``Public choice is like the small boy who said that the king really has no clothes. Once he said this, everyone recognised that the king’s nakedness had been recognised, but that no-one had really called attention to this fact.”-James M. Buchanan, Politics Without Romance
In this issue:
Why The Sell-Offs In Global Markets Are Unlikely Signs Of A Double Dip Recession
-President Aquino’s Baptism Of Fire: The “Wang Wang” Policy
-Misreading The Decline Of Global Markets
-Europe Tightens Monetary Spigot
-Yield Curves Does Not Suggest Of A Prospective Recession
-Gold Challenges The Recession Outlook; From Policy To Market Divergences
-Summary and Conclusion
The Phisix and ASEAN bourses continue to astonish. They weren’t immune from the steep downdraft seen in global markets. However, the degree of decline was starkly less than those suffered by their contemporaries, such as the US S&P down 5.03% or Germany Dax down 3.9% or China’s Shanghai index down 6.7%. In fact, one of the outlier, Thailand SET even rose by 1.12%.
President Aquino’s Baptism Of Fire: The “Wang Wang” Policy
The Phisix endured a 1.83% loss this week.
And if I use mainstream reasoning to connect the dots, by attaching developments in current events, then this implies that President Noynoy Aquino’s ‘baptism of fire’ policy of hunting down illegal police sirens (Wang Wang) and blinkers, which was one of the major points in his inaugural speech, has important link to the market’s loss.
In the speech, the president aims to reduce the perceived gap between the people and the political leaders, which according to this editorial[1], “Walang lamangan, walang padrino, at walang pagnanakaw. Walang wang-wang, walang counter-flow, walang tong,” he said, vowing to put an end to thievery, patronage, petty extortion, the use of sirens and traffic counter-flow.
Nevertheless, the recent populist acts by new President have several important ramifications;
One, this shows that there have been far too many unenforceable laws. The labyrinth of unenforceable laws reveals of the extent of depth of institutional deficiencies.
Two, laws get to be enforced only upon political convenience.
The law, PD 96, which was signed last 1973 have apparently been flagrantly abused, mostly by those in power. As proof of this, an industry emerged[2] to cater to this once “dormant” and ineffective law.
Moreover, when politics arbitrarily dictate on the priorities of enforceability of specific laws, then the other laws get to be overshadowed. Thereby, the ever shifting political priorities, as set by the whims of political authorities, would only undermine the effectiveness of the institutionalization of the current set of laws.
Three, the arbitrariness of application of laws subjects the enforcer and the violating parties into arbitrary relations.
Once the public gets tired of this issue or once other concerns captures or diverts the public’s attention, then this law would only be a source of corruption, extortion and other ungodly compromises. Remember since many of the offenders are from the political class, then we can expect a lot of this behind the scene reactions. Otherwise, such political vaudeville will die a natural death or revert to hibernation.
Fourth, while President Aquino’s good intention isn’t the object of our critique, this policy seems to be an extension of the political euphoria from the recently concluded elections. It appears that President Aquino mistakenly thinks of the Office of the President as a perpetual popularity contest as manifested by such action. Unfortunately the rubber will meet the road and farcical symbolisms will be exposed for what they are.
Fifth, enforcing Wang Wang laws won’t “put an end to thievery, patronage, petty extortion”. That’s because Wang Wangs are not cause of these misdemeanours. Wang Wangs are only symptoms of an underlying disease.
Therefore, this seems no more than a superficial approach to a very complex issue.
What people don’t see is that the arbitrariness of the implementation of laws signifies as one of the major causes of “thievery, patronage, petty extortion” and such political showmanship won’t resolve the deeply rooted issue.
For laws to be effective, they should be known to everyone, they should be stable for everyone to observe and follow, and they should be always enforced evenly. Therefore, changeability, arbitrariness and selective applications of laws only adds to (and not reduce) these endemic imbalances.
This only puts to light that President Aquino and his strategists reveal of the poor understanding of the drivers of the Philippine political economy and partially affirms our prognosis of the direction of his prospective political actions.
President Aquino needs to deal with the existing cobweb of laws that enables the political power centres to exist and thrive, which prompts for the concurrent inequitable distribution of political (and economic) power from which the Wang Wang pathology has emerged, and the political framework of the bureaucracy--something which incidentally would be politically inconvenient and an exercise he won’t likely underwrite.
