Why EURO Skeptics Are Wrong

The big culprit in all of this is short-term debt. There would be no crises if governments had issued long-term debt to match long-term plans to repay that debt. If investors become gloomy about long-term debt, bond prices go down temporarily—but that's it. A crisis happens when there is bad news and governments need to borrow new money to pay off old debts. Only in this way do guesses about a government's solvency many years in the future translate to a crisis today. There are two lessons from this insight. First, given that the Europeans will not let governments default, they must insist on long-term financing of government debt. Debt and deficit limits will not be enough. Second, the way to handle a refinancing crisis is with a big forced swap of maturing short-term debt for long-term debt. This is what "default" or "restructuring" really means, and it is not the end of the world.- Professor John Cochrane 'Contagion' and Other Euro Myths

Since political developments have weighed heavily on the marketplace, it would a mistake to isolate politics or interpret the marketplace outside of the political dimensions. That’s because governments, which are socio-political institutions, are made up of human beings. And as human beings, their actions are driven by incentives and purposeful behaviour premised on their respective operating environments.

Additionally, as regulating bodies or agencies, they likewise interact with participants of the marketplace. Thus, any useful analysis must incorporate the role of the political economy.

Current Government Actions Validate Our Call

I am glad to say that it’s not only in the markets where our outlook appears to get substantial validation but likewise in our predictions of the political economy.

We have repeatedly argued that faced with a crisis, the predisposition or mechanical response or path dependency of today’s global political leaders is to inflate the system (or throw money at the problem). And these actions are primarily channelled through central banks.

As we declared last week[1],

And like the US dollar, the Euro will be used as an instrument to achieve political goals but coursed through the central bank (ECB).

Here are some recent evidences which corroborates on our call.

Central banks appear to surreptitiously encroach on the fiscal aspects of democratic governments in developed economies.

From Bloomberg[2], (bold highlights mine)

``European Central Bank officials tried to force Ireland to seek a bailout earlier this month and European officials are now trying to do the same to Portugal, Irish Justice Minister Dermot Ahern said.

“Clearly there were people from outside this country who were trying to bounce us in as a sovereign state, into making an application, throwing in the towel before we had even considered it as a government,” he told Irish state broadcaster RTE in an interview today. “And if you notice, they are doing the same with Portugal now.”

``Asked about who was pressuring Ireland, he said “quite obviously people from within the ECB.”

Markets do not only make opinion, importantly they affect policymaking.

Yet in a world where the morbid fear of deflation has been instilled by mainstream economics, governments would use to the hilt its inflationary magic wand.

Another news report from Bloomberg[3], (bold emphasis mine)

``The European Central Bank delayed its withdrawal of emergency liquidity measures and bought more government bonds as President Jean-Claude Trichet pledged to fight “acute” financial market tensions.

``Under pressure from investors to lead the charge against the spreading sovereign debt crisis, Trichet said the ECB will keep offering banks as much cash as they want through the first quarter over periods of up to three months at a fixed interest rate. As he spoke, ECB staff embarked upon a new wave of purchases, triggering a surge in Irish and Portuguese bonds.”

And bailouts of the privileged political class will never end until forced by the markets.

From Bloomberg[4],

``Belgian Finance Minister Didier Reynders said the euro region could increase the size of its 750 billion-euro ($1 trillion) bailout fund, breaking ranks with German Chancellor Angela Merkel and France’s Nicolas Sarkozy.

``Reynders told reporters in Brussels yesterday that the current cash pool could be increased if governments decide to create a larger fund as part of a permanent crisis mechanism in 2013. “If we decide this in the next weeks or months, why not apply it immediately to the current facility?”

``European officials are under pressure to find new ways to stop contagion spreading from Greece and Ireland amid concern the bailout package may not be large enough to rescue Spain if needed. While Sarkozy and Merkel rejected expanding the fund on Nov. 25, European Central Bank President Jean-Claude Trichet on Dec. 3 indicated governments should consider just such a move.”

A popular analyst misleadingly labelled the Euro a political currency[5] in the assumption that US dollar epitomizes as more of an “economic currency”.

Yet in contrast to such false claim, the recent disclosure by the US Federal Reserve on recipients of bailout money during the 2008 crisis suggests otherwise.

