Contagion Risk: Watch for China’s Catastrophic Deleveraging

Dee Woo at the Business Insider has an insightful analysis on why we should continue to keep vigil on China’s banking and financial system. (bold emphasis mine)

China’s policy makers have been caught in a dangerous bind.

1. The frustrated and aggressive central bank

If one wants to know how bad the health of China's economy has gone, look no further than the PBOC's composure, which seems rather frustrated and aggressive as of late. On 5th July, the central bank cut benchmark interest rates for the 2nd time in less than a month. This happened right after the fact that in December 2011, PBOC cut the reserve requirement ratio(RRR) by a 50 bp to 21%, it followed up with another 50 bp in February and another 50 bp in May to 20% currently.

On top of all the rate cuts, PBOC also made its biggest injection of funds into the money market in nearly six months. The PBOC injected a net 225 billion yuan ($34.5 billion) through the reverse-repurchase operations(repo) on last Tuesday and Friday, following a combined injection of 291 billion yuan in the previous four weeks.

2. The systematic short-circuit of debt financing's in order

So why PBOC is in such an urge to open the floodgate of liquidity? This economist will spare you the boredom of looking at the diagrams of China's economic misery: HSBC PMI, etc, since you can find those eye candies everywhere else on the web. Let me cut to the chase: However high it aims, PBOC's action in practice merely work as the band aid to the bleeding economy. But it won't be able to fix it. The central bank's aggressive pro-liquidity maneuvers at best serve to sustain the over-leveraged economy and avoid the systematic short-circuit of debt financing. Now allow me to divulge:

The main drivers of China's debt financing,China's state-owned banks, are starving for cash. According to Citigroup estimates, in 2011 seven of the biggest Chinese banks raised 323.8 billion renminbi ($51.4 billion) of new fund. Several financial firms are expected to raise another $17.7 billion in the next few months, with China’s fifth-biggest lender, the Bank of Communications, accounting for $9 billion. The unprecedented lending binge encouraged by the central government,increasingly rigorous requirement of regulatory capital and excruciating maintenance of excessive dividend payouts have rendered the most-profitable banks in the world--Chinese banks--in a rather precarious position.

GaveKal's data will illustrate this is no exaggeration: In 2010, China’s five biggest banks — the Big Four plus the Bank of Communications — paid more than 144 billion yuan in dividends while raising more than 199 billion yuan on the capital markets. The ballooning balance sheet caused by the loan frenzy and strict capital requirement make China's banks' cash-craving burning at both ends:this march, China’s big four— Industrial and Commercial Bank of China, the Bank of China, China Construction Bank and Agricultural Bank of China — have a combined 14 percent increase in total assets, to 51.3 trillion yuan, which is roughly the size of the German, French and British economies combined.

Meanwhile, under a new set of rules, the country’s biggest banks will need to increase their capital levels to 11.5 percent of assets by the end of 2013.Their core Tier 1 capital ratio will need to be at least 9.5 percent. These requirements are more stringent than the rules that apply to American and European banks. Hereby, we shouldn't be surprised why the world's most profitable banks are in the dire need of cash. It has to be PBOC who comes to the rescue.

Diminishing returns of China’s inflationism…

According to the great Ray Dalio's principles, the credit-fueled China's economy is so over-leveraged that a great de-leveraging is going to be the only way out. The pyramid of debt/credit is cracking and will collapse since the conditions of underlying economic agents are deteriorating.There's no mount of monetary band aids that can alter that destiny.

According to Fitch’s data, the ratio of total financing/GDP in China rose from 124% at end‐2007 to 174% at end‐2010, and rose by another 5pp to 179% in 2011.In 2012 the growth of broad credit will slightly decelerate but still outpace GDP. Clearly China is not suffering a liquidity crisis but the diminishing economic return on credit. According to Fitch, in 2012, each CNY1 in new financing will yield ￥0.39 yuan in new GDP versus ￥0.73 yuan pre-crisis.Returns would have to rise above ￥0.5 yuan for domestic credit/GDP to stabilize at 2011’s 179%.

The dilemma is that business entities will need more and more credit to achieve the same economic result, therefore will be more and more leveraged, less and less able to service the debt, more and more prone to insolvency and bankruptcy. It will reach a turning point when the increasing number of insolvencies and bankruptcies initiate an accelerating downward spiral for underling assets prices and drive up the non-performing loan ratio for the banks.

And then the over-stretched banking system will implode. A full blown economic crisis will come in full force. The chain of reaction is clearly set in the motion now. The question is when we will reach that turning point. What PBOC has done is only adding fuel to the fire because it is unable to tackle the root causes of China's economic ills.

Again interventionism will require more interventionism. Yet interventionism via inflation is a policy that will not and cannot last. Has China reached that moment?

More, insufficient savings to tap for bank recapitalizations…

Let's examine the structural reasons that China's domestic demand will have its work cut out to refill the tank space of the economic growth left out by collapsing investment and export:

1st, Contrary to what many choose to believe, China's trade surplus is not caused by Chinese consumers' high saving rate, but has much to do with their deteriorating disposable incomes which far lag behind GDP growth and inflation. According to the All China Federation of Trade Unions (ACFTU), workers' wages/GDP ratio have gone down for 22 consecutive years since 1983. It goes without saying that the consumption/GDP ratio is shrinking all the while.

Meanwhile, Aggregate Savings Rate has increased by 51% from 36% in 1996 to 51% in 2007. Don't jump to your conclusion yet that Chinese consumers has been over-tightening their purse strings. The truth is far away from conventional perceptions: according to Development Research Center of the State Council's report, that increase is mainly driven by the government and corporations and not by the household. For the past 11 years, Household Saving Rate has only increased from 19% to 22%. Even India's Household Saving Rate of 24% is higher than China's right now.