Lastly, in my view this seems to be a strategic folly or a misstep for President Aquino. Where the miscue from present post elections euphoria could lead to what Nobel Prize winner James Buchanan[3] would call as “non-performance measured against promised claims”. Political gimmickry can only have a short term impact, thus he would need a bagful of other tricks to keep people entertained.
Yet, an overreach to implement this law at the expense of other concerns would likely lead to failed expectations and subsequently a decline in popularity ratings.
As we have said before, the more things change the more they remain the same.
Misreading The Decline Of Global Markets
Of course, the hyperbolic Wang Wang policies have little to do with the current state of market actions.
The fact is that most of the major financial markets have been in convulsion. Some see this as raising the risks of a ‘double dip’ recession while some see this as “deflation”.
We don’t share both views.
First of all, it is misguided to interpret falling markets as deflation in a monetary sense. Because deflation can used to describe the market activity, such as ‘deflation’ in the prices of stocks, deflation has been mostly utilized as an observation to “effects” rather than the enunciation of causal linkages.
Aside from misreading cause and effect, monetary deflation isn’t the same as deflation in the stock markets because wealth and money are not only different[4] but in stock markets, where every seller (outflow) has a corresponding buyer (inflow), there are NO NET outflows or inflows or transfers of money. Therefore, changes in the pricing of stocks signify as changes in expectations.
And the fudging of definitions won’t make any analysis “sound” or “accurate”, since they are manifestations of (mostly political) bias.
Instead, people’s mental picture of “deflation” is cash hoarding similar to the Great Depression of the 1930s, which arose from frenetic liquidation activities (from intensive government intervention) which led to a massive withdrawal in the banking system. Yet, this scenario hasn’t been true today.
There was indeed a short bout of deflation in late 2008 seen in some developed economies. But this was different from the 1930s. The 2008 episode had been a consequence of a financial gridlock centered upon the US banking system. This affected both payment and settlement activities, from which many in the world resorted to barter trade and in the US the emergence of scrip “local” currency[5].
Deflation, then, didn’t signify outright lack of demand, instead it posited of a “supply shock” from the massive dislocation of monetary or financial flows in the global banking system.
Thus, when global central banks, led by the US Federal Reserve, provided “temporary” patchwork to the immobilized system, aside from applying massive inflationism by absorbing and providing guarantees to securities of dubious quality, global economic activities fiercely rebounded in defiance of the expectations of the mainstream (see figure 1).
Figure 1: Danske Bank[6]: Global Business Monitor
In fact the speed, the magnitude and the ferocity of the ensuing rebound had been so astonishing that global economic indicators as OECD leading indicator (left window- blue line) Global PMI manufacturing (left window- red line) and PMI new orders manufacturing (right window) has equalled, if not surpassed, the highs of the boom days of 2003-2007.
But unless one lives in planet Mars where some harbour the expectations of a sustained rebound in defiance of the laws of gravity, it is natural or normal to expect a “slowdown” to occur following a vigorous V-shaped rebound. Thus the basic axiom applies: no trend goes in a straight line.
True, there are meaningful signs of declines in some economic activities, such as a slowdown in China as her government tries to prevent an overheating (see figure 2), the ongoing fiscal problems and tightening monetary policy in Europe (see below)-which should translate to a temporary slowdown and signs of weaknesses in the US economy particularly seen in the survey of consumer confidence, housing market, durable goods, labor market, mortgage applications, impact from BP oil spill, state budget, and even the Economic Research Institute’s weekly Leading Indicator which has been made by deflation advocates as the primary tool today to declare a bear or market collapse. Some even use the technical death cross in the US markets to suggest of the next crash).
Figure 2: Danske Commodities[7]: Asia: Odds for soft landing in China are good
For instance, the fall in China’s market seem to exhibit manifestations of the ongoing decline in the rate of credit expansion. While this policy induced actions may account for temporary or short term pain, the plus side is that the risk of a ballooning bubble would likely be diminished.
However, the strong showing of fixed asset investments (right window-red line) amidst today’s credit conditions (note: NOT a contraction in credit but a decline in the rate of growth) still implies of a resilient but moderating economic growth.
As a side note: Again, this gives more evidence to our Machlup-Livermore model where China’s current bear market is being driven, not by changes in economic fundamentals but by changes in liquidity conditions. The slowdown in credit conditions in China has prompted for a bear market which seems quite similar to the accounts of 2008 where China did NOT undergo a recession yet the Shanghai index fell by 71%!
My point is that ALL these global economic activities can be construed as reactions by the financial markets to evolving realities from an unsustainable “winning streak” momentum.
Yet again, these indications of economic infirmities hardly exhibit signs of deflation similar to the Great Depression.
