An Overextended Phisix, Keynesians On Retreat And Interest Rate Sensitive Bubbles

``The belief that a sound monetary system can once again be attained without making substantial changes in economic policy is a serious error. What is needed first and foremost is to renounce all inflationist fallacies. This renunciation cannot last, however, if it is not firmly grounded on a full and complete divorce of ideology from all imperialist, militarist, protectionist, statist, and socialist ideas.-Ludwig von Mises

The Philippine benchmark, the Phisix, remains overextended. (see figure 4) However, deep into major trends, periods of overextension happens, thus this shouldn’t be a surprise.

Figure 4 stockcharts.com: Phisix, Gold and Asian Markets On The Uptrend

And it appears that we could be, perhaps, in one of these unique periods.

I have been expecting the overheated ASEAN markets and the Philippine Phisix (see Relative Strength Index in top window) to take a breather. Apparently this hasn’t been so. My suspicion is that expectations of more monetary accommodation in developed economies may have prevented this from taking place.

Yet for some, this would seem as unsustainable, from which I agree, except that unsustainable can last several years before suffering from a major implosion or a regression to the mean.

The reason for such is that I understand global inflationism as giving rise to serial bubbles. And I don’t share the view that the world is hounded by lack of aggregate demand or liquidity traps or deflation in a world of central banking unless the later would see global monetary authorities submit to the market forces, a political dynamic of which has yielded no indications whatsoever.

And as the conditions of the Phisix (PSEC main window) and of the ASEAN bellwethers have shown, a financial asset boom signifies one of the symptoms of diffusing inflationism taking hold.

And it is also why chart reading cannot be consistently relied upon because they incorporate past data and performances which do not account for the next or prospective actions by the public and the officialdom, as well as their feedback mechanism, given the ever fluid conditions.

And as one would note, the outperformance of the Phisix shadows an equally vibrant Asian ex-Japan markets (P2DOW) and the gold market (GOLD), which means that NONE of the above has manifested the strains of what mainstream permabears calls as the “deflation menace” which is no more than a mainstream Keynesian bugbear that gives justification for authorities to engage in “inflationism”.

The Last Straw For Keynesians: Serial Bubbles

Of course, the prevailing dominance of the Keynesianism seems to be receiving a well deserved smackdown and a comeuppance in Europe as leaders there have opted to observe fiscal discipline[1] than wantonly engage in wasting taxpayer resources on non-market unproductive ‘pet’ projects of politicians in order spruce up the strawman of “aggregate demand” which for them translates to “employment”.

Contra Keynesians, needless consumption of resources on non-productive politically designated activities translates to a loss of capital, a reduction of productivity and subsequently lowered standards of living.

This may be just one of the evolving paradigm shifts that perhaps could serve as an epiphany over the limitations and the hazards of excessive government interventions.

And in contrast to permabears, the adaption of fiscal discipline is surely a path towards sound recovery and a vital source of optimism.

And as the US heads towards elections in the first week of the coming month, we may also see the same results.

Hence, the last straw for Keynesianism following the political retreat will likely be channeled towards the unelected bureaucrats, the central banks.

And for us, central banks are the clear maestros or engineers when fostering bubbles.

And bubble cycles are steeply sensitive to interest rates movements.

Emerging Markets And Fed Policy Rates

BCA Research has an interesting perspective on how emerging markets have reacted to Fed policies (figure 5).

Figure 5 US Global Funds[2]/BCA Research: Emerging Market Correlations

They posit that correlations with the US interest rates had been negative during the mid 90s and positive during the last crisis, where the BCA infers that a dismal global economic growth won’t likely buoy emerging market equities in spite of a Fed liquidity booster.

My comment is that the supposed divergences may not be all that persuasive.

One, the negative correlation in the 90s (left window) may be a function of lagged effects.

Half-way through the rising Fed rates has shown an equally strong emerging market performance which eventually peaked as the Fed rates continued to rise. Hence, the negative correlation may be skewed more towards the interpretation by the analyst more than evidence of strong correlation.

The second but most important factor is that in the 90s, bubbles were centered outside of the US particularly in Emerging Markets—the Tequila (Mexican) Crisis of 1994 and the Asian Financial Crisis of 1997. This implies that the transmission mechanism from Fed policies may have been eclipsed by unsustainable internal imbalances, seen in the said emerging markets, which imploded even as the US economy and her financial markets were left unscathed and continued to perform robustly.

It’s an entirely different story during the period of supposed positive correlation (right window), where the US had been the epicenter of the crisis which essentially rippled throughout the globe and thus the positive correlation.

In short, the major difference between the performances of the emerging markets and the US Fed policy rates, over the two time zones, has been source of the bubbles. Hence the economic growth story relative to Fed rates, for me, seems largely irrelevant.

Overall, interest rates will likely be the most critical factor in ascertaining the sustainability of financial asset inflation in emerging markets, ASEAN, the Philippines and elsewhere, as previously discussed[3].

For as long as the artificially suppressed rates stay low in real and nominal terms and remain unaffected by rising demand for credit or a surge in inflation or that the credit quality or credit ratings of crisis stricken highly levered developed nations remain beyond doubt, then these would be signs of the sweetspot of inflationism.