All the while, government and corporations' saving rate has increased from 17% to 22%, which accounts for nearly 80% of the increase on Aggregate Savings Rate. For the past decade, Government's fiscal income is growing faster than GDP or Household Income. In 2009, the fiscal income was 687.71 billion yuan, and achieved an annual growth of 11.7% while GDP growth was 8.7%, Urban household disposable income growth was 8.8% and agriculture household disposable income growth was 8.2%. It is obvious that the state and corporations has taken too much out of national income and hence they continue to weaken the consumers rather than empower them.

All inflationism is deceptively about self-serving politics…

The biggest problem for China is the state, central enterprises and crony capitalists wield too much power over national economy, have too much monopoly power over wealth creation and income distribution, and much of the GDP growth and vested interest groups' economic progress are made on the expanse of average consumers stuck in deteriorating relative poverty. If these problems aren't solved, the faster the Chinese GDP growth, the less Chinese consumers will be able to support the over-capacity expansion, the more export momentum China will need to sustain its growth. This is a vicious circle of global imbalance. Even the revaluation of RMB can't break it.

Read the rest here

To recall the admonitions of the great Professor Ludwig von Mises against Keynesian policies…

The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system.

Will China's policymakers ease on bank capital regulations? Or will China's authorities opt to finance these through PBoC's money printing that increases the risk of hyperinflation? Or will China be forced to deleverage? Many questions that has yet to be answered.

Be careful out there.

Phisix: Why the Contagion Risk Must Not be Discounted

Here is what I wrote last week[1]

after 3 successive weeks of advances which racked up 8.53% in returns, it would be normal to see some profit taking.

So apparently correction of the Phisix materialized.

In line with the activities of the region’s bourses, the Phisix fell 2.76% this week.

For our ASEAN peers, the outcome had been mixed. Thailand and Malaysia was modestly higher while Indonesia joined the Phisix in a correction mode but had been down moderately.

The BRICs or Brazil, Russia, India and China continue to suffer from hefty losses.

Whatever bounce we have seen lately have mostly signified as deadcat’s bounce for the BRICs. So far only India (BSE) has shown a little bit of strength compared to her contemporaries; China (SSEC), Brazil (BVSP) and Russia (RTSI)

If you have noticed, events have become sooo incredibly short term oriented, exceedingly volatile, and at worst, complacency seems to have become a dominant feature, especially in the Philippine setting, where the current environment has largely been seen as hunky dory.

And part of my concern stems from idea that BAD news has been interpreted as GOOD news where many have come to believe that either local and regional markets have become immune to the external developments or that interventions has been seen as a sure thing and will always be successful.

And as I have pointed out during the past few weeks, my other concern is that perhaps the Philippine market may have been “jockeyed” to project political goals.

Bubble Cycles: This Time Will NOT be Different

“This time is different” are four words that I fret most. For the late investment legend Sir John Templeton these are the four most dangerous words in investing[2].

Such statement is symptomatic of overconfidence, a deeply ingrained euphoric sentiment or an embedded belief that a new paradigm has somewhat reconfigured how life would play out.

A classic example is when the late distinguished monetary economist Irving Fisher infamously declared that the US stock market, at the climax of the bullmarket in 1929, had reached “a permanently high plateau.”[3] What followed in the coming months were the gruesome Wall Street Crash and the Great Depression.

So when I stumble upon news which avers that “Southeast Asia is looking more a safe haven than a risky bet, with foreign investors souring on China and India and pouring money into markets proving resilient to the global gloom”[4] such assumptions gives me a creepy feeling.

That’s because such sentiment evokes of the memories of the excruciating Asian crisis which once was heralded as the “Asian Economic Miracle”[5] in 1994 and which ultimately turned out into a grand cataclysmic bubble bust in 1997.

Yet it took 3 years for the bust to occur.

But euphoria does seep through public’s consciousness even when bubble cycles have not been homemade.

Exactly during the pinnacle of the last boom phase of the Philippine stock market, a local news outfit featured the ‘basura queen’ in June of 2007[6]. Basura is a local term for garbage and a stock market colloquial or slang for high risk issues.

The ‘Basura’ Queen swaggered about her making millions out of ‘basura’ issues, or the penny stock equivalent of Wall Street.

Overconfidence and the increasingly desperate search for returns seem to be revving up the public’s appetite for gambling.

But the seeds of a homegrown bubble are also being sown.

The Fitch Rating, a US credit rating agency recently, seems to have echoed on what I have been repeatedly warning about: that the Philippines may be on the ‘brink’ of a domestic credit boom[7]. Not just on the brink, we are already having a domestic credit boom[8].

Of course, local officials will hardly do anything about this, since the credit boom will spruce up the economy over the short term and would thereby provide an image booster or political advertisement to the incumbent administration as their “major accomplishment”.

The boom will be seen as a feat, but the bust will be passed on like a hot potato. In politics, who cares about the future?

Besides, officials have limited knowledge of the unseen or undefined “equilibrium” levels from where or which point to put the policy brakes on.

In addition, since the Philippine political economy have been mostly state driven, chieftains of the industries involved in the boom, who are most likely allies of the administration, will exert their political capital to influence on the direction of policymaking thereby extending the boom to unsustainable levels.