As Friedrich von Hayek described[8], (all bold highlights mine)
``How confused ideas still are with respect to the problems of the liquidation and readjustment of the economic system after a crisis is well illustrated by the vague and indefinite way in which in recent years financial journalists and others have discussed the problem of liquidation of the present depression. The analysis of the crisis shows that, once an excessive increase of the capital structure has proved insupportable and has led to a crisis, profitability of production can be restored only by considerable changes in relative prices, reductions of certain stocks, and transfers of means of production to other uses. In connection with these changes, liquidations of firms in a purely financial sense of the word may be inevitable, and their postponement may possibly delay the process of liquidation in the first, more general sense; but this is a separate and special phenomenon which in recent discussions has been stressed rather excessively at the expense of the more fundamental changes in prices, stocks, etc.”
In short, we seem to seeing natural adjustments in relative pricing and the attendant fine-tuning of economic activities from the recent dramatic ascension. Hence, the recent fall does not necessarily imply a double dip recession or deflation.
Europe Tightens Monetary Spigot
Europe seems to be defying the US in terms of monetary policy approach.
Despite the G-20 rapprochement on growth and deficit targets, which according to the Businessweek[9], (bold emphasis added)
``Advanced economies will aim to at least halve deficits by 2013 and stabilize their debt-to-output ratios by 2016, according to a statement released as leaders finished meeting in Toronto today. The G-20 said banks need to raise capital “significantly” and countries will be allowed to phase in new rules, with a goal of meeting new standards by the end of 2012…
``The G-20 had to bridge a gap between leaders such as President Barack Obama who want to focus on growth and officials such as Merkel who favor budget cuts. The statement says the global recovery, which has been faster than expected, remains “uneven and fragile.”
Europe’s ardent desire to cut deficits seems being reflected on the monetary policies (see figure 3).
Figure 3: Danske Bank: Europe Debt Crisis Watch
The European Central Bank (ECB) has been slowing its liquidity provision to the banking system (right window) while simultaneously engaged in monetary tightening by sopping off liquidity in the marketplace (left window).
According to the Danske Bank research team[10],
``The expiry of the ECB 12-month LTRO [Long Term Re-financing Operation] on Thursday is creating jitters in the European money markets, where conditions have worsened despite a tightening of the EONIA EURIBOR spread. The 3M EONIA has risen to the highest level since July 2009, as markets are worrying that weak European banks may have difficulties rolling over short-term funding, although the ECB has announced that it will continue to provide liquidity at 1% full allotment in a three-month LTRO.
``ECB’s purchases of PIIGS government bonds remain very limited and the market is increasingly questioning the central bank’s commitment to support PIIGS.”
So like in China, falling stock markets in Europe have been evincing of a policy based liquidity slowdown, which basically reflects on the adjustments based on these events.
In other words, there seems to be a brewing policy divergence between the US, on the one side and Europe and China on the other, where both Europe and China seem willing to accept the pains of a slowdown as tradeoff to unsustainable spendthrift policies as advocated by US authorities.
These imply that economic activities that had emerged out of the false market signals via inflationism will bear the pain of losses which markets apparently have been pricing in.
As Friedrich von Hayek explained[11], (all bold emphasis mine)
But if prices then do not rise more than expected, no extra profits will be made. Although prices continue to rise at the former rate, this will no longer have the miraculous effect on sales and employment it had before. The artificial gains will disappear, there will again be losses, and some firms will find that prices will not even cover costs. To maintain the effect inflation had earlier when its full extent was not anticipated, it will have to be stronger than before. If at first an annual rate of price increase of five percent had been sufficient, once five percent comes to be expected something like seven percent or more will be necessary to have the same stimulating effect which a five percent rise had before. And since, if inflation has already lasted for some time, a great many activities will have become dependent on its continuance at a progressive rate, we will have a situation in which, in spite of rising prices, many firms will be making losses, and there may be substantial unemployment. Depression with rising prices is a typical consequence of a mere braking of the increase in the rate of inflation once the economy has become geared to a certain rate of inflation.
On the account of this policy divergence, the Euro surged by 1.59% this week.
Moreover the results of the banking stress test[12] will be published on July 23rd, which if the results are positive should diminish the negative sentiment.
Nonetheless, outside the emergence of any unforeseen tail risks, the temporary slowdown which signals a move away from mainstream Keynesian policies, presents a medium term bullish case for European and China equities. Perhaps we shall see a bottoming of these markets in the coming quarter.
