Inflation Is The Global Political Choice

``Conventional wisdom contends that the current recession was caused by the free-market zealotry of recent economic policy and by excessively low interest rates. It is an absurd view, given that interest rates are not determined by market forces. Interest rates are manipulated by central banks with a government-mandated monopoly in the issuance of money. Some of those still defending free markets protest that, contrary to popular opinion, banks were heavily regulated before the financial crisis. So they were. But this is quibbling. The role of central banks means that, at its core, we did not have a free market financial system. We had a command economy. Command economies do not fail because the central planning agencies lack the powers required to bring about the best outcomes. They fail because, without market prices, nobody has the information required to adapt the allocation of scarce resources to the demand for them. They fail because central planners have an impossible job.” Jamie Whyte, banker and philosopher and the author of Bad Thoughts: A Guide to Clear Thinking, Strip the Bank of England of its power

I find it amusing when mainstream experts and officials argue about the risks of systemic deflation. That’s simply because we understand their mental or thought process and their latent intentions-they have been selling fear in order to justify the further expanded use of government inflationary programs.

As Ludwig von Mises predicted over half a century ago, ``In discussing the situation as it developed under the expansionist pressure on trade created by years of cheap interest rates policy, one must be fully aware of the fact that the termination of this policy will make visible the havoc it has spread. The incorrigible inflationists will cry out against alleged deflation and will advertise again their patent medicine, inflation, rebaptising it re-deflation. What generates the evils is the expansionist policy. Its termination only makes the evils visible.” (bold emphasis mine)

Recently there have been raging debates on whether the US Federal Reserve Balance sheet [see Figure1] will trigger inflation or not.

Figure 1: Cumberland Advisors: Composition of Fed Balance Sheet

For the inflationists, despite ballooning reserves, the fundamental argument boils down to a highly indebted consumer that couldn’t afford take up additional or more loads of debt and the banking systems’ vastly impaired balance sheets which have opted to rebuild capital by playing the yield curve or by receiving interest payments from the US Federal Reserve on their bank reserves than to operate on the normal credit lending process.

So bloated reserves, for them, won’t translate to “circulation credit” or a credit process-which is not supported by savings or by deposits-but from money “created from thin air”.

For the mainstream, this is called the “liquidity” trap where monetary policies have been rendered impotent and where the only solution lies in a cycle of government taking over the spending process.

Further, for some, it is even held with confidence that the Fed’s interest payment scheme on bank reserves will reduce the risks of an outbreak of inflation once the credit lending process starts improving.

It’s kindda bizarre that the polemic on inflation have been reduced to a technical dimension when the essence of the entire process has been apparently circumvented or shortcircuited.

To put on our Ivory Tower thinking cap, inflation is the process of expanding government’s liabilities over the economy’s goods and services. This can be done through different channels: the banking system via circulation credit (which has underpinned the debate) or by government deficit spending programs or central banking buying of private assets (Quantitative Easing).

The point is as Henry Hazlitt wrote, ``For inflation does not come without cause. It is the result of policy. It is the result of something that is always within the control of government—the supply of money and bank credit. An inflation is initiated or continued in the belief that it will benefit debtors at the expense of creditors, or exporters at the expense of importers, or workers at the expense of employers, or farmers at the expense of city dwellers, or the old at the expense of the young, or this generation at the expense of the next. But what is certain is that everybody cannot get rich at the expense of everybody else. There is no magic in paper money.” (bold highlight mine)

Inflation As Public Policy

And what is a public policy, if not a politically determined legal action?

It is derivative from a process where the government determines the redistribution of resources coercively acquired via taxation. It’s a mechanism where some vested interest individuals or groups in the society, who intends to benefit from other people’s money, utilize the welfare state to impose regulation, subsidies, protection and other forms redistribution programs to achieve such goals at the expense of the rest.

In addition, policy decisions are always determined by political influences, ideology, party affiliation, compromises, perceptions shaped by divergent knowledge or familiarity or biases or priorities or other forms of preferences ingrained in the policymakers.

Policies are never about “right” moral virtues. In the same plane, policymakers are merely human beings, whom are subject to moral frailties, cognitive biases, limited knowledge, and operates on a preferred set of network. In short, the officialdom does not possess God like omniscience.

Proof?

The recent cap and trade bill which sailed past the house of the US Congress by a slim margin is a fundamental example, this from the New York Times, ``As the most ambitious energy and climate-change legislation ever introduced in Congress made its way to a floor vote last Friday, it grew fat with compromises, carve-outs, concessions and out-and-out gifts intended to win the votes of wavering lawmakers and the support of powerful industries.”

So for those thriving under the illusions of morality in governance- our reply is-Get Real!

All these suggest that the preferred policy route by the present policymakers in the US, the Philippines, China or elsewhere has been inflation.

It is a direction borne out of the comfort zone by the present crops of political leaders, by their adopted economic ideology, and the emphasis on narrow time preferences to approach any social or economic ills.

It doesn’t really matter if “output gaps” or “Phillips curve” didn’t work in the stagflation era of the 70s or in the Hyperinflation episodes in Weimar Germany or in Zimbabwe, what matters is that these models have been convenient tools for adopting policy frameworks used by the governing politicians and their bureaucracy and advanced by their academic allies and adherents.

It’s almost been a forgotten principle that political leaders exists primarily for power and is hardly about plutonic salvation of their constituents- a prevarication continually peddled by media and politicians, and solemnly embraced by the gullible public.

Hence the preferred solutions have basically been short term fixes that would enable these officials to carry past any unintended effects after their tenure. And it is also why political leaders almost always fall for populism based policies.

Thereby, the risks of the unintended consequences from kneejerk reactions to the present financial market turmoil will breed and nurture the next crisis.

This has been a political, economic and social cycle.