Finally since policymakers have innate Keynesian leanings, who try to promote consumption as the main policy thrust, the policy of negative real rates will drive

1. consumer spending through acquisition of more debt via mortgages, credit cards, and other consumer loans,

2. encourage more government spending which will be financed by low interest rates from the private sector, particularly channelled through banks and other financial institutions, which again would add to systemic debt, and importantly leads to consumption at the expense of production, and lastly,

3. fuel capital intensive speculation which will likely be directed to real estate projects, manufacturing and mining, and which again leads to more systemic debt accrual. Such misdirection of allocations of resources eventually leads to the consumption of capital. A great bust.

Again all inflation is political, designed to push the interests of a few at the expense of the society

And I am talking here of a locally fuelled bubble which is aside from today’s present risk: contagion.

Europe’s Capital Flight Paradigm

In case of a full blown global recession, there has hardly been convincing evidence that ASEAN bourses will entirely decouple.

As I predicted Japanese foreign direct investments capital flows into ASEAN has currently been intensifying[9].

Since Japan’s capital flows into ASEAN have still been couched on the term ‘investments’ based on ‘growth’, this has yet to translate into a full capital flight dynamic where Japanese investors frantically stampede into ASEAN assets regardless of risk conditions.

Once Japan’s debt crisis reaches a ‘tipping point’[10], where in the face of the dearth of access to private capital and from external financing, and where the Bank of Japan (BoJ) will substitute as the buyer or financier of last resort of local sovereign papers in order to save the banking system, then this ‘growth’ dynamic will likely be substituted for ‘flight to safety’[11].

Such dynamic appears as partially being played out in the Eurozone: government debts of Germany, Finland and Netherlands[12] (as well as Denmark[13]) have become lightning rods against the concerns of the Eurozone’s dismemberment and this dynamic has also began to diffuse into Belgium and France.

Yes, it is panic time in the Eurozone as expressed by the bond markets…

…but not in the equity markets

I think that the difference is that the European Central Bank (ECB) has yet to aggressively step up as the buyer and financier of the last resort which is why most of the capital flows have been absorbed into government bonds.

Nevertheless some of these safehaven flows may have already been rechanneled to the equity markets of Germany (DAX), Denmark (KFX), Netherland (AEX) and Belgium (BEDOW).

Meanwhile the Finnish and French bellwether has yet to ventilate similar ‘capital flight’ dynamics.

Remember if the risk conditions in the Eurozone stabilize, then these capital flight dynamics will likely be reversed as money flows back to their sources, and the current boom may turn out to another bust, which ironically may again fuel more destabilization.

Some bullish background, eh?

Contagion Risk Must Not be Discounted

We shouldn’t forget that the Asian Crisis proved that contagion risk was a real risk that spread throughout the region.

As the Reserve Bank of Australia noted[14],

One can then locate the onset of crisis in Korea, Indonesia, Malaysia, and the Philippines in a process of contagion: a flip to the bad equilibrium to which the economies were vulnerable, in response to the ‘wake-up call’ (i.e. signal) from Thailand that this was a possible outcome.

This was likewise true with the 2007-2008 meltdown of the US property and mortgage bubble.

Remember that the real effects of an external transmission of contagion were hardly felt since the Philippine economy escaped a recession and that the ensuing global slowdown hardly left an imprint to local corporate earnings, yet the Phisix lost over half of its value from peak to trough[15]!

So while it may be true that those years had different conditions from today, despite some of the real relatively positive changes on ASEAN economies, we must be reminded that globalization and dependence on the US dollar through international currency reserve accumulation via the global banking system has been the umbilical cord for global asset markets.

Merchandise trade as % of GDP remains as a significant factor to ASEAN economies particularly to the Malaysia and Thailand.

But the Philippines also depends on foreign remittances (10.73% of GDP 2010[16]) as well, and to the lesser extent Indonesia (>1% of GDP 2010[17])

While the Philippines and Indonesia may be less exposed, the question will be internal dynamics.

Dependence on government spending only provides temporary relief (benefits the cronies) at the expense of the future (higher taxes, higher debt levels, and higher inflation)[18].

Has the political, legal, tax and regulatory environment eased to incentivize entrepreneurs to take on more productive ventures?

Philippine economic growth has recently been powered by exports[19], most likely due to global restocking. But with a ongoing recession in the Eurozone, as well as, a pronounced slowdown China and other major emerging market economies, and importantly the US, expectations of robust “double digit” growth signifies as wishful thinking…unless major central banks come up with more aggressive short term palliatives.

And a slowdown in global merchandise trade has been prompting for a contraction on trade surpluses (perhaps partly due to increasing domestic demand) and a reduction of foreign currency reserves, as some emerging market central banks have attempted to stabilize exchange rate values with use of these surpluses and thus results to monetary tightening conditions that may not be conducive for equities[20].

In addition, the banking crisis at the Eurozone will prompt for major balance sheet adjustments in order to raise capital mostly through shrinkage, particularly banks are slated to reduce balance sheets by €2 trillion by dumping 7% of these assets by the end of 2013. This also means that supply of credit to the economy will contract.

Of course the real problem isn’t due to credit contraction which affects mostly the government and their protégé the banking system but of the failure to undertake real reforms focused on competitiveness and productivity[21].

Yet under the worse policy scenario arrived by IMF estimates according to DBS Research[22], a dramatic slowdown in the economy compounded by bank deleveraging (bursting bubble) will affect even the US and emerging markets will not be spared (most especially in Eastern Europe).

So we can hope for the best and prepare for the worst.

So underneath the headlines, ASEAN+3 (China Japan and South Korea) have doubled their Chiang Mai Initiative Multilateralism (CMIM) currency swap buffer to USD 240 billion which was a third funded by total foreign reserves accumulated by ASEAN 5 (US 765 billion as of April)[23][24].