According to the Wall Street Journal Editorial[6],

``We learn, for example, that the cream of Wall Street received even more multibillion-dollar assistance than previously advertised by either the banks or the Fed. Goldman Sachs used the Primary Dealer Credit Facility 85 times to the tune of nearly $600 billion. Even in Washington, that's still a lot of money. Morgan Stanley used the same overnight lending program 212 times from March 2008 to March 2009. This news makes it impossible to argue that either bank would have survived the storm without the Fed's cash.

``The same goes for General Electric, which from late October to late November 2008 tapped the Fed's Commercial Paper Funding Facility 12 times for more than $15 billion. Thanks to the FDIC's debt-guarantee program, GE also sold $60 billion of government-guaranteed debt (with a balance left of $55 billion). The company finished a close second to Citigroup as the heaviest user of that program from November 2008 to July 2009. GE is lucky it was too big to fail, or it might have failed as smaller business lender CIT did.

``The blogosphere was hurling pitchforks yesterday because some foreign banks also took the Fed's money, including such prominent names as UBS, Barclays and BNP Paribas, and even names like Dexia and Natixis that most Americans might confuse with pharmaceuticals marketed on TV. But this was inevitable given the interconnectedness of the global financial system, and the fact that these foreign banks had U.S. subsidiaries. The Fed could not have quelled the panic by offering only U.S. banks access to these loan facilities.”

As seen above, the Fed bailouts were extended heavily to the banking system in the US and abroad, which shows of the immense reach of the political redistribution process, apparently designed to save the system or the status quo.

In effect, the US Federal Reserve can be said to have been transformed as lender of the last resort of the world[7].

Let me further clarify that instead of the whole banking system, the bailouts had been concentrated to the politically connected elite or the “too big to fail” banking behemoths.

This means the US dollar is even more representative of a political currency than the Euro (As a caveat all paper money are political in nature)

Bailouts Equals Crony Capitalism

For Euro bears, it is also a fatal mistake to imply of the political correctness of bailouts when done or executed geographically or within borders. To argue that Germans are unlikely to agree to a bailout of Greece or that Texans are unlikely to agree to a bailout of the Illinois seems like a strawman.

Bailouts, as shown above, hardly represent geographical boundaries. For instance in the case of the Euro, none EU members such as Sweden, United Kingdom and Denmark have even participated in the recent Irish bailout[8] while Norway[9] have offered to join the non-EU consortium. In other words, taxpayers of these non-EU nations have been exposed to credit risks.

Instead, bailouts function as a redistributive process in support of a politically favoured class regardless of territorial boundaries.

Bailouts, in principle, equates to crony capitalism. As Cato’s Gerald P. O'Driscoll Jr. explains[10]

(bold emphasis mine)

Distorted prices and interest rates no longer serve as accurate indicators of the relative importance of goods. Crony capitalism ensures the special access of protected firms and industries to capital. Businesses that stumble in the process of doing what is politically favored are bailed out. That leads to moral hazard and more bailouts in the future. And those losing money may be enabled to hide it by accounting chicanery.

In short, bailouts signify a form of protectionism that only benefits the politically connected or the “insiders” at the expense of the public.

The act itself is condemnable, where boundaries do not mitigate its iniquities.

And apparently, as the Irish bailout and the Fed bailout of 2008 demonstrate, the global banking class has been the privileged insider.

The Endowment Effect And The Euro’s Regional Political Imperatives

Moreover, Euro bears seem to be afflicted by a cognitive bias known as the endowment effect. Such bias, according to wikipeida.org[11], is “where people place a higher value on objects they own than objects that they do not”.

Figure 6: Euro Zone Members as U.S. States[12] (Wall Street Journal Blog)

In other words, Euro bears could possibly be underestimating the deficiencies of the US dollar, while on the other hand, overestimating on the omissions of the Euro simply because many of these Euro bears are domiciled in the US.

Another way to vet such behaviour is to see such bias in the light of nationalism.

Yet in measuring the relative scale of problems (as shown in Figure 6), one would note that the problematic states of the US today[13], according to their pecking order: Illinois, California, New York and New Jersey, which ranks in terms of US GDP[14] 5^th, 1^st, 3^rd, and 8^th respectively, would dwarf the PIIGS of the Eurozone.