Interest rates will only start to impact the financial system and the markets once rising rates would render many highly levered unsound projects or speculative endeavors as unprofitable. We are nowhere near this point.

And even if there could be some interim reprieve in the markets, this means for now, party on!

---

[1] New York Times, Europe Seen Avoiding Keynes’s Cure for Recession, October 20, 2010, Wall Street Journal, Britain's 'Austerity' Lessons, October 22, 2010

[2] US Global Funds, Investor Alert October 22, 2010

[3] See Interest Rates As Key To Stock Market Trends, October 2010

Video: Spontaneous Versus Planned Orders

This is an insightful video showing why and how spontaneous orders are superior and more efficient in allocating resources than a hierarchy. The secret: it's all about the maximizing the use of knowledge. --hat tip Greg Ransom

Prohibition: Even Jails Can’t Stop Them

Jeremiah Dyke at the Mises Blog has an interesting post showing how contraband items have not been contained by the authorities even in jails!

Mr. Dyke writes,

Like contraband, drug paraphernalia, sharp objects and the various other illegal objects that make it into our prison system on a daily basis, prison systems can’t seem to keep cell phones out of the jail cells. It’s reached a point now where prison systems are seeking outside assistance from mobile phone companies, asking them to jam mobile phone signals by flooding the prison systems with airways.

Well such phenomenon isn’t isolated in the US.

We see a similar dynamic here in the Philippines. This from the Philippine Inquirer

A surprise inspection of inmates’ cells at the Quezon City jail Sunday morning yielded more than 200 sachets of drugs, drug paraphernalia, cell phones and deadly weapons.

The operation, which was ordered by Senior Supt. Emilio Culang, city jail warden, led to the seizure of at least 250 grams of dried marijuana leaves, 206 sachets of marijuana and shabu, several bottles of solvent and paint thinner and drug paraphernalia.

Also confiscated were 70 cell phones, lewd magazines, playing cards, a bottle of wine and dozens of improvised deadly weapons.

These included spoons, forks, toothbrushes and pencils with sharpened points. There were also needles, lighters, belts, electrical wires, scissors, hammer, assorted ropes and nail cutters.

It’s seems to be a perpetual cat and mouse game even under highly controlled environment by the government.

To share Mr. Dyke conclusion,

The lesson that won’t be learned is of course, if we can’t keep illegal items out a fully secured prison facility, with 8×10 jails cells, how in the world can we expect to keep these items out of a nation with over 9,000 miles of border?

In short, most of prohibition laws can only signify as government failure.

Recipe To Canada’s Miraculous Transformation: Less Government And More Economic Freedom

David Hay CIO of Evergreen Capital Management enumerates how Canadians miraculously transformed her economy from one of a near basketcase “an honorary member of the Third World in the unmanageability of its debt problem” to a first world economy (hat tip John Mauldin)

(all bold emphasis mine)

• Paul Martin, the finance minister for the national Liberal Party, unveiled a budget in early 1995 that shocked all the cynics accustomed to smoke-and-mirrors accounting. It reduced program spending by 8.8% over two years (and our politicos quiver over a mere hint of spending freezes).

• As part of this radical spending rationalization, federal government employment was reduced by 14%.

• Federal grants to the provinces were reduced by 14% as well, but the trade-off was that they were allowed to control how the money was spent. Provincial governments also needed to provide half of all funding (i.e., put skin in the game).

• While some taxes were raised (and, according to the authors, these worked against the recovery), spending cuts were 4 ½ times tax hikes.

• Canada’s welfare system was dramatically modified. Rather than just providing a blank check to the provinces (which administered the welfare programs), Ottawa incentivized them to put the funds to better use. Benefits were cut for single, employable individuals and aggressive efforts were made to get them back in the work force.

• Despite accusations from the far left that the poor would suffer due to these changes, the percentage of welfare recipients fell in just a few short years from 10.7% of the population to 6.8% by 2000. From 1997 to 2007, the percentage of Canadians classified as low-income plunged by over 30%.

• The tax structure was dramatically redesigned. Corporate tax rates were cut by nearly a third, taxes on corporate capital were abolished, and personal income and capital gains taxes were reduced.

• The General Services Tax (basically a consumption tax or VAT) was instituted to pay for the tax cuts described above. While initially very unpopular, it was a key part of the rehab plan.

• The Canada Pension Plan (CPP), the country’s version of Social Security, also underwent major surgery. Instead of payroll taxes gradually rising to 14%, the increases were pulled forward but capped at under 10%. This produced immediate surpluses that were invested in higher-returning corporate securities. (As noted in past EVAs, this is a huge defect with our Social Security system; its many trillions are tied up in low-yielding US government bonds that simply add to our overall national indebtedness.) The CPP today is well-funded and actuarially sound.

• As a result of these actions, and many others I’ve left out, the federal budget was balanced within three years.