So while Asian central bankers have been adding insurance against the risk of the aggravation of Europe’s banking crisis, domestic investors have been in a buying binge.

Yet the ongoing Euro-Brazil, Russia, India, China slowdown compounded by deleveraging within their respective economies has already affected Singapore whose economy suffered a contraction last quarter[25]

Yes China’s economy managed to post 7.6% growth last quarter, but many questioned on the validity of the statistics used to arrive at this output which for some have been overstated for political reasons[26]

And yet US and European markets rallied fiercely last Friday, which according to news drew on the conclusion that the recent conditions of China’s economy will lead to more monetary accommodation by policymakers[27]. Bad news again seen as good news.

I think that such knee jerk response represents more of a melt-up from “crowded short positions” rather than a major inflection point.

As Prudent Bear analyst Doug Noland rightly points out[28],

But the downside of the Credit cycle radically alters rules of the game. Over time, reality sinks in that the previous prosperity was in fact an unsustainable boom-time phenomenon. The downside of the Credit cycle ensures faltering asset prices, deflating household net worth and financial sector deficiencies, along with the revelation of problematic economic imbalances and maladjustment. It’s not long into the bust before many see themselves as losers – and to have lost unjustly at the hands of an unfair system. The growing ranks of losers become an increasingly powerful political force.

Nevertheless I expect Friday’s huge jump to filter into Asian markets including the Phisix at the start of the week.

My conclusion remains: for as long as political gridlock over policies persists (in the US, China and Eurozone) and central bankers of major economies remain rudderless, markets will remain subject to extreme volatility from the collision of hope (expectations of decoupling, deeply embedded Pavlovian expectations of major central bankers coming to the rescue and of the narcotic effects of inflationism) and reality (ramifications from deflating bubbles: economic slowdown and deleveraging). Not to discount of the possibility of major policy errors from too much focus on the short term fixes.

While I remain bullish over the Phisix over the long term, the short term horizon has been filled to the brim with uncertainties coming from almost every direction. This for me magnifies the tail event risks.

---

[1] see Why Current Market Conditions Warrants a Defensive Stance July 9, 2012

[2] SirJohnTempleton.org Consider these 'words of wisdom' about investing September 20, 2006

[3] Wikipedia.org Irving Fisher

[4] Reuters.com Southeast is Asia safe haven as China, India stumble, July 14, 2012

[5] Wikipedia.org 1997 Asian financial crisis

[6] See Philippine Stock Exchange: The PUBLIC’s MILKING Cow???!!!, June 17, 2012

[7] Inquirer.net Philippines on the brink of a credit boom, must be wary of dangers—Fitch Rating, July 6, 2012

[8] See Why has the Phisix Shined? July 2, 2012

[9] See Japan’s Capital Flows to ASEAN Accelerates July 4, 2012

[10] See The Coming Global Debt Default Binge: Japan’s Government Under Financial Strains July 9, 2012

[11] See Will Japan’s Investments Drive the Phisix to the 10,000 levels? March 14, 2012

[12] Bloomberg.com AAA Yields At Zero Drive Investors To Belgian Debt: Euro Credit July 13, 2012

[13] See Denmark Cuts Interest Rates to Negative July 6, 2012

[14] Corbett Jenny, Irwin Gregor and Vines David From Asian Miracle to Asian Crisis: Why Vulnerability, Why Collapse? 1999 Reserve Bank of Australia

[15] See Dealing With Financial Market Information February 27, 2011

[16] Tradingeconomics.com Workers' remittances and compensation of employees; received (% of GDP) in Philippines

[17] Tradingeconomics.com Workers' Remittances And Compensation Of Employees; Received (% Of GDP) In Indonesia

[18] See S&P’s Philippine Upgrade: There's More than Meets the Eye July 3, 2012

[19] ABS-CBNNews.com May exports growth at 17-month high, July 10, 2012

[20] See Emerging Market “Liquidity” Conditions Deteriorate July 5, 2012

[21] See What to Expect from a Greece Moment June 17, 2012

[22] DBS Vickers Economics Markets Strategy 3Q 2012 June 14, 2012

[23] Ibid

[24] Wikipedia.org Chiang Mai Initiative

[25] See Contagion Risk: Singapore Economy Contracts, July 13, 2012

[26] See China’s Economic Growth Slows Anew, Economic Data Questioned July 13, 2012

[27] Bloomberg.com S&P 500 Erases Weekly Loss On JPMorgan Rally, China, July 13, 2012

[28] Noland Doug Game Theory And Crowded Trades Credit Bubble Bulletin, Prudent Bear.com July 13, 2012

Quote of the Day: The Market Does NOT Ration

The market was never set up by people to achieve a purpose. It is not a device or an invention aimed at satisfying an intention. “Market mechanism” is a metaphor. The market — as a set of continuing relations among people — emerged, unplanned and unintended, from exchanges, initially barter, in which the parties intended only to improve their respective situations. Lecturing at FEE . . . , Israel Kirzner recalled that one of the first things Mises said to him as a graduate student was, “The market is a process,” by which he meant “a series of activities.” This is similar to what the French liberal economist Destutt de Tracy (1754–1836) wrote in A Treatise on Political Economy, “Society is purely and solely a continual series of exchanges.”

Mises, Hayek, and Tracy help us to sort out the rationing question. I submit it makes no sense to say that an undesigned series of exchanges rations goods. If we were to observe a free market (wouldn’t that be nice?), what would we see? Rationing? Allocation? Of course not. We would see people exchanging things—factors of production, services, and consumer goods—for money. Where would they have gotten those things? From previous exchanges or original appropriation from nature.