Yield Curves Does Not Suggest Of A Prospective Recession
Figure 4: News N Economics[13]: Japan And US Yield Curve, ECB[14]: Euro Area Yield Curve
The yield curve, by far, is the best indicator of recessions. The yield curve signifies as perhaps the most potent price signal which shapes the public’s expectations that coordinates the distribution of resources across the economic sphere.
As Dr. Frank Shostak explains[15], (all bold emphasis mine)
``To the extent that investors are forming expectations regarding future course of monetary policy, this only tends to reinforce the shape of the curve as set by the central bank. This means that the shift in the shape of the yield curve is ultimately set by the central banks monetary policies and not by investors’ expectations. At best, expectations can either reinforce or moderate the slope of the yield curve.
``Whenever the central bank reverses its monetary stance and thus alters the shape of the yield curve, it sets in motion either economic boom or an economic bust. The effect of a change in monetary policy shifts gradually from one market to another market, from one individual to another individual. It is this gradual increase in the effect of a change in the monetary policy that makes the change in the shape of the yield curve a good predictive tool.”
Thus, if the yield curve is instrumental in generating business cycles, then this means that part of the cyclical activities is the incentives which the yield curve provides the public to arbitrage through interest rate spreads or by profit spreads.
True, US yield curves have been flattening of late, but it is misplaced to suggest that this presages a recession, because as seen from the larger picture, US yield curves remain significantly steep since the onset of the crisis (left window).
Importantly, US yield curves (red line) can’t be compared to Japan’s lost decade. Japan’s yield curve (blue line) since 1998 has remained mostly flat. So any comparison with Japan is likely to be misguided and inaccurate.
And even the yield curve in the European Union has likewise been steep (right window).
So while the present action of the yield curve in the US may suggest of a slowdown they are far from pointing to a recession in the US or in the EU area yet.
The other point is that the monetary climate remains largely expansionary in spite of the current turbulence. And given money’s relative effects to the economy, this should likewise impact financial markets on a relative scale. And perhaps this partly explains the ongoing divergences between ASEAN and global developed markets.
Thus, we differentiate from those advancing the deflation scenario because we see the relative impact of interest rates from the perspective of money’s non-neutrality.
As Ludwig von Mises once wrote[16],
``Public opinion is prone to see in interest nothing but a merely institutional obstacle to the expansion of production. It does not realize that the discount of future goods as against present goods is a necessary and eternal category of human action and cannot be abolished by bank manipulation.”
Gold Challenges The Recession Outlook; From Policy To Market Divergences
Furthermore, as we previously[17] pointed out, another indicator that doesn’t suggest of a market collapse or the imminence of recession is Gold.
True, gold prices fell by 3.55% this week but that’s after setting a new nominal record (see figure 5).
Figure 5: Gold’s Retreat From Record Run, Emerging Divergences
Therefore, gold’s price action can be deemed as merely a routine correction following the new milestone high.
Remember, gold prices have NOT been immune to recessions[18]. Therefore, we take this as signs that gold isn’t a hedge against deflation[19]. Hence, a prospective recession is also likely hammer hard on gold prices. So far this hasn’t been the case yet.
Unless gold continues to fall hard, we should take the recent action to be a normal phase of adjustments based on evolving conditions.
I would like to further add that the so called fiscal austerity or the shift away from Keynesian policies is likewise going to somewhat hurt gold. That’s because gold has essentially been riding on global government’s reckless adaption of Keynesian policies.
And as the G-20 meeting has demonstrated, the policy divergences by Euro-China relative to the US would likely have disparate impact on gold prices. Gold is likely to underperform in Euro and Yuan terms, but outperform based on the US dollar terms as the US government is likely to pursue policies of inflationism.
And such policy divergences will also likely disharmonize the impact on financial asset markets.
And possibly the current disparities in the gold-copper market (where gold drifts near record highs while copper prices have been lethargic) and the emerging market stocks (EEM)-bonds (XESDX) [where EM stocks have been sluggish while EM bonds have been recovering) have been suggesting of these developments.
Finally it’s also a mistake to equate falling commodity prices as signs of deflation.