Seen in a different light, when ranked according to world GDP[15], Illinois is 21^st, California 8^th, New York 15^th and New Jersey 25^th compared to Portugal (58^th), Ireland (47^th), Italy (7^th), Greece (40^th) and Spain (8^th).

Figure 7: US Troubled States: Calm Before The Storm? (chart from Bespoke Invest[16])

Fortunately, the focus of credit quality concerns has yet shifted to the PIIGS rather than to these problematic states. Otherwise, whatever disintegration blarney that has been bruited by the Euro bears should also apply to the US.

Lastly, Euro bears seem to forget that the Euro or the EU was NOT forged overnight. The Euro was founded on the premise of the avoidance to indulge in repeated wars which has tormented her for last centuries as earlier discussed[17]. Thus, a free trading zone operating under a hybrid[18] of supranationalism and intergovernmentalism, was established to reduce tensions from nationalistic tendencies.

While we don’t see the Euro as an ideal currency, as she falls into the same “power inducing” trap that intrinsically haunts paper based currencies, the Euro ultimately will share the same fate of their forbears as with the US dollar.

However, at present the Euro has been less inflationary than the US, which serves as the main bullish argument for the Euro.

Moreover, these regional politics imperatives postulate that domestic politics will be subordinated, as reflected even by the actions of the non-EU members in facilitating for the Irish bailout.

Bottom line: Aggregate demand, deflation (whatever this means, that’s because for Euro bears deflation has many definitions which makes the term amorphous) and the inability to devalue a currency don’t make a strong case for the disintegration of EU.

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[1] See Ireland’s Bailout Will Be Financed By Monetary Inflation, November 28, 2010

[2] Bloomberg.com ECB Tried to Force Ireland Into Bailout, Minister Says, November 30, 2010

[3] Bloomberg.com ECB Delays Exit, Buys Bonds to Fight ‘Acute’ Tensions, December 2, 2010

[4] Bloomberg.com, Reynders Says Bailout Fund May Be Boosted in Break With Merkel, December 5, 2010

[5] See Paper Money Is Political Money, December 4, 2010

[6] Wall Street Journal Editorial, The Fed's Bailout Files, December 2, 2010

[7] Bloomberg.com Fed May Be ‘Central Bank of the World’ After UBS, Barclays Aid, December 2, 2010

[8] Guardian.co.uk, Ireland bailout: full Irish government statement, November 28, 2010

[9] Reuters.com Oil-rich Norway may lend direct to Ireland, November 29, 2010

[10] O'Driscoll Gerald P. Jr. An Economy of Liars, Cato Institute, April 20, 2010

[11] Wikipedia.org Endowment effect

[12] Wall Street Journal Blog, Euro Zone Members as U.S. States, December 1, 2010

[13] See Global Debt Concerns Overwhelmed by Liquidity, October 15, 2010

[14] Wikepedia.org List of U.S. states by GDP

[15] Wikepedia.org Comparison between U.S. states and countries nominal GDP

[16] Bespoke Invest, State Default Risk Levels, December 2, 2010

[17] See Inflationism And The Bailout Of Greece, May 02, 2010

[18] Wikipedia.org European Union

Paper Money Is Political Money

Populist blogger John Mauldin writes,

The euro never was an economic currency. It is a political currency, and for it to remain a currency or at some point in the future become an economic currency, it will take massive political resolve on the part of the members of the EU.

Unless the US dollar operates on a genuine gold standard or a monetary system based on free banking, then this statement or implied comparison or categorization is patently false.

Although to give credit to Mr. Mauldin for admitting that he has been a “Euro skeptic”, his opinions has apparently been shaped by biases rather than from facts.

So why is the above statement false? Because paper money has always been political money.

ALL paper money, whether the US dollar, Euro, the Yen, the Yuan or the Peso, operates on a platform which is not determined by the market forces but by the judgments of unelected bureaucracy whom are appointed by their respective governments.

Thus, from the organizational structure to the operating “technical” procedures to the underlying incentives of the bureaucracy in conducting administration of these instituted statutes or policies, which are all outside the profit and loss dimensions and whose operations are underwritten by taxpayers, all these represent the political nature of the system.

Importantly, the paper money system is founded from legal tender laws, which according to Wikipedia.org, is “a medium of payment allowed by law or recognized by a legal system to be valid for meeting a financial obligation”.