Consumer Choice

When a person buys five apples in a grocery store rather than ten because he wishes to use the rest of his money for other purposes, it seems entirely wrong to say the market (or even the grocer) has rationed the apples. The customer makes his choice on the basis of his preferences and the money available (which is the result of previous transactions).

It is true that as a result of market exchanges, goods and resources change hands and (except for land) locations. But in no sense is this rationing or allocation. The resulting arrangement of resources is simply a product of many transactions. Of course, people’s choices of what and what not to buy and sell at which prices create an arrangement of goods and resources that tends to be intelligible in terms of consumers’ subjective priorities. But that does not warrant calling the process rationing or allocation.

Those words—especially ration, which shares its root with rational–suggest conscious decision-making—as part of a plan—by an agent. In a free market there is no consciousness overseeing this “distribution”—another inappropriate word when it comes to describing the market process.

That’s from Sheldon Richman at the Freemanonline defending the free market from statist healthcare reformers.

Let me add, dictionary.com defines rationing as “a fixed allowance of provisions or food” or “an allotted amount”. Differently put, a one size fits all distribution of resources that are NOT based consumer choices (preferences or valuations) are barely about free markets.

Quote of the Day: The Secret of the US Shale Gas Revolution: Free Markets

From the Wall Street Journal editorial (hat tip Prof Mark Perry) [bold emphasis added]

The U.S. ranked 159th in GDP growth last year. But in natural gas production, it's now No. 1.

How did that happen? Partly it's the luck of geology, though plenty of other countries have abundant shale resources. Partly, too, it's American technological leadership in developing hydraulic fracturing (fracking) and horizontal drilling. But those techniques are now widely understood the world over.

What has given the U.S. its edge is that the early development risks were largely borne by small-time entrepreneurs, drilling a lot of dry holes on private land. These "wildcat" developers were gradually able to buy up oil, gas and mineral leases from private owners while gathering enough geological data to bring in commercial producers…

Now compare this to Europe, which sits on an estimated 639 trillion cubic feet of shale gas yet remains heavily dependent on Russian imports. The governments of France and Bulgaria have banned fracking on dubious safety grounds, with nary any pushback from their publics. That might not be the case if French farmers, for example, were able to profit from the riches underneath their terroir.

Countries such as Poland and Great Britain are willing to develop their shale potential. Yet in both places the absence of private mineral rights has delayed exploration and production…

In time, perhaps even the French will recognize their lost opportunity and lift their ban on fracking. But the deeper lesson is that this is a revolution that came about not through government planning or foresight, but through a combination of individual risk-taking and private property. Europeans could benefit by doing more to broaden the latitude for both.

Classical Liberal and Libertarian Legacies: Ludwig von Mises and Murray Rothbard

The classical liberal and libertarian legacies of Ludwig von Mises and Murray N. Rothbard in the account of Professor Gary North (at the LewRockwell.com)

Ludwig von Mises

My only meeting with Mises came in the fall of 1971. I had been hired by the Foundation for Economic Education. I was invited to attend a special ceremony. F. A. Harper had edited a second collection of essays honoring Mises. The first book of essays honoring Mises had been edited by Mary Sennholz and was published in 1956. The meeting was held in a nice hotel in New York City. After the meeting, I was able to talk with Mises about a number of things, including his connection with the German sociologist, Max Weber. Weber referred to Mises's 1920 essay on Economic Calculation in the Socialist Commonwealth, in a footnote in a book that Weber did not complete. He died in 1920. Mises told me he had sent the essay to Weber.

Mises left a legacy that has steadily grown since his death in 1973. He was one of those rare men who had two phases in his career. The first phase, beginning in 1912 and ending after the publication of John Maynard Keynes's General Theory (1936), established his reputation as a major economic theorist. His 1912 book on money and banking, his 1922 book on socialism, and his many articles on specialized topics in economic theory identified him as a major theorist. But his opposition to all forms of fiat money gained him a reputation as a 19th-century Neanderthal in the world of fiat currencies, which began with the abolition of the gold standard at the outbreak of World War I in 1914. His hostility to socialism also contributed to his status as a pariah. He was clearly resisting what was regarded in academic circles as the wave of the future. Academics want to be trendy. Mises was not trendy.

The triumph of Keynesianism after 1936, coupled with the outbreak of World War II in 1939, led to an eclipse in Mises's career. When he came to the United States in 1940 as a refugee, he was virtually unknown here. He had no teaching position. He was 59 years old. He had never been known in the United States. He was dependent on occasional writing assignments, and also on donations from friends, including Henry Hazlitt.

He served as a free market voice crying in the Keynesian wilderness for the next 30 years. He presided over a graduate seminar at New York University which went on for a quarter-century. Murray Rothbard was one of the regular attendees, although as an auditor. He was not paid by the university, which relegated him to the status of visiting professor. He was supported by donors. Yet there was no one on the NYU economics faculty who is remembered today. They were nonentities, and they left no legacy.

The publication of his book, Human Action, by Yale University Press in 1949 did begin to establish his reputation in America. The book sold far better than anyone had expected. This book was the first comprehensive, integrated theory of free market economics that had ever been published. Very few people understood this in 1949, but anyone who has studied the history of economic thought finds in this book the first comprehensive application of economic theory to the entire market-based economy. The analysis is integrated in terms of the Austrian economic defense of subjective value theory and methodological individualism.