And all these yammering about deflation risks is understandable, say from Janet Yellen, President of the Federal Reserve Bank of San Francisco (WSJ), or from mainstream’s pop economic icon Nobel Prize awardee Paul Krugman who recently wrote policymakers to “stay the course” who incidentally wrote in 2002 advocating a bubble ``To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble” or from hedge fund manager” (now you know his model depends on serial bubble blowing), or from Hedge fund manager Eclectica’s Hugh Hendry, ``I think this paranoia today that inflation is happening today I think it puts in place a motion for a decline in the economy. I think they're not printing enough money… with regards to the wealth destruction that has been happening over the past 18 months.”(CNBC/greenlightadvisor.com)

And this is why the obvious route is to inflate the system regardless of the impact of the puffed up FEDERAL RESERVE balance sheet, because the alternative recourse of policy actions could be to increase deficit spending (although this could encounter some difficulties due to the growing recognition of its attendant risks and burdens) or it may resort to the more abstract and less publicly understood central bank action known as the “printing press” or QE.

As Ludwig von Mises presciently warned over 60 years ago ``There is need to stress this point, because the public, always in search of a scapegoat, is as a rule ready to blame the monetary authorities and the banks for the outbreak of the crisis. They are guilty, it is asserted, because in stopping the further expansion of credit, they have produced a deflationary pressure on trade. Now, the monetary authorities and the banks were certainly responsible for the orgies of credit expansion and the resulting boom; although public opinion, which always approves such inflationary ventures whole heartedly, should not forget that the fault rests not alone with others. The crisis is not an outgrowth of the abandonment of the expansionist policy. It is the inextricable and unavoidable aftermath of this policy. The question is only whether one should continue expansionism until the final collapse of the whole monetary and credit system or whether one should stop at an earlier date. The sooner one stops, the less grievous are the damages inflicted and the losses suffered.”

So the US government will inflate because it deems such path as the most politically correct and justified for its interest. This implies that such policy actions would need keep asset prices afloat in order to “prevent a collapse” of the reverse debt pyramid foundation from which the US financial system has been built upon, and because the only other path of resolving the debt or overleverage problem other than inflation is to accept deflation or bankruptcy. And yielding to debt deflation essentially undermines the deified image from which has been used as rationale to undertake the vastly shifting structure of its political institutions.

Evidences Of Globalized Inflation

Moreover, in contrast to the one dimensional oversimplistic thinking that the world revolves around the US, the trend of inflationary policies has been global see figure 2.

Figure 2: DollarDaze.org: Estimated Global Monetary Aggregates

The world monetary base has been exploding.

Morgan Stanley’s Joachim Fels enumerates the inflationary actions of global central banks (all bold highlights mine),

``QE is alive and kicking... The sharp increase in US 10-year yields and mortgage rates, with 10-year yields reaching 4% in mid-June, led many investors to question the effectiveness of the QE programme. While a continued increase in yields would certainly create headwinds for economic recovery, it is important to keep in mind that keeping yields low was only one aspect of the programme. As important, if not more so, is the increase in money supply and excess liquidity. On this measure, the Fed has continued to run a successful campaign, as have a host of other countries that have implicitly or explicitly turned to QE.

``...globally: On our count, the Fed, the ECB, the BoE, the BoJ, the Swiss National Bank, the Swedish Riksbank, the Norges Bank and the Bank of Israel all adopted some form of QE around September 2008 (see "QE2", The Global Monetary Analyst, March 4, 2009). M1, the measure of narrow money supply, has been growing strongly in most of these countries since then. M1 growth in the G4 is ticking along at 12%, driven by M1 growth of nearly 20% in the US, around 8% in the euro area, and a move into positive territory for M1 growth in Japan. Outside the G4, money supply is moving up strongly in Switzerland and Israel, with the latest M1 growth numbers showing 42%Y and 54%Y growth, respectively. The Norges Bank's QE programme has kept the monetary base at highly elevated levels and M1 growth has begun to shrug off the effects of previous tightening and is now in positive territory. Finally, the increase in the monetary base allowed by the Riksbank has pushed up M1 growth to over 6%.

``While there has been no QE announcement from the Chinese monetary authorities, the efforts made to increase money supply and credit in China over the past few months have been highly successful. M1 growth has clocked in at 18.5%Y while loans are growing at 28%Y. India briefly flirted with QE-type policies by buying a sizeable chunk of government bonds since April. However, efforts to push up money supply don't seem to have been pursued vigorously since then. Both economies are expected to outperform the global economy. If anything, our economics team sees the dramatic rally in equities and property as a development that central banks will have to monitor closely.

``More to come: In the major economies, there is plenty more to come. The Fed is about halfway through its US$1.75 trillion purchase programme, while the Bank of England has about 18% (£23 billion) of its programme yet to go. Meanwhile, the ECB will start purchasing €60 billion of covered bonds this month. In short, there is plenty of firepower waiting to come out of the central banks' QE muzzles. If the impact on money supply so far is anything to go by, we can expect excess liquidity to continue to grow and support economic recovery and asset markets.”

So all these unfolding events have been happening exactly in accordance of the von Mises manual or guidebook.

Reconfigured Global Economy Heightens The Inflation Transmission

In addition, structural dynamics on a national scale applied globally are likely to influence the inflation transmission by central banks.

If inflationists argue that excess capacity amidst a slack in global demand will lead to a globalized “deflation”, we have countered that nations with less systemic leverage and high savings rate will respond positively to zero bound interest rates and see an expansion in circulation credit and most likely become breeding grounds of the next bubble.

And this is the reason why we have been witnessing a big jump in emerging markets and Asian stocks.

It isn’t mainly the issue of “excess capacity” but of the issue of accelerating speculative activities induced by easy money policies.

It’s because sustained elevation of asset prices fueled by central bank policies will likely absorb some of the “idled” resources. Inflationists tend to ignore the impact of money to demand and supply of goods and services.

