterns[1].

For most of the perma bears, whom have been influenced by some form of (political or economic or cultural) bias rather than sound analysis, they can characterized by the frequent use of post hoc fallacy and data mining to support their desired outcome.

This is why I also correctly disproved earlier notions of chart based bearish patterns which ALL failed to pan out.

I earlier wrote[2],

``They never seem to run out of materials to throw in, after the earlier “death cross” and the ERCI leading indicator, whose effects remain to be seen, now they point to the Hindenburg Omen as a reason to take flight.”

Now that the actions have been reversed and that all former bearish patterns have evaporated, chartists have been talking about the bullish “Golden cross”. Duh!

Yet even if one looks at the charts, the synchronous breakouts in global markets imply a tailwind effect or “momentum” in favour of continuity going forward. As charts have yet to signify distribution or exhaustion.

Also the assumption that charts impute all the necessary information is similar to the flawed premises of the Efficient Market Hypothesis (EMH) which ignores the role of the individual entrepreneurial activities that generate variable outcomes and the erroneous implication that all participants have the same homogenous ‘rational’ expectations[3].

And in learning from the recently departed Benoit Mandlebroit, the father of fractal geometry, on why not to trust charts, Mr. Mandlebroit wrote[4],

``And in the fun-house mirror of logic of markets, the chartists can at times be correct...But this is a confidence trick: Everybody knows that everyone else knows about the support points, so they place their bets accordingly. It beggars belief that vast sums can change hands on the basis of financial astrology. It may work at times, but it is not a foundation on which to build a global risk-management system.” (bold emphasis mine)

In other words, Mr. Mandlebroit shares the analysis disputing the homogeneity of rational expectations incorporated in charting, such that everyone employing the same pattern recognition techniques would render charting to be impractical and an undependable tool for investment or trade.

For me, chart patterns have higher probability of repetitions only when it treads on major trends.

Yet I find more value in identifying the stages of the trend or the cycle, where charts only serve as supplemental role or a guidepost for entry and exit points rather than for main reasons to anchor on a major investment or trading decision.

Hence, given the current market actions and fundamental based developments brought about by QE 2.0, I am unlikely to recommend any position that would fight the major trend.

Remember, QE 2.0 represents uncharted waters in modern central banking, unless we’d include Zimbabwe Gideon Gono’s approach as part of this.

So why use traditional or conventional tools to engage in something unprecedented?

---

[1] See Seeing Patterns Where None Exist, February 17, 2010

[2] See The Importance of Peripheral Vision, August 23, 2010

[3] Shostak Frank, In Defense of Fundamental Analysis: A Critique of the Efficient Market Hypothesis

[4] Mandlebroit, Benoit B and Hudson Richard, The (Mis) Behaviour of Markets, Profile Books p .8

Oil Markets: Inflation is Dead, Long Live Inflation

There seems to be an ongoing dissonance in the oil or energy markets.

Bespoke Invest shows us that crude oil inventories “are now at their highest levels of the year”, while distillates and gasoline “both saw larger than expected draws in their stockpiles”.

Yet crude oil prices are approaching the April highs.

And as mentioned above it isn’t just crude oil, such dissonance is likewise extended to the gasoline markets (Gaso).

The obvious answer is that the recent actions don’t just reflect on the consumption pricing model but from the reservation pricing model.

As we previously pointed out, commodities are not just meant to be consumed (real fundamentals) but also meant to be stored (reservation demand) if the public sees the need for a monetary safehaven.

Thus, we seem to seeing inflation dynamics incrementally playing out in the commodity markets.

Meanwhile, there has also been a small recent pop in the natural gas market (NATGAS).

I’d be convinced of the deepening risks of the inflation cycle, when Natural Gas chimes in. So far, this hasn’t been so.

Yet the odd part is that mainstream says inflation hardly exist. I wonder what kind of world they seem to be living in.

Global Equity Markets Update: Peripheral Markets On Fire, Philippines Grabs Lead In ASEAN

Here is a nice update on the performances of global equity markets from Bespoke Invest

Says Bespoke Invest,

At the moment, the average 2010 performance of the 81 countries listed is +12.19%. As shown, Sri Lanka leads the way with a gain of 97.16%. Bangladesh ranks 2nd at 74.88%, followed by Estonia (62.46%), Lithuania (49.56%), and the Philippines (43.54%). Of the G-7 countries, Germany has done the best with a gain of 11.30%. Canada ranks 2nd at 7.24%, and the US ranks third with a gain of 6.78%. Japan has been the worst performing G-7 country with a decline of 13.15%. Italy and France are both down still for the year as well.

Of the BRIC countries, India is leading the way with a gain of 17.18%. Russia ranks 2nd at 11.08%, followed by Brazil (+4.84%) and then China (-7.51%).