He continued to write after 1949. His books were sold by the Foundation for Economic Education, which brought him to the attention of readers who were in favor of the free market. His articles appeared in the Foundation's magazine, The Freeman. The Freeman did not circulate widely in academic circles, but it was a widely read magazine on the Right.

I bought a copy of Human Action in 1960. I was aware of Mises's importance in the history of economic thought, but at my university, I was probably the only student who knew about him. I suspect that the only professor who knew about him was Carl Uhr, who taught a course in the history of economic thought.

Mises was tenacious in his commitment to free-market principles. Probably more than any other major scholar of the 20th century, he was known to his peers as uncompromising. He was regarded as ideological by Chicago school economists. They were correct. Because of his consistency in applying the principle of nonintervention into every nook and cranny of the economy, but above all in his opposition to central banking, free-market economists regarded him as eccentric. "Eccentric" for them was a word for "rigorously consistent."

He was known to the Left as the West's most implacable opponent of economic intervention. When the Nazis marched into Austria in 1938, they confiscated his library. He had left it behind when he left the country to go to Switzerland in 1934. He feared that the Nazis would take over in Austria, and he was correct. As a free market economist and a Jew, he would not have survived in Austria.

The Soviets also recognized who he was, and they confiscated the library from the Nazis, and sent it to Moscow. It was not discovered there by any Western economist until the 1980s. That was a great irony: Western economists did not know who he was, but Soviet economists did. This became increasingly true in the 1980s, as the Soviet economy began to disintegrate, exactly as Mises had predicted it would.

Mises's great advantage over almost all of his peers was this: he wrote in English as a second language. Most economists write in English as a third or fourth language. He did not use equations. He did not use a lot of jargon. He developed paragraphs based on sentences that were developed consecutively. You could begin on page 1 of any of his books and, if you paid attention, you could get to the end without becoming confused.

This was an advantage because average people who were interested in economics could follow his logic. His reputation spread by way of "The Freeman" throughout the late 1950s and the 1960s. That magazine had a circulation as high as 40,000 in some years. There were not many economists who could reach an audience that large.

He really did stick to his knitting, and he really did stick to his guns. He stuck to his guns with such tenacity that for decades he had no influence whatsoever in the academic community. They wrote him off. But, after his death in 1973, his influence began to grow. In 1974, his disciple F. A. Hayek won the Nobel Prize in economics. Bit by bit, his reputation spread. Because of the Mises Institute, his name is now more widely known than almost any other economist of his generation, either before World War I or after World War II. The average person would be unfamiliar with the name of most economists in the first half of the 20th century, and he would be unable to read the works of almost any economist in the second half.

So, because Mises was unwilling to compromise, especially in the area of methodology, refusing to use equations, his legacy has been greater than most of his long-dead peers. His legacy is growing, and theirs is almost nonexistent.

Murray Rothbard

Much of Mises's influence is the result of Murray Rothbard's voluminous writings, in powerful, captivating, and flawless English, from the late 1950s until his death in 1995. Rothbard became the primary interpreter of the works of Mises, even though he did not share Mises's commitment to 19th-century limited government. It is possible to read Human Action, but it is a lot easier to read Man, Economy, and State. Rothbard never found full-time employment in a college or university that had an economics department until late in his career. He taught engineering students, who were not interested in economics and surely did not know who Rothbard was. If he had any legacy from his classes at Brooklyn Polytechnic, nobody has been able to discover it.

He gained his reputation as an economist mainly through the publications that appeared in a 12-month period from 1962 through early 1963. Columbia University Press published his doctoral dissertation on America's first depression: The Panic of 1819. It read like a dissertation, unlike anything else Rothbard ever wrote. It had some minor influence in the economic history, but it was a narrow topic.

Then came Man, Economy, and State in the fall of 1962. Then, the following spring, came America's Great Depression. That book was a study of the statist policies of the Hoover Administration. It applied the Austrian theory of the trade cycle to the economic and political events of the Hoover Administration. Because it was based on Austrian economic theory, academic economists rejected it. Because it was hostile to Herbert Hoover, any conservative who found out about it probably rejected it before even looking at the table of contents. It was almost a perfect book for alienating everybody. Then came the acceleration of the Vietnam War and the development of the antiwar movement. Rothbard became actively involved in the antiwar movement, and he ceased writing books on economic theory. This continued until the early 1980s, when he wrote the best upper division textbook in money and banking that has ever been written, and which has probably never been assigned in any university in the United States: The Mystery of Banking. It is totally hostile to fractional reserve banking, central banking, and all forms of fiat money. It is the primary task of all university-level courses in money and banking to establish the students' confidence in all three of these. Rothbard once again had painted himself into a corner.

Only at the very end of his life did he begin to do a detailed academic study in economics. He wrote two volumes on the history of economic thought. He died before the third volume was completed. There has never been any history of economic thought to rival it in terms of a mixture of minute details of the lives of economists, coupled with careful analyses of their economic doctrines.

His legacy stems from the power of his economic analysis and the cogency of his writing style.

He left another legacy in the area of early American history: his study of colonial America up to, but not including, the American Revolution. Sadly, he took his notes on a piece of audio recording technology that disappeared, so he was never able to finish the fifth volume.

Then there is his legacy as the most literate defender of economic and political anarchism in the history of anarchist thought.

He stuck to his knitting. He never stopped writing. He did not compromise in his hostility to economic intervention by the state. He did short articles, midsized articles, fat books, heavily footnoted books, pamphlets, newsletter articles, movie reviews, political analysis, and whatever else interested him, which was everything except possibly nuclear physics. The huge volume of his writings, the clarity of his writings, the ideological consistency of his writings, and the fact that he got Lew Rockwell on his side, established a legacy which has been leveraged by the power of the World Wide Web. He is reaching a larger audience today than he could have imagined. He died in 1995, the year that the Netscape browser was introduced. He could not have foreseen the impact of this event.