But again, many of the redirected flow of speculations will account for temporal misallocations that will be subject to the business cycles or boom bust cycles. Whether it is the Japan bubble bust, the Tequila Crisis, the Asian Crisis, the dot.com bust or today’s US mortgage and banking crisis, the underlying forces that cultivate such bubbles remain the same and in operation. But only this time the degree involved is way bigger than the past and is likely going to get a lot bigger.

Moreover, the unfolding accounts of deglobalization amidst a reconfiguration of global trade, labor and capital flow dynamics, which used to be engineered around the US consumer, will likely be reinforced by an increasing trend of reregulations which may lead to creeping protectionism and reduced competition and where higher taxes may reduce productivity and effectively raise national cost structures, as discussed in Will Deglobalization Lead To Decoupling?

Proof?

The gradual escalation of protectionism in the form of policy induced programs to reduce migration flows. This from The Economist, ``Governments are reducing quotas for foreign workers and imposing tougher entry requirements on them in an effort to control the flow. Some are even paying existing migrants to go home”.

Figure 3: OECD-FAO Agricultural Outlook: CPI and Food Price Inflation in select Emerging Markets and select OECD economies.

More proof?

Amidst the culmination of the near systemic collapse of the US banking system that rippled across the globe in September-October of 2008, and where global “deflation” became the main cause of concern, the chart from OECD-FAO 2009 outlook shows how CPI rates have been mostly positive on a year to year basis in most OECD or even in Emerging markets!!!

So this Ivory Tower analyst operates in a world of real evidence compared to mainstream or conventional thinking, which operates in a world of models fitted to validate their biases or data mining.

Clash in Policies And Expectations A Source Of Confidence?

Another bizarre notion is the expressed confidence over global central banks ability to overturn present policies once the recovery in the global economy gains traction.

For countries unaffected by the deluge of debt in the past bubble, this could be true. But for economies scourged by overleverage hangover, this would seem highly questionable.

For instance, the ability by the US Federal Reserve to pay interest on bank reserves has been inferred to by some as a superior tool, which would function as a brake, against the risk of an outbreak of inflation.

Yet this wonkish article Federal Reserve of Atlanta shows how the US Federal Reserve has been in a bind-it has been struggling to close the gap between Fed Fund rates and Interest on paid bank reserves. If under a benign environment the Fed seems in a predicament on managing some of its tools under watch, how much more when the psychology tips towards inflation?

Be reminded that inflation, aside from being a political process, is importantly psychologically driven. As Nassim Taleb in a recent interview said, ``Because all you need is for people to think there’s gonna be inflation to start hoarding.”

And that’s why central bankers keep a close vigil to inflation expectations as signaling channel. It is also another reason why governments can and will manipulate gold (a major barometer of inflation) or other commodities as oil, as part of their array of tools to manage inflation expectations. Hence, the idea of free markets in a world of central banking is a delusion.

Moreover, even the objectives of government policies appear similarly in a fix, as actions and intent have been in a collision. Let’s call it the paradox of save and spend.

Where savings under the present economic ideology is an anathema to aggregate spending, government deficit spending which substitutes for lost private consumption requires financing from global savers, official forex surpluses or local savers.

Nonetheless, if the official surpluses from emerging central banks or global savers won’t suffice to fill in to fund US government spending programs, then it would require resident savings to do so.

Yet ironically, the policy thrusts have been directed against attaining these goals. So essentially, clashing goals and policies from the paradox of save and spend, don’t account for an optimistic outcome.

This means that without sufficient financing, the US government would have a Hobson’s choice which is to monetize these debts.

I’d like to further point out that it’s an apples-to-orange comparison when experts use the debt to gdp ratio to account for deficits.

For instance, the US economy at $14.265 trillion is about 24% of the global economy at $60.690 trillion in 2008 (IMF), second to the Euro zone. So even if Japan’s public debt is about 170% (2008-Flag counter) of its $4.924 trillion (IMF) economy which translates to around $7.3 trillion, the US debt which is 60% of the GDP (2007) translates to some $8.6 trillion. So nominal debt figures or debt to global GDP would be a better measure since funding options would likely be on a global scale.

The striking difference is Japan has huge surpluses ($1.02 trillion-chosun.com) and even more humongous savings ($14.9 trillion!!!-Bloomberg) that can finance most of its locally held debt.

Hence the crux of the matter is that the financing aspect of the deficits is more important than the deficit itself. And here savings rate, foreign exchange reserves, economic growth, tax revenues, financial intermediation, regulatory framework, economic freedom, cost of doing business, inflation rates, demographic trends and portfolio flows will all come into play. So any experts making projections based on the issue of deficits alone, without the context of scale and source of financing, is likely misreading the entire picture.

Finally, it is equally odd for experts to become confident on global governments exiting the remodeled structure of today’s financial markets when the underlying expectations appears to have been built around the sustained backstop of governments.

Consider this piece from Richard Barley at the Wall Street Journal (bold emphasis mine), ``As policy makers discuss how to exit from quantitative easing, investors need to position themselves for the government-bond-market turmoil that is likely to follow.

``The markets got a taste of what might be in store this week when the Bank of England decided to stop buying two bonds originally included in its £125 billion ($204.68 billion) quantitative-easing program. The prices of those bonds plummeted, suggesting there is big money to be made for investors who get their trading strategy right.

``The snag is that some government-bond markets are so potentially distorted by central-bank programs that it is hard to feel confident of where prices should be…

``But even if the bank decides to continue with quantitative easing, it may come under pressure to expand the basket of securities it is buying to avoid building up excessive holdings in other single issues…”

Three observations from this article:

One, take away the pillar of the present platform and renewed volatility follows.

Two, intervention begets even more intervention which is the basic premise of any inflationary cycles.