Additional observations:

Only 17 out of the 81 bourses are in the red. This includes the crisis affected PIIGS, China (whose bourse has been repeatedly under siege from her government aimed at curtailing her inner ‘bubble’ demons) and Vietnam (agonizing from high inflation)

Another way to see this is that global inflationism has led a rising tide lifting all boats phenomenon

It’s been a tight race among peripheral emerging markets led by South Asia, Eastern Europe and Southeast Asia.

The relative performances of BRIC and G-7 bourses have been mixed.

The Philippines has eked out a marginal lead from Indonesia (this is based on local currency. For the moment I don’t have access to dollar based returns)

Opinions As Opiate

I like this graphic depiction by Jessica Hagy on opinions because I find it poignantly relevant.

While Ms. Hagy calls it Opinions are like bellybuttons, I would call this ‘opinions as opiate’.

For me, the proportion of mainstream opinions are tilted towards what Ms. Hagy describes as based on low evaluations:

- parroting someone else ideas or regurgitating statements like an incantation or

-engaging in nice sounding political or economic talking points that in the end only signifies gossip.

Since gossips are hardwired on us for social/peer acceptance or for “feel good” or for attention generating or for self-esteem purposes, this may seem like an opiate. After all, gossips are hardly premised on sound evaluation but mostly on heuristics or mental short-cuts.

Global Equity Markets: Decoupling or Recoupling?

Many have come to believe that the outperformance of ASEAN markets represent signs of decoupling.

BCA Research argues otherwise and observes that the “average correlation between national equity markets has trended higher over the past decade”

They add, (bold emphasis mine)

Equity market correlation reached a peak during the 2008 financial crisis, and what eventually led to the largest global easing episode in history. But correlations still remain high and this suggests that the benefits of diversification are dwindling as investors shift between asset classes rather than between regions in response to market events. It is unlikely that the period of high correlation will end soon. The importance of macro events/drivers (government deficits, financial system health, emphasis on monetary stimulus) over the past decade has been rising and will be an ongoing feature on investors’ radar screens for years to come.

Worth noting:

1. Intensifying globalization has made financial markets more correlated and not less. Hence the above average activities seen in ASEAN or many emerging markets represent outperformance and can hardly be construed as strong indications of decoupling.

And the above dynamic seems also reflected in terms capital flows on direct investments (chart from Google Public Data).

In other words, cross border movements of capital has intensified similar to scale of improvements in world trade. I see this as financial globalization.

And as we have repeatedly been saying, the decoupling is dynamic that has yet to be proven. This will only be evident when global markets and the economies come under duress and not during inflation driven booms.

2. Since the world has been more integrated than in the past, macro dynamics will equally play a bigger role in determining trends in the financial markets or in economic developments. The relevant macro factors will perhaps depend on the proportion or the extent of a country’s exposure to world integration or globalization. And this is where the variability in national performances would emerge.

Surging Gold Prices Reveals Strain In The US Dollar Standard-Paper Money System

Tocqueville Asset Management LP’s John Hathaway poignantly writes:

The world’s monetary system is in the process of melting down. We have entered the endgame for the dollar as the dominant reserve currency, but most investors and policy makers are unaware of the implications.

The only questions are how long the denouement of the dollar reserve system will last, and how much more damage will be inflicted by new rounds of quantitative easing or more radical monetary measures to prop up the system.

Whether prolonged or sudden, the transition to a stable monetary system will become possible only when the shortcomings of the status quo become unbearable. Such a transition is, by definition, nonlinear. So central-bank soothsaying based on the extrapolation of historical data and the repetition of conventional wisdom offers no guidance on what lies ahead.

History has shown that paper money system don’t last long.

The only exception is that of the medieval Chinese experience which reportedly lasted 600 years. But the historical account of this isn’t certain: wikipedia says it was during the Song Dynasty, the Buttonwood’s Blog at the Economist says it was during Emperor Tsung while Dollardaze.org’s Mike Hewitt says this was during the Tang dynasty.

Meanwhile Murray Rothbard argued that the first paper money in the US was issued by the colonial government of Massachusetts in 1690.

Nevertheless Dollardaze’s Mike Hewitt examined 775 world currencies which includes the 176 in circulation (as of 2009) and 599 not in circulation, and found that

-the “median age for all existing currencies in circulation is only 39 years” and

-that the extinction of currencies had primarily been through acts of war and hyperinflation.

Incidentally and ironically, the US dollar standard since 1971 is 39 years old and seems to feel the same strain from old political habits.

Yet the attraction of the paper money system is that it allows government to pursue its political agenda via unsustainable free lunch policies.