His skills were ideally suited to this new technology. His skills in written communication are exactly what people doing Web searches are looking for. He was a print-media person, and while the Web is equally geared to video, for those who are looking for cogent writing, Rothbard's body of material is vast.

Brain Drain Politics: Ecuador’s Gambit

Ecuador’s foolish gambit

From AP

Galo Guarderas is starting off on five years of study in Spain to make himself an expert in photovoltaics, a vital field for a world tapping into solar energy.

The price tag for the studies is more than $150,000. But the 47-year-old professor of electrical engineering won't owe a cent for his doctorate.

His country, Ecuador, is footing the bill.

Guarderas is a pioneering participant in a new program that aspires to convert this small South American nation into a global competitor. In exchange for each state-paid year of school, the professionals guarantee to work at least two years back at home.

President Rafael Correa isn't just bent on staunching brain drain, in which talented people flee developing countries for lack of local opportunity. He's determined to reverse it, create a brain gain.

"Without human talent Ecuador won't advance," Correa said in a speech last month. "We lack the minimum critical mass of top-flight professionals needed to spur the country's development."

Ecuador's deputy minister of science and innovation, Hector Rodriguez, said the goal is "a radical transformation" from a country whose exports are 77 percent raw materials, chiefly oil, to one that exports technology.

This is represents another example where when you are the hammer everything looks like a nail.

Lavishly spending money for “foreign education” to supposedly solve the nonsensical brain drain issue does not deal with root of the problem particularly “talented people flee developing countries for lack of local opportunity.”

Yes the problem, to repeat, is THE LACK OF ECONOMIC opportunities because of Ecuador’s socialist government (new age or 21st century socialism). Economic opportunities are not driven by education alone but by investments or through a political environment which encourages businesses or enterprises (economic freedom).

In the US, contrary to political wisdom, science or math graduates have not been guaranteed employment.

Feel good policies (to get elected or to remain power) like always will eventually just blow up. In politics, insanity or doing the same thing over and over again and expecting different results represents the norm.

Japan’s Capital Flows to ASEAN Accelerates

I have been saying that the current international monetary environment will prompt for a deluge of (direct and portfolio) investments (euphemism for capital flight) towards ASEAN, mainly from Japan, as well as from Western Countries.

As I previously noted

Japan’s investments in ASEAN do not seem to be country specific, but more of a regional dynamic. Or that the Japanese probably hedge their ASEAN exposure by spreading their investments throughout the region…

We are getting some signs of confirmation.

Japan has reported intensifying direct investment flows to:

Indonesia. As per the account of Kenichi Amaki of Matthews Asia,

The Japanese are pursuing opportunities beyond just the auto industry in Indonesia. A local operator for a major convenience store chain talked to us about the intense quality control training they receive from their Japanese partner. This operator plans to significantly accelerate store openings over the next several years.

The investment push into Indonesia makes sense from a return perspective. According to Japan's Balance of Payments statistics, return on direct investment into Indonesia has averaged 10.7% in the decade up to 2010. In contrast, investment returns from North America and China have averaged only 5.4% and 8.1%, respectively, during the same period. As growth in China moderates, Southeast Asian nations such as Indonesia are emerging as a new source of growth for Japan Inc.

Economic growth seems to be a secondary factor or a rationalization to the real cause: Japan’s domestic financial repression mainly through inflationism as political recourse to her ballooning debt woes.

Malaysia. From the Malaysian Trade Industry

There has been no let-up in interest among Japanese investors in Malaysia's main industrial pillar - the electrical and electronics (E&E) sector, said International Trade and Industry Minister Datuk Seri Mustapa Mohamed.

"There continues to be interest either by way of reinvestments or interest by those companies (from within and out of Japan) to relocate their businesses here," the minister said at a media briefing after the 2012 Panasonic Scholarship Award ceremony at the ministry yesterday.

He said there was no slowdown in the trend of Japanese interest in the E&E sector which last year accounted for 34 per cent of the total employment in the manufacturing sector.

For the first seven months of this year, Japanese investors poured in some US$824 million (RM2.6 billion) into 48 projects, almost double the US$400 million (RM1.2 billion) invested in 26 projects in 2010.

Malaysia saw a 76 per cent jump in foreign direct investments (FDIs) in the first half of the year with RM21.3 billion versus RM12.1 billion in the same period last year. Some 52 per cent of these FDIs valued at RM15 billion were in the manufacturing sector.

Japan led the foreign investment pack, in the first seven months of the year, with RM3.4 billion worth of investments followed by the US (RM2.3 billion) and Singapore (RM1.4 billion).

Thailand. As reported by the Organization of Asia Pacific News Agencies

Thai Industry Minister M.R. Pongsvas Svasti has acknowledged that foreign direct investment (FDI) in Thailand has kept steadily growing, with FDI from Japan alone doubling in the first five months of this year, compared with the corresponding period of last year.

Let me repeat what I wrote

But since (inward) capital flows into ASEAN will reflect on global central bank activities, this dynamic would not be limited to Japan but would likely include western economies as well.

And under the political climate that induces yield chasing dynamics, YES we should expect these flows to translate to a vastly higher Phisix and ASEAN bourses overtime, largely depending on the degree of inflows. This will be further augmented by the response of local investors to such dynamic as well as to local policies.