Three, markets are built around incentives and expectations. Short term policy based patchwork could result to a clash between policies and expectations.

Implications For The Financial Markets

What does these mean to the financial markets?

It means that global financial markets have been operating fundamentally on the expectations of sustained government interventions and persistent inflationary actions. And expectations have seemingly been geared towards the deepening of such activities.

Any expectations built on sound recovery will likely be a mirage. Any economic recovery will probably be temporary and predicated on bubble dynamics of malinvestments.

Because deflationary forces remain in several OECD economies, the policy thrust will likely be to further reinflate the system, most likely by QE, justified by low current CPI rates and the bogeyman of deflation. Nevertheless, recessionary forces and policy inflation will likely result to sharp volatilities.

Any major liquidity withdrawal, especially from the US Federal Reserve, will likely cause massive dislocations in the global markets.

Emerging markets and Asia are likely to be the center of the next bubble.

We seem to be approaching a threshold point where bubble afflicted governments will have to decide whether to embrace deflation or accelerate the inflation process to a greater level even at the risks of compromising the conditions of their currencies.

And those saying the US dollar will unlikely be replaced as the international currency reserve anytime soon should heed the lessons of inflation. Once the public recognizes that the sustained and accelerated erosion of money’s store of value, they will be replaced as history has shown. Hence, the fate of the US dollar will depend on the underlying policies taken.

As an old saw goes, nothing is certain in this world except death and taxes, and may I add, popular delusions and lies.

Phisix: Weighing On the Seasonal Effects

``The long-term trend in an inflation is toward less work and production, and more speculation and gambling.”-Henry Hazlitt, What You Should Know About Inflation p.131

The recent weakness in the global stock markets and commodity markets have exuded some apprehension that the impact from the combined stimulus packages may be wearing off and that the recessionary forces could be settling in. This is unclear yet, but it maybe the case for the US.

Figure 4: stockcharts.com: Global Recoupling?

In the recent liquidity driven rally, global stock markets appear to have “recoupled” anew with the US markets, see figure 4.

Since March, the peaks and troughs of the Philippine Phisix, the S&P 500 and the Dow Jones ex-Japan index have been tightly correlated. The blue vertical lines manifests of the “troughs”.

My initial impression had been to extrapolate the recent past performance to the future due to this correlated motion where perhaps the weakness in the US could also be equally projected on global markets.

However, it was a surprise when the US markets fell hard by over 2.6% last Thursday and Asian markets appear to have shrugged off or have been impacted substantially less by the said downdraft.

While one day doesn’t make a trend, it has been my bias that the global inflationary process could have cushioned the Asian markets. And this one day divergence could possibly serve as the prologue for the tale of this cycle.

Nonetheless we have said that given the sheer overbought levels, momentum and seasonal effects could all weigh on the Phisix and global markets.

Figure 5: Phisix: Seasonal Effects

But looking at the seasonal effects (see figure 5), the Phisix has responded variably to the July-September periods, mostly anchored on its major trend-where it has declined or consolidated during secular bear markets of 2000-2002 and similarly have risen or consolidated during the recent bullmarket 2003-2006.

In 2007, July marked the peak of the cyclical bullmarket as manifested by the extreme volatility.

In 2008, July-August seemed as the only period where a significant rally took place since the October 2007 zenith.

We don’t do short term predictions, nonetheless given the season’s penchant to reflect on the activities of the major trend, then perhaps we could most likely see either a consolidation or even a chance for an upside.

Of course, all these depends on the persistence of liquidity flows from the present policies and how the regional markets will respond to any infirmities manifested by the US counterparts.

The US Federal Reserve: The Creature From Jekyll Island

Learn about the origins of the US Federal Reserve system, the nature of its operations, the underlying principles and unstated goals, the personalities, the organizations and networks involved in its conception and its operation, and ultimately the price that Americans and the world pays for its existence.

G. Edward Griffin, author of The Creature from Jekyll Island, gives a fantastic one hour audio presentation. [Hat tip Chrismarteson.com]

press on the link below...

http://0101.netclime.net/1_5/202/057/247...

In case you'd be interested with the transcript I've included a scribd document which partly covering the speech.
The Creature from Jekyll Island, by Edward Griffin

Risk Of Food Crisis Creeping Back?

In a recent article Whatever happened to the food crisis?, The Economist drudges anew over the enigma of conflicting developments: rising food prices in a recessionary environment.

Nonetheless like us they see the risks of a food crisis creeping back.

(bold emphasis mine)

``If this was happening during a boom, it might be understandable. But recession would normally dampen down price rises. So what explains the return of food-price inflation? And does it mean that the so-called world food crisis is returning?

``There are two clusters of explanation: cyclical factors—features of the farm cycle and world economy that fluctuate from season to season—and secular, long-term factors. Cyclical influences include re-stocking: cereal stocks were run down as prices spiked and need to be replenished. In 2006 and 2007, stocks fell below 450m tonnes, about 20% of consumption; now they are back up over 520m, or 23%. That is one source of new demand. Another comes from ethanol. As oil prices rise, ethanol starts to be competitive again (as a rule of thumb, ethanol is profitable when petrol costs $3 a gallon in America, a level it has just reached in California). The fall in the dollar and in freight rates has also kept the local-currency costs of importing a tonne of cereals lower than dollar-denominated world prices. This has encouraged many countries to buy more.

``Lastly, it is possible that the widespread hunger brought about by soaring prices—the FAO says a billion people will go hungry this year—may have reached a peak and the poor may be back in the market for grain again. This may sound unlikely, as traditionally poor consumers have had little influence over world food prices, but economic growth has continued in the largest emerging markets (notably China and India) and governments in much of the developing world have been expanding aid programmes for the poor, such as conditional cash-transfer schemes. That may be boosting demand; it would explain why prices of grain, which everyone eats, have been rising this year while prices of meat—the food of the rich and aspiring middle classes—have continued to fall."