As Ludwig von Mises explained[20], (all bold highlights mine)
``As soon as the depression appears, there is a general lament over deflation and people clamor for a continuation of the expansionist policy. Now, it is true that even with no restrictions in the supply of money proper and fiduciary media available, the depression brings about a cash-induced tendency toward an increase in the purchasing power of the monetary unit. Every firm is intent upon increasing its cash holdings, and these endeavors affect the ratio between the supply of money (in the broader sense) and the demand for money (in the broader sense) for cash holding. This may be properly called deflation. But it is a serious blunder to believe that the fall in commodity prices is caused by this striving after greater cash holding. The causation is the other way around. Prices of the factors of production--both material and human--have reached an excessive height in the boom period. They must come down before business can become profitable again. The entrepreneurs enlarge their cash holding because they abstain from buying goods and hiring workers as long as the structure of prices and wages is not adjusted to the real state of the market data. Thus any attempt of the government or the labor unions to prevent or to delay this adjustment merely prolongs the stagnation.”
In short, while falling commodity prices may suggest of a forthcoming recession, they do not automatically suggest signs of deflation-since recessions are manifestations of adjustments from the misallocation of resources through price signals.
Summary and Conclusion
To recap:
Falling global markets doesn’t necessarily imply a forthcoming recession or deflation. More importantly little of the current market actions signal “monetary deflation”.
Following a surge in the activities in the global economy it would be normal to see a moderation of activities which may have been reflected on the markets. Thus the retreat in the momentum suggest of a market misread by some as a “double dip” or deflation.
Despite the G-20 consensus, US and Europe appears to have drawn the proverbial line on the sand; there will be policy induced divergences among G-20 member nations.
Europe and China appears to be in a tightening mode, hence their markets seem to be reflecting on such policy actions.
Europe seems signalling a retreat from Keynesian policies. Current weakness should be seen as temporary. The Euro is already affirming this action.
The US will likely continue to inflate, where more signs of market distress would possibly lead to the reactivation of the Quantitative Easing facility.
Policy divergences are likely to impact markets distinctly. Therefore, we may be seeing further signs of market disaccord or decoupling.
The yield curve remains steep in the US and Europe or in Asia. This hardly signals a double dip or of deflation. Perhaps too, the steep yield curve has prompted Europeans to engage in tightening and to veer away from Keynesian policies.
Gold’s recent retreat from its record run doesn’t signal a return of recession.
There seem to growing signs of divergences across asset markets seen even in the commodity and in emerging markets.
Falling commodity markets doesn’t automatically translate to deflation.
Philippine President Noynoy Aquino’s first “Wang Wang” policy shouldn’t have any impact on the markets and could herald the general direction of his administration’s policy.
ASEAN markets continue to display peculiar resiliency. Should global markets begin to recover, ASEAN markets are likely to go on full throttle and outperform the rest. This includes the Philippine Phisix.
This means a buy on the Phisix and the Peso.
[1] Philippine Star, EDITORIAL - No more wang-wang, July 2, 2010
[2] GMANEWS.TV, Cops helpless vs 'wang-wang' dealers, July 2, 2010
[3] Buchanan, James M. Politics Without Romance
[4] See Are Recessions Deflationary?
[5] See Emerging Local Currencies In The US Disproves The 'Liquidity Trap’
[6] Danske Bank, Global Business Monitor
[7] Danske Bank, Commodities Monthly: New price floors materialising, June 30, 2010
[8] Hayek, Friedrich von The Present State And Immediate Prospects. Of The Study Of Industrial Fluctuations Profits, Interest And Investment P.176
[9] Businessweek, Bloomberg G-20 Agrees to Cut Deficits Once Recoveries Cemented, June 27, 2010
[10] Danske Bank: Europe Debt Crisis Watch, June 29, 2010
[11] Hayek, Friedrich August von Can We Still Avoid Inflation? The Austrian Theory of the Trade Cycle
[12] ABC News, European Bank Stress Test Results Due on July 23, July 4 2010
[13] News N Economics, Yield curves in Japan and the US: similar but not the same, June 29, 2010
[14] European Central Bank, Euro Area Yield Curve
[15] Shostak, Frank, What's With the Yield Curve?, Mises.org
[16] Mises, Ludwig von The Monetary or Circulation Credit Theory of the Trade Cycle, Chapter 20 Section 8, Human Action
[17] See What Gold’s Latest Record Prices Mean
[18] See Why The Current Market Volatility Does Not Imply A Repeat Of 2008
[19] See Gold Unlikely A Deflation Hedge
[20] Mises, Ludwig von, The Gross Market Rate of Interest as Affected by Deflation and Credit Contraction Chapter 20 Section 7, Human Action
Update: Since I'm not familiar with the new Google doc set-up, I am having a hard time trying to integrate the new format to my blog. Hence the bold highlights noted above were not reflected.The original document can be found below...
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