In other words, a monetary system imposed by the government (by fiat or decree), which has largely been operated by central banks, has always been political.

Yet to speak of an “economic currency” extrapolates to a market based currency from which the legal tender-paper money system is not required.

According to the great Friedrich August von Hayek,

We owe it to governments that within given national territories today in general only one kind of money is universally accepted. But whether this is desirable, or whether people could not, if they understood the advantage, get a much better kind of money without all the to-do about legal tender, is an open question. Moreover, a "legal means of payment" (gesetzliches Zahlungsmittel) need not be specifically designated by a law. It is sufficient if the law enables the judge to decide in what sort of money a particular debt can be discharged.”

Thus, to besmirch a currency without the appropriate consideration of the overall framework of the system would seem misguided if not a flimflam.

Caveat Emptor.

BBC’s Hans Rosling: 200 Years of Remarkable Progress and a Converging World

Great video from BBC's Hans Rosling on 200 years of human progress. (hat tip Professor Don Boudreaux)

Video: Why Keynesian Economics Is Wrong

Here is an instructive video, from Center For Freedom and Prosperity, on why Keynesian economics is flawed... (Thanks to Professor Dan Mitchell)

The video mainly focuses on the misleading segments of the widely used statistical construct from which most policies have been premised.

The essence here is that the major flaw in the theory is the focus on aggregate demand, as reflected on consumption spending, as the principal driver of economic growth.

There are other flaws in Keynesian economics not included in the video:

-fixation on "full employment"

-"countercyclical policies" via deficit spending or inflationism

-"animal spirits"

-money is "neutral"

Understanding the flaws is important because the gist of mainstream politics have been shaped from the assumption of the validity of these models. Thus, knowledge thereof represents as emancipation from the delusion of the messianic virtues or the infallibility of government. At the end of the day the law of scarcity prevails.

Competition Brings About Economic Growth

In an article, “Greater competition in mobile providers accelerates business growth in Solomon Islands” the World Bank writes, (bold highlights mine)

The introduction of a new mobile phone provider earlier this year has significantly reduced call costs in Solomon Islands.

More people now have access to cheaper telecommunications services, resulting in business growth due to better access to market information.

The multilateral 'government' institution admits that competition is the essence of business and or economic growth.

As Friedrich A. Hayek wrote in The Meaning of Competition

Competition is essentially a process of the formation of opinion: by spreading information, it creates that unity and coherence of the economic system which we presuppose when we think of it as one market. It creates the views people have about what is best and cheapest, and it is because of it that people know at least as much about possibilities and opportunities as they in fact do. It is thus a process which involves a continuous change in the data and whose significance must therefore be completely missed by any theory which treats these data as constant

In a competitive society, everybody’s opinion counts because they are expressed through the markets. And competition brings out the best in men, mostly for the benefit of society.

Obama’s Pay Freeze and The Public Choice Theory

In contrast to his previous approach, US President Barack Obama has reportedly made a turnaround and seemingly embraced ‘austerity’.

From the Washington Post, (bold highlights mine)

Bowing to growing budget concerns and months of Republican political pressure on federal pay and benefits, President Obama today announced he would stop pay increases for most of the two million people who work for the federal government.

The freeze applies to all Executive Branch workers -- including civilian employees of the Defense Department, but does not apply to military personnel, government contractors, postal workers, members of Congress, Congressional staffers, or federal court judges and workers.

"Getting this deficit under control is going to require some broad sacrifices and that sacrifice must be shared by the employees of the federal government," Obama said in a speech Monday afternoon explaining the decision. He added, "I did not reach this decision easily, this is not a line item on a federal ledger, these are people's lives."

President Obama’s apparent change of heart mainly reflects on the outcome of the recently concluded national election, where his party got clobbered.

In other words, President Obama’s populist approach merely substituted highhanded interventionism (out of the public’s desperate sentiment which instantaneously emerged out as fallout from the financial crisis which ushered him to office) with government discipline (consequence of the failed government activism).

And this serves as a good example of how politicians pander to the electorate with the view of getting elected rather than the myth where politicians look after the betterment of society.

Like any ‘human being’, politicians exercise self interests over general interests. This is otherwise known as Public Choice.