My comment: So cyclical factors of restocking, rising oil prices (transmitted via the ethanol channel) and low prices could have contributed to a demand boost, although the Economist admits that government programs-such as aid expenditures could have also been key variables.

And as we have long mentioned inflationary policies impact prices relatively. It affects sectors that are the primary beneficiaries of government programs- in this case, aid spending which could have resulted to the disparities between meat and grain price trends.

However, sustained government fiscal spending is likely to cause a diffusion of increases consumer which means that even meat prices will likely increase over time.

The Economist adds some important secular trend dynamics,

``But the world food crisis of 2007-08 showed that food prices are not influenced solely, or even mainly, by cyclical factors. They soared in large part because of slow, irreversible trends: population growth; urbanisation; shifting appetites from grain to meat in developing countries. There is no sign that these trends are abating."

Finally, the Economist imputes regulatory and political obstacles as substantially distorting the marketplace.

``The failure of farmers in poor countries to respond to price signals does not mean they are deaf to them. Rather the signals they get are often scrambled or muted. Farmers were frequently not paid the full world price for their crops, because governments were determined to keep local prices low in order to relieve hard-pressed consumers. Some governments also banned food exports.

``Even in rich countries, farmers are responding to many things other than food markets. Take oil prices, for example: these (and government subsidies) determine how much maize is planted for ethanol. That in turn influences how much land is planted to soyabeans, which for American farmers are interchangeable with maize. Growers are also responding to the flow of investment capital into farming as a result of the global financial meltdown. Food is recession-resistant, and farming has been one of the sectors least affected by the worldwide slump. The FAO’s Abdolreza Abbassian argues that increasing links between farming and other parts of the economy are making it more difficult for farmers to calculate in advance the profitability of any one crop, so the area they plant is tending to fluctuate more sharply from year to year. Farming—as the past two years have clearly demonstrated—is becoming a more volatile business, both in terms of price and area planted."

``On the face of things, markets last year were adjusting exactly as economic theory predicts they should: prices rose, drawing investment into farms; supplies then rose sharply, pushing prices down. But that was not the whole story. The price fluctuations of 2007-09 suggested that uncertainty in the world of agriculture was deepening under the influence both of oil prices and capital flows. The fact that prices are still well above their 2006 average, even in a recession, suggests that the spike of 2008 did not signal a mere bubble—but rather, a genuine mismatch of supply and demand. And this year’s price increase suggests that there is a long way to go before that underlying mismatch is eventually addressed. “I don’t see that anything has fundamentally changed,” says Mr Abbassian. “That means we cannot go back to where we were in 2007.”

While the Economist alludes to capital flows as another variable in passing, it didn't dwell on the influence of global monetary policies -where zero bound interest rates and a loosened credit policy environment have sparked credit booms in emerging markets as China and may have added further pressures on the demand side.

At the end of the day, the growing risks of a food crisis all boils down to extensive government intervention that has deadened market price signals, and severely distorted the balance of supply and demand.

Aside, this could also possibly signify a flight to commodities or the crack up boom phase of our Mises moment.

Jessica Hagy's Indexed On The Regret Theory

Jessica Hagy makes a great diagram illustrating the Regret Theory in her Wish you had, or wish you hadn’t? post.

Regret theory as defined by investopedia.com is ``A theory that says people anticipate regret if they make a wrong choice, and take this anticipation into consideration when making decisions. Fear of regret can play a large role in dissuading or motivating someone to do something."

How does this apply to investing? Dr. John Hussman has a befitting explanation,

``Anytime you discover you are taking too much risk, realize in advance that you will experience some level of regret as you correct it, if you sell your first portion and the market advances, you'll regret having sold anything. If you sell your first portion and the market continues to decline, you'll regret that you didn't sell everything. The way to keep from being "paralyzed" in the financial markets is to realize in advance that gradually changing an investment position will always involve regret. It is better to "lock in" an acceptable level of regret than to risk an unacceptable loss."

Nassim Taleb: Monetary Policy Is Out of Control

Monetary Policy is out of control says Black Swan author Nassim Taleb in an interview at CNBC.

Some noteworthy quotes

-Don’t be fooled by complex system, you can have a positive number, but that doesn’t mean anything. System is very fragile, your talking about something that is deleveraging

-You may have a temporary relief but you still are in a world that is breaking, and that world should break…gonna break.

-Whatever is fragile in complex system breaks, in other words, you took at nature, nature breaks anything that is too big, not to create interdependency just to reach equilibrium.

-We’re in a middle of a crash

-If I am going to forecast something I know its going to get worst not better.

-If things start breaking as you can see it, they break much harder than they build themselves

-Monkey on our back is debt.

-Instead of deflating debt they are thinking of inflating assets, actually they even don’t know what they are doing. They’re doing lot of contradictory things.

-Hyperinflation is a mechanism that’s very vicious. Because all you need is for people to think there’s gonna be inflation to start hoarding. So it’s a perceptional mechanism and TIPS won’t save you from that. If you have TIPS, TIPs pays you nominal inflation but expectations can go wild.

-My statement is not that we are going to have hyperinflation, my statement is that Monetary policy is out of control.

-What makes me very pessimistic in not seeing any leadership or awareness on parts of government on what has to be done, which is deleverage $40-to-$70 trillion

-Those who basing themselves on past history, don’t know anything about history, because we are in an environment that doesn’t resemble the past at all.

Global Financial Industry: More Upside Ahead?

Bloomberg's David Wilson presents a UBS study showing sustained bullishness for the global financial industry.

We quote Mr. Wilson, (all bold emphasis mine)

``Financial stocks are poised to keep rising worldwide after posting this quarter’s best performance, according to Jeffrey Palma, a global strategist at UBS AG.