Although NO the Philippines will not decouple from events abroad and the pace of FDIs and investment flows will largely be grounded on the general liquidity environment.

Japan’s deepening capital flows will likely be a medium to long term trend and has been conditioned or will be significantly influenced by evolving global dynamics.

Yet all these seems as an eerie reminiscent of the Asian Crisis of 1997.

America’s Growing Informal Economy?

The US government’s deepening embrace of statism particularly economic and political fascism and the fast expanding unsustainable welfare state, financial repression and the burgeoning police state will likely not only fuel a diaspora for the wealthy but likewise drive the average Americans to operate on the informal or shadow economy.

Professor Gary North explains why, (bold emphasis added, hat tip Bob Wenzel)

Americans are learning how to beat the system, cheat the system, and outfox the system. As the bureaucrats tighten their many nooses, Americans are finding ways to slip the noose.

An article in Forbes offers examples. They are everywhere. Businesses are just ignoring the rules. They hire lawyers to help them avoid the law. They are fed up with the federal squid. They are not cooperating.

This is significant for the future. The heart of every legal system is legitimacy. If the government — family, church, or civil — is viewed as legitimate, people who are under its jurisdiction cooperate. They add self-government to external systems of sanctions. If they refuse to do this, the government’s enforcement system cannot force them to obey consistently. The system does not have enough resources to enforce compliance.

At some point, the government loses its ability to gain its goals. Collecting more taxes in Greece is not possible. The Greek government can promise austerity, but it can gain this only by reducing spending, not by collective more taxes. The same is true of Spain. The same is true of Italy.

If the people who live under the regime think the regime is corrupt, they cheat. They feel no guilt. If they think a law is immoral or stupid, they refuse to cooperate. The government can do little to change this outlook, other than shrink. No government does this voluntarily.

The federal government is now at the limit of enforcement. The bureaucrats write 83,000 pages of new rules every year, yet the country changes only slowly. The bureaucrats think they are in charge. They are not.

In reality, the informal sector is a manifestation of government failure. The more the arbitrary laws the lesser chances of enforcement, the susceptibility to corruption and of the gaming of the system by the politically connected all at the expense of society.

Yet if this dynamic should become a reality then this would signify as the Philippinization of the US.

Interesting signs of times.

Warren Buffett Sees Rising Municipal Bankruptcies

Obama crony Warren Buffett predicts that municipal bankruptcies will increase

From Bloomberg,

Warren Buffett, the billionaire chairman of Berkshire Hathaway Inc. (BRK/A), said municipal bankruptcies are set to rise as there’s less stigma attached after three California cities opted to seek protection just weeks apart.

The City Council of San Bernardino, California, a community of about 210,000 east of Los Angeles, decided July 10 to seek court protection from its creditors. The move came just weeks after Stockton, a community of 292,000 east of San Francisco, became the biggest U.S. city to enter bankruptcy. Mammoth Lakes, California, also sought the shelter this month.

“The stigma has probably been reduced when you get very sizeable cities like Stockton or San Bernardino to do it,” Buffett, 81, said in an interview today on “In the Loop with Betty Liu” on Bloomberg Television. “The very fact they do it makes it more likely.”

Cities and towns across the U.S. have been strained by rising costs for labor, including pensions and retiree health benefits, while the longest recession since the 1930s crimped sales- and property-tax revenue.

I don’t think “stigma” has anything to do with the real issue of the unsustainable financial and economic conditions of the excessively (welfare and bureaucracy) bloated public sector, driven by Keynesian policies. As per Herb Stein’s Law, if something cannot go on forever, it will stop.

So goes with Munis.

Bernanke Doctrine: New York Fed Boasts of Pushing Up the US Stock Markets

Remember the following statement which I have quoted numerous times on this blog?

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.

Those came from Ben Bernanke when he was yet in the academe.

Nevertheless such priorities seems to have served as the guiding policy creed by the Bernanke led US Federal Reserve ever since he took on the helm.

Proof?

The New York Fed even brags about their supposed accomplishments: providing lift to the US stock markets.

From CNBC

A report from the Federal Reserve Bank of New York suggests that the bulk of equity returns for more than a decade are due to actions by the US central bank.

Theoretically, the S&P 500 would be more than 50 percent lower—at the 600 level—if the bullish price action preceding Fed announcements was excluded, the study showed.

Posted on the New York Fed’s web site Wednesday, the study sought out to explain why equities receive such a high premium over less risky assets such as bonds.

What they found was that the Federal Reserve has had an outsized impact on equities relative to other asset classes.

For example, the market has a tendency to rise in the 24-hour period before the release of the Fed’s statement on interest rates and the economy, presumably on expectations Chairman Ben Bernanke and his predecessor, Alan Greenspan, would discuss or implement a stimulus measure to lift asset prices.

The FOMC has released eight announcements a year at 2:15 ET since 1994. The study took the gains in the S&P 500 from 2 pm the day before the announcement to 2 pm the day of the statement and subtracted that market move from the S&P 500’s total return over that time span.

Without the gains in anticipation of a positive Fed action, the S&P 500 would stand at just 600 today, rather than above 1300. (bold emphasis mine)

So there you have it: the ultimate insider trading and manipulators of stock market.

This also implies that the FED’s priority has been to advance the interests of the financial markets (Wall Street, bankers and the financial industry) at the expense of the real economy (entrepreneurs).

Yet many carp about US trade deficits (mostly mercantilists), when it seems clear that policy directives of the US government has long been in the direction of the financialization of the US economy.

Bottom line: Each time the US stock markets will come under selling duress, expect Bernanke’s FED to throw in taxpayers money in support of equity shareholders.