As Murray Rothbard wrote in Mystery of Banking,

The inventions of paper and printing gave enterprising governments, always looking for new sources of revenue, an “Open Sesame” to previously unimagined sources of wealth. The kings had long since granted to themselves the monopoly of minting coins in their kingdoms, calling such a monopoly crucial to their “sovereignty,” and then charging high seigniorage prices for coining gold or silver bullion. But this was piddling, and occasional debasements were not fast enough for the kings’ insatiable need for revenue. But if the kings could obtain a monopoly right to print paper tickets, and call them the equivalent of gold coins, then there was an unlimited potential for acquiring wealth. In short, if the king could become a legalized monopoly counterfeiter, and simply issue “gold coins” by printing paper tickets with the same names on them, the king could inflate the money supply
indefinitely and pay for his unlimited needs.

Eventually, as always, monetary debasement gets abused and suffers from rampant inflation or at worst hyperinflation. And this will require either massive reform or a new currency system.

The current US dollar standard paper money system seems to be in a no different path from its forbears, as free lunch and mercantilist policies are being subtly pursued through global currency debasement.

Some call this the “currency wars”. I call this cycle the Mises moment.

And rampaging gold prices priced in every major currency (US dollar, Euro, Yen, Pounds, Canadian Loonie, Aussie Dollar, Indian Rupee, South African Rand and Gold in G5 index) seems to be saying this for quite sometime—the endgame could be near.

Charts from Gold.org (as of October 25, 2010)

For the “gold is barbaric metal” camp, paper money will reign forever even when unsupported by history and economic laws for the simple reason of dogmatic belief over free lunch politics.

But as Professor Ludwig von Mises once wrote,

The return to gold does not depend on the fulfillment of some material condition. It is an ideological problem. It presupposes only one thing: the abandonment of the illusion that increasing the quantity of money creates prosperity.

Unfortunately, anything unsustainable won’t last. And Voltaire would be validated anew, paper money eventually returns to its intrinsic value—zero.

Ireland’s Fiscal Austerity Seen From The Big Picture

One of the popular rejoinders or justifications made by mainstream economists has been to refer to Ireland as an example of the perils of having to impose fiscal austerity.

The general idea is the lack of aggregate private demand as measured by a decline in private spending should be substituted for by the government, in order to boost the economy. This is premised on the assumption that every variable in the economy are homogenous and subject to the same sensitivity from interventionist policies.

Yet we understand Ireland as having an ongoing crisis with her banking industry such that her government has undertaken massive recapitalizations of Allied Irish Bank and Anglo Irish Bank to the tune of “some €50 billion ($68 billion) this year and will push Dublin's budget deficit to an estimated 32% of GDP” according to Wall Street Journal.

Ireland’s banking woes continues to be reflected on her sovereign spreads as with the other crisis affected Euro nations classified as the PIIGS. (chart courtesy of Danske)

If the focus is plainly on unemployment, then the mainstream is right, high unemployment continues to plague the country. (chart courtesy of tradingeconomics.com)

However, unemployment will always be a lagging indicator. In a market economy as Ireland, profitability will be the primary gauge for investments, which eventually will be reflected on the job market.

First of all, despite the selective nature of evidence brought by the mainstream, Ireland isn’t in all that deep funk.

Ireland appears to be emerging from a deep recession and is expected to continue to grow through 2011 in spite of the fiscal tightening measures.

According to Finfacts

IBEC, the business group, said today the economy will return to growth in 2011 despite the greater than anticipated scale of the fiscal adjustments needed over the coming four years. GNP (gross national product) will grow 1.2% in 2011 and 3.4% in 2012 while GDP (gross domestic product with no adjustment for the profits of multinational operating in Ireland) will grow 2.2% and 3.1%. The forecasts for 2012 can be only guesswork and the outturn depends on the robustness of the international recovery in rich countries.

The business group says the final national accounts data for 2009 show that the nominal size of the economy was much lower than the Department of Finance had originally estimated while the global economic recovery has lost steam in recent months and Government’s growth forecasts for the 2011 to 2014 period now appear too optimistic.

The full accounting of the banking costs means that the debt-to-GDP ratio will reach 100% this year and will peak at about 115% in 2014. While this represents a rapid escalation from the pre-crisis debt ratio it is not exceptional in international terms - - IBEC says it is just above the debt level of the Eurozone and the US, about the same as that in Belgium and below that in Italy.

Second, deflation hasn’t been a persistent scourge as the mainstream paints it to be.

True, the unravelling of the global crisis has brought about a bout of deflation, but this appears to be on the mend.

Third, for the mainstream to argue that politics always favours government intervention, this report from the BBC, (bold emphasis mine)

Despite public sector cuts averaging more than 15%, and a further huge bank bail-out, making Ireland the EU's most indebted nation, the popular backlash against the government's fiscal tightening has never really materialised.

Bottom line: All these add up to demolish the myth that adapting fiscal discipline will be a bane to the economy.