``The industry stands to benefit from “a much improved backdrop,” Palma wrote yesterday in a report. He recommended that investors increase their percentage of assets in financials to a “modest overweight” relative to benchmark indexes. They had been “neutral.”

chart from Bloomberg

``As the CHART OF THE DAY shows, financials are headed for the second quarter’s biggest gain among the 10 main industry groups in the MSCI World Index. They last set the pace in the second quarter of 2003, according to data compiled by Bloomberg. The chart has the MSCI World Financial Index's quarterly rankings and percentage moves during the past six years, including this quarter’s gain through yesterday.

``Relatively steep yield curves globally will help financial companies lift earnings, Palma wrote. The gap between yields on two-year and 10-year U.S. Treasury notes reached 2.76 percentage points, a record, on May 27. Falling loan-loss provisions and rising asset values, including share prices, may also lead to higher profits, the report said.

``There is still room for profitability to recover” even if the industry’s return on equity stays well below its 16 percent in 2007, Palma wrote. He favors banks in Australia, Canada and emerging markets.

``Financials amount to 20 percent of the MSCI World Index’s value, more than any other industry group, according to data compiled by Bloomberg."

My Comment:

All financials aren't cut from the same cloth. My impression is that the financials in the bubble bust afflicted economies (such as in the US or UK) may seem like landmines that could be triggered by a wrong move. Such risk remains until the issue of toxic assets in the industry's balance sheets are resolved.

Although I do share the enthusiasm for emerging markets and Asian financials, primarily on the steepening yield curve dynamics as previously discussed in Steepening Global Yield Curve Reflects Thriving Bubble Cycle, which should augment profitability, enhance lending and induce more risk taking.

However, cyclical weakness could be in the short term horizon given the bearish head and shoulders formation as seen below.

chart from stockcharts.com

But for as long as the dynamics of liquidity and wide spreads across yield curve persists, we should use this dips as buying windows.

In essence it is all a matter of time horizon, possibly short term weakness with strenght going into the medium to the longer term.

The Parallels Of The Philippine Con Ass And The Honduran Political Crisis

In a recent post on Philippine politics, particularly, the brouhaha over the CON ASS we wrote, ``We must remember, in politics, those in power will always work or attempt to preserve their political privileges, while those in the periphery will always work or attempt to usurp such privileges. Such is the vicious cycle of politics.’ [See Philippine Politics: "Con Ass" Much Ado About Nothing?]

Well, the ongoing political crisis in Honduras could be interpreted as a seeming parallel to the local Con Ass situation. Basically, it's about an attempt by the incumbent political leader to extend his stay in power.

Honduran President Jose Manual Zelaya wanted to force a referendum on his people to approve a new constitution to achieve this goal.

Sounds familiar?

This from Cato’s Juan Hidalgo,

``Zelaya, a close ally of Hugo Chávez, is barred from pursuing a second term in the general elections in November.

``Unfortunately for Zelaya, he doesn’t have the backing of his own party, much less any other major political group. So he has moved unilaterally to call for a referendum on the need for a new constitution. The vote, which is scheduled for this Sunday, has been declared illegal by the Supreme Court and the Electoral Tribunal, and condemned by the Honduran Congress and attorney general (whose office is not part of the cabinet in Honduras).

``Despite the widespread institutional opposition to his plans, Zelaya is pushing for the vote. On Wednesday he ordered the Honduran armed forces to start distributing the ballots and other electoral materials throughout the country. The army chief, complying with the Supreme Court ruling, refused to obey the order. Zelaya sacked him, which prompted the resignation of all other leading army officers and the defense minister.”

``The attorney general is asking Congress to impeach Zelaya for violating the institutional order and abusing his powers. Last night, the Congress discussed removing Zelaya from his office. The president is defiant and has accused the Congress of attempting a coup.``The attorney general is asking Congress to impeach Zelaya for violating the institutional order and abusing his powers. Last night, the Congress discussed removing Zelaya from his office. The president is defiant and has accused the Congress of attempting a coup.”

But events unfolded quite hastily out of desperation.

It didn’t take long for the Honduras military to mount a coup and successfully oust President Zelaya which sent him into exile in Costa Rica (CNN Blog).

The Honduran Congress swiftly responded by legally stripping Pres. Zelaya of the Presidency and appointed a provisional president in Roberto Micheletti (CNN Blog)

Meanwhile Zelaya’s ally Venezuela’s Hugo Chavez has threatened to intervene militarily-by invasion (guardian).

As of this writing, the Honduran political crisis still remains unresolved.

As in the earlier post, I think PGMA understands that the Honduran Crisis could be the most probable outcome if her followers insist to let her remain in office.

Given her unpopularity, its almost a no win probability for her if she adamantly opts for this route. And this is why I think, the Con Ass controversy, seems more of a diversionary tactic than an outright attempt to grab power.

Nonetheless all these reeks of what Lord Acton once warned of, ``Power corrupts; absolute power corrupts absolutely”

INO's Adam Hewison on Gold: Energy Fields Signaling The Next Big Move

INO.com's Adam Hewison explains the technical aspects -energy fields and reverse head and shoulders-as the signaling gold's big move.

Pls click on the image below..

Documentary On The Risks of US Hyperinflation

The National Inflation Association presents an interesting three part documentary on the risks of Hyperinflation in the US, called the Hyperinflation Nation. I might, with a possible spillover or contagion effects to the world.

The interesting part for me are the accounts or footages of the wrong analysis by US Federal Chairman Ben Bernanke on the housing crisis, and its impact to the markets and the economy.

Makes you wonder how the public or even the administration continues to put their unwavering faith in him, even with such a terrible track record. In addition, Mr. Bernanke of late has been yearning to consolidate even more power under him.