After achieving this remarkable feat, Canada went on to produce 11 straight budget surpluses. This allowed our northern neighbors to reduce their federal debt from 80% of GDP to 45%. Further demonstrating how quickly good policy can turn things around, the provinces enacted similar measures.

For most of the permabears, whose economic outlook have been framed on utter dependence on government, they seem to be afraid of their own shadows—they recognize that too much reliance on government is unsustainable, yet they subscribe to the very same prescriptions that has led to the current predicaments of unwieldy debts and perilous fiscal imbalances.

However, as the Canadian model has shown, less government is the answer to any economic recovery or the path to prosperity.

It goes with less taxes, minimal interventionism, fiscal discipline via reduced government spending and the empowerment of the entrepreneurs.

The above also shows that politics evolves—transitions are never smooth. Yet, people learn to adapt to the changes brought about by economic liberalism.

Again David Hay…

in case you think that Canadians universally supported these rational reforms as they were first enacted, consider how similar our northern friends are to us. They are every bit as fractious as we are. There was a cacophonous chorus of extreme Keynesians (those who believe government spending should never be cut) who predicted Canada’s grand experiment would be an abject failure. Yet, despite all those who were sure that downsizing government would do the same to their growth rate, Canada’s economy grew at 3.3% per year versus the developed-world average of 2.7%. Notwithstanding Canada’s undeniable success, should we decide to follow in its footsteps, be prepared for folks like NY Times columnist Paul Krugman to wax apocalyptic. Come to think of it, given his forecasting track record, that would be a good thing.

Bottom line: there will be hope if the incumbent leaders realize, accept and adapt to what are needed most: reforms towards greater economic freedom and the broadening of free trade.

Czech President Vaclav Klaus: IMF A Barbaric Relic

Here is a strong statement from Czech Republic President Vaclav Klaus:

The IMF is a different topic. As someone who in January 1990 – as a newly appointed minister of finance – sent his very first letter abroad asking for the renewal of our IMF and World Bank membership and who was extremely honored to sign our accession treaty to both of these institutions in Washington, D.C. in September 1990, I hope I can afford to say something critical and politically incorrect. I consider the IMF a barbaric relic from the Keynesian and fixed-exchange rate era. I know it is a harsh verdict but Keynes himself repeatedly used similar strong statements about his colleagues which justifies my using such a terminology.

I am convinced the IMF should be dismantled or radically restructured as soon as possible. To do the opposite, to increase its role as it happened as a result of the last year’s G20 decision in the middle of the panic connected with the then looming crisis or to speculate about creating similar institutions on individual continents (especially in Europe) is a wrong way to go. It is yet another manifestation of a mistaken and dangerous global governance mindset which – to my great regret – has been getting more and more support in the intellectual and political circles these days. To whom and how at all can the IMF be held responsible for its activities? And if its proposals or measures turn out to be mistaken (and this can happen very easily), who will face the consequences? Certainly not the IMF.

Signs of evolving times.

The Possible Implications Of The Next Phase Of US Monetary Easing

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

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

QE 2.0 And The Legal Face Of The US Mortgage Crisis

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

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

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

Figure 1: US Stocks Rallying Without Financials

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

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

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

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

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

The initial tremor has been a wave of foreclosure moratorium.

According to Chad Fisher of USA News[4],

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

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

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

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

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

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

The Deadly Effects Of Competitive Devaluation

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

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

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

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

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

Figure 2: Imports Then And Today

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

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

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

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

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

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

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

Figure 3: Stockcharts.com: Commodity Inflation

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

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

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

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

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

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

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

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

In A Currency War No Nation Wins

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

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

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

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

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

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

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

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

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

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

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

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

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

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

QE 2.0 Should Boost Emerging Market and Asian Equity Assets

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

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

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

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

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

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

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

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

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

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

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

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

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

[6] Wikipedia.org Bretton Woods system

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

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

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

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

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

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

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

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

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

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

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

Greece And Economic Freedom

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

This from the Wall Street Journal Blog

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

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

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

Yes, they indeed need more economic freedom.

How Capitalism Saved The Chilean Miners

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

Mr. Henninger writes, (bold emphasis mine)

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

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

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

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

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

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

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

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

Is Social Cooperation A Product of Evolution?

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

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

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

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

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

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

To quote Henry George, (bold emphasis mine)

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

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

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

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

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

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

As Paul Rubin eloquently explains,

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

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

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

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

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

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

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

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

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

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

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

Global Debt Concerns Overwhelmed by Liquidity

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

They write,

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

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

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

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

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

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

Eventually something has to give.

For the meantime, party on.

World’s Richest Women

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

According to the Economist,

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

Certainly signs of changing times.

Globalization And World Hunger

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

According to the Economist, (bold highlights mine)

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

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

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

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

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

Stephen Roach: Quantitative Easing Won't Work

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

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

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

Currency Wars And The Philippine Peso

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

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

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

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

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

As the Wall Street Journal editorial writes[3],

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

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

Here is my take on the currency episode:

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

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

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

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

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

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

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

Why?

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

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

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

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

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

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

From Mr. Belka, (bold emphasis mine)

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

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

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

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

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

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

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

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

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

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

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

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

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