Further the documentary shows how hyperinflation emerged in Zimbabwe, Weimar Germany and Yugoslavia; not consumer spending as the mainstream has repeatedly argued but from excessive and unrestrained government spending.

Video includes terse commentaries by Dr. Marc Faber, Jim Rogers, Peter Schiff and Dr. Ron Paul.


Here is is part 1

Here is is part 2

Here is is part 3

PSE: The Handicaps Of A One Directional Reward Based Platform

``A free market has to and does coordinate current and future production against future unknown demands, supplies, and shocks; and it has to and does find ways to alleviate the negative effects of shocks. People generally accomplish this by planning, forecasting, conservative practices, saving, hedging, insuring, and diversifying. There are countless ways, each tailored to particular circumstances. When a man has a backup trade, he is hedging against being laid off in his main occupation. When a family saves, it is hedging against loss of income. When family members help one another in hard times, they are insuring each other. When a business is conservative in obtaining credit and expanding, it is hedging against possible stringent business conditions. When a person diversifies investments, he is hedging against loss in one part of the portfolio. When a business controls inventories, it is managing the risk of shocks to the business.”- Michael S. Rozeff, Destination Collapse

Over at a recent huddle, a good friend asked me “how does one maintain discipline if it is an extended bear market?” The underlying concern was that the temptation or the urge to “catch the falling knife” or to “scalp (day trades)” had been quite strong given the nearly 2 years of drought in profit opportunities.

I would believe that such sentiment fundamentally embodies the unappreciated circumstance that inhibits the progress of our capital markets.

The principal problem with the Philippine Stock Exchange (PSE) is that the sustainability of the equity market industry is almost entirely dependent on a UNIDIRECTIONAL trend- that’s because people and the industry generally make money only when the Phisix goes up or is in a bullmarket!

True, “short” or the securities borrowing and lending facilities lending have been recently introduced. But apparently unfamiliar to the public or to the authorities or regulators is that any regulatory framework operates on economic dimensions : It’s always about the tradeoffs between costs and benefits.

If brokers don’t implement these, for reasons of perceived cost outweighing perceived benefits, primarily due to the compliance albatross, then effectively the program is rendered inoperative. Even if it seems noteworthy in paper, what good is a new trading platform if it can’t be used at all?

Unforeseen Consequences

Nonetheless a one dimensional reward based market has these unforeseen consequences:

1. Deprives market participants to earn

Obviously since markets operate on secular cyclical trends, then the industry or the public profits only from a bullmarket and suffers from a period of agony of “deprivation” once the bearmarket reign.

In Biblical analogy, the PSE is reduced to FAT and LEAN years with basically nothing in between. This, sadly to say, reflects on the primitive state of our financial markets.

2. Limits Liquidity

Industry participants whine of the lack of liquidity or volume. But this is exactly why hardly volume hardly progresses:

In a bullmarket, the volume of trade improves because the public churn trades profitably. In contrast, in a bearmarket, buyers have essentially been confined to a “catching a falling knife” position, where loses from wrong market “timing” or “expectations” would compel a mostly “long” position, thereby containing incidences of trades which effectively shrivels volume.

And reduced liquidity diminishes the incentives for private companies to get publicly listed, increases the market’s risk profile and exaggerates volatility.

3. Restrains growth potential of the industry

Moreover, major industry participants, particularly, brokers, mutual funds or Unit Investor Trust Funds (UITFs) would be reluctant to invest for expansion under the recognition of operational handicaps of a unidirectional reward based market, hence, the growth rate mediocrity of the Philippine capital markets.

Figure 1: ADB Bond Monitor 1^st Quarter 2009: Year on Year Performance

The chart above (which shows the year on year changes) also shows state of the Philippine equity markets in terms of market capitalization calculated in US dollars, which has severely lagged the region.

4. Handicapped Financial Industry Is Transmitted To Suboptimal Economic Growth

Another underappreciated dimension is that a unidirectional reward based market has an economic wide impact.

While for most people, the stock market is seen as a gambling casino or as some form of legal embellishment, for us, the stock market functions as a fundamental pillar to national development. And to reprise its importance, from our A Primer On Stock Markets-Why It Isn’t Generally A Gambling Casino:

-The stock market is a vital part of the process from which we coordinate production. Ideally stock prices should reflect the productivity of business firm aside from market’s discernment of the entrepreneurial judgments concerning future productivity.

-It competes with the banking sector in determining the degree of mobilization of savings into investment. From a national scale this becomes a formidable channel for economic advancement in terms of efficiency of capital deployment.

-Unknown to many, stock markets often function as forward indicators, such that they have been known to predict upcoming recessions or prospective recoveries. Thus, movements in the financial and stock markets can give a clue to the transitioning business environment, which should help management or businessmen, in allocating resources or in applying their business strategies going forward.

-It operates as alternative avenues for fund raising (public listing), intermediation (using shares as collateral for borrowing-lending) or liquidity generation (buying or selling a company).

-Because the markets operate as an organized platform of exchange, the ease from a market’s liquidity allows companies to save on transaction costs: search cost (matching buyers and sellers), contracting costs (cost of negotiation) and coordination cost (meshing securities of different industries into a single platform), which frees up capital for other usage.

-Allows wider public participation in the ownership of major companies, which expands the concept of private property ownership.

-Allows some individuals to save from taxation (e.g. inheritance taxes)

-Because stock markets function as repository of collateral or store of value, it can serve as protection or safehaven against hyperinflation or a severe form of a loss of purchasing power of a currency.

Hence in a unidirectional reward based market the following factors have been compromised:

-market pricing efficiency (reduced liquidity amplifies volatility and structurally raises risk premium or the hurdle rate),

-the optimum channeling of savings into investment or capital deployment (which translates to lesser investment opportunities and suboptimal returns),

-access to alternative financing (extrapolates to high cost of financing, which implies low public listings),

-investment opportunities that allows for a wider public participation or the “trickle down effect” (limited income growth opportunities for the public),

-the lowering of transactional costs (reduces the incentives for attracting wholesale or bulk institutional investments and requires higher hurdle rate) and

-hedging and other opportunity costs as seen from any sophisticated and deep markets (increases risk profile or premium, and heightens volatility)

From which all of these translates to lost opportunities for national wealth generation.

5. Emits Wrong Impressions and Reduces Role of Specialization

A unidirectional rewards based market exacerbated by Principal Agent problem reinforces the public’s perspective of the simplistic functionality of stock markets.

Information derived from commission based Sell Side institutions accentuates on the short term orientation of market exposure to most retail investors. And this also applies to some institutional accounts as well.

Where markets are seen as operating in a short term framework, the degree of risk taking appetite would be intensified by cyclical extremities. Again this magnifies volatility, increases perception of risk from the international institutional standpoint and diminishes the requirement or the need for division of labor or the role of specialization for domestic industry participants.

Who would want to invest in mutual funds, or UITFs or broker discretionary accounts, when the impression portrayed is -what the so-called experts can do is available to anyone? Who cares about risk, when mainstream literature almost always expounds on momentum, preened in the fundamental or technical charting garb?

To respond to such objections local sell side institutions would then expound on emphasizing on their capability to trade short term fluctuations-which is nothing more than a hokum operating on the graces of lady luck!

It’s is of no wonder why losses suffered by retail investors during bearmarkets, in many occasion, leads to abhorrence and complete desertion of the markets. This is mainly due to the wrong expectations inculcated from misleading foundations of how markets operate and the lack of alternative instruments to protect market participants from market losses during cyclical transitions.

6. Distorts Incentives

Some discretionary accounts operating under a bearmarket would prefer to withdraw proceeds than leave them with industry fund managers.

In my mind’s eye, the perception is that cash would be better off under the clients’ management since there would be no alternative options to put these at work in the capital markets. Hence, these risks skewing the incentives for managers to long the client’s account, despite the realities of an unfolding bearmarket cycle, than to lose handle.

In other words, because the operational arrangements of the fund industry could be impaired by the lack of instruments to employ idle funds in a market which only profits from one direction, fund managers could be motivated to take on more risks than required. Again, the Principal Agent Problem at work here.

From my standpoint, bearmarkets can be classified into two strains: structural or contagion based/cyclical. Both of which requires different investment approaches.

The latter of which is one that can be longed or endured with, since the national economy has no major fundamental impairment (mostly clustering errors from malinvestments from bubble policies) and could be expected to recover and to profit from a reversal of the cycle in the fullness of time. The 2007-2008 financial crises serves as lucid example of this scenario applied to the Philippine setting.

Nonetheless, the former requires total exodus regardless of the conditions of the portfolio when such a cycle emerges. That’s because bubble afflicted markets or industries can vaporize issues regardless of its previous stature. Think AIG, Bear Stearns, Lehman Brothers, General Motors and Chyrsler.

In short, there are no blue chips in an unwinding bubble afflicted industry! The idea that paper losses are merely paper losses without liquidations consummating the transaction is false.

So the analytical approach of the analyst or fund manager ultimately distinguishes between portfolio salvation and damnation, and matters more than what the public normally expects of them.

7. Cognitive Biases Also Shaped In One Direction

Again since markets are basically psychologically driven, participants are thereby influenced by cognitive biases or the reflexivity theory.

Analysts or experts as well as the general public, here, are predisposed towards a bullish bias simply because the current operating environment rewards participants only when the markets move in a sustained upward trajectory.

And we see the same dynamics applied to politics, market participants audibly cheer upon policies that temporarily boost market prices at the expense of the future simply because the public’s general expectation is predisposed towards the short term expectations.

And it is the same reason why many participants, like my good friend, despite the understanding of key market tenets, have been tempted to defy such guidelines to engage in ‘catching a falling knife’ trades- out of the psychology directed by the reward incentives provided for by the present operational market mechanism.

And such a bias doesn’t elude me entirely.

Conclusion and Recommendations

And so what could be done?

For PSE authorities:

We suggest that the “ease of use” principle founded on a sound legal framework, or the proverbial horse before the cart, as the main thrust to introduce market reforms.

New market platforms depend on the functionality or utility more than mere technical legal vernaculars which risks of high compliance costs or choking regulatory requirements that could render reforms inapplicable.

Remember, all regulations operate on latent economic dimensions. Fundamentally, success of any market platform will depend on the cost-benefit tradeoffs and not on intricate legalese.

Moreover, it would be more convenient and pragmatic to rush market reforms to include expanded local investor access to markets as Exchange Traded Funds, basic derivatives (such as options-put or call) and commodity spot and futures markets (I’d say currency markets as secondary) to enable local investors:

-the ability to hedge on or minimize risks by diversification or by utilizing hedge instruments,

-to increase capital efficiency allocation, and

-to utilize moderate leverage to augment returns

Markets that profits from the upside or the downside or sideways complimented with the ability to minimize risks by hedging or diversification will likely attract a larger and more diversified base of capital and deepen the local financial markets that should translate to value added economic growth.

For market participants:

We can only operate under the platform from which the PSE operates on, this means identifying and positioning based on cyclical or secular trends.

Next, for sophisticated investors is to tap the same aforementioned hedge instruments such as ETFs (an inventory list here), basic derivatives or commodity markets overseas. [For a related article see my previous outlook see Should Filipinos Invest Abroad?]

Finally, choose wisely on your investment analyst for guidance or for managing your funds. Avoid from selecting opinions which merely confirms your biases and from embracing viewpoints that merely deduce present price signals as basis for prospective market action. Market analysis should be objective and dispassionate where risk must always be weighed against prospective gains.

In short, avoid the bias traps.