A wonderful explanation from Professor Steve Horwitz

The Public Choice problem refers to the fact that many arguments for government intervention assume that politicians and bureaucrats are selfless and public-spirited, concerned only with doing what is best. In the real world, though, we know that politicians often act in their self-interest, just like market participants do. Unlike the market, however, political institutions do not channel self-interest into unintended consequences that benefit the public at large. Self-interested political action leads to undesirable unintended consequences. (italics his)

We should learn how to discern between reality and superstitions.

Philippine Infrastructure Development Fund: The More Things Stay The Same

In a recent conference sponsored by Finance Asia, the Philippine government showcased to international investors a proposed $280 million government funded Infrastructure Development Fund.

Unfortunately it seems that the investor response had been tepid.

This from Asian Investor, (bold emphasis mine)

As reported by AsianInvestor recently, the President of the Philippines has promised that these new public-private partnership deals would not be tainted by corruption on the part of the national government. Since he is new to the job, people may give him the benefit of the doubt until it’s proved that nothing has changed.

However, there are worries that international investment funds are going to be embezzled and siphoned off by people seeking backhanders and kickbacks, irrespective of the good intentions expressed by the head of state.

International infrastructure investors would therefore like to see a modest track record of success and a proven ability to administer this programme before they make significant commitments, even if that is based on the evidence of just a couple of honestly and effectively managed projects that can be held up as good examples.

This seems to be a natural reaction from international investors considering the poor track record and that public-private partnership deals signify no less than political concessions subject to the caprice of politicians.

As we previously said,

PPP’s signifies as politically privileged economic rent/concessions to favoured private entities that will undertake the operations in lieu of the government. They will come in the form of monopolies, cartels or subsidies that will benefit only the politically connected.

Since the private partner partnerships aren’t bound by the profit and loss discipline from the consumers, the interest of the private partners will most likely be prioritized or aligned to please the whims of the new political masters.

And because of it, much of the resources that go into these projects will not only be costly or priced above the market to defray on the ‘political’ costs, but likewise, they will be inefficiently allocated.

The more things supposedly would change, the more things seemingly would stay the same.

The Philippine growth model still depends on crony capitalism arising from its ardent adherence to the elitist based social democracy.

Ireland’s Financial Crisis Equals The Euro End Game?

There have been many commentaries suggesting that the Irish financial crisis represents as the Euro Endgame.

Well, not so fast.

This from Bloomberg, (bold emphasis mine)

Ireland’s banks will get as much as 35 billion euros ($46 billion) of aid while senior bondholders will escape the cost of the bailout led by the European Union and International Monetary Fund, the government said.

Banks will get an immediate 8 billion euros to bolster capital, and will raise a further 2 billion euros by shedding assets, the central bank said in a statement yesterday. Lenders will be able to draw on a further 25 billion euros depending on how they fare in a round of stress tests in the first half of next year, the government said in a statement…

The banks are getting the money after rising loan losses and shrinking deposits forced the government to seek the rescue. The state pledged to back all deposits in Irish banks two years ago, requiring the government to inject 33 billion euros into the lenders. The estimated cost of rescuing the banks rose to as much as 50 billion euros in September after losses from the collapse of the country’s decade-long real estate boom jumped, fueling concern Ireland couldn’t fund a rescue itself.

Ireland will in total receive 67.5 billion euros from the EU and IMF, Prime Minister Brian Cowen told reporters in Dublin yesterday after EU finance ministers backed the plan at a meeting in Brussels. The country will pay average interest of about 5.8 percent. The government will meet about half the cost of the 35 billion-euro banking bailout from its own resources, including the National Pension Reserve Fund, Cowen said.

Lenders will use the money to boost their core capital ratios, which gauge financial strength, to at least 12 percent. Bank of Ireland Plc and Allied Irish Banks Plc, the country’s two biggest lenders, will also be able to transfer all their remaining “vulnerable” commercial real estate loans to the National Asset Management Agency, the so-called bad bank set up to take over lenders’ riskiest loans, by the end of March.

As we earlier said, one of the primary role of central banks is to finance government directly or indirectly. And such redistribution process means ‘rescuing’ political privileged interest groups. Apparently this has been the case with Ireland.

Alternatively this means much of the bailouts will be coursed through stealth monetary inflation. Yes, this means you won’t read them on the papers.

To say that the Euro would disintegrate because of the populist upheaval predicated on ‘lack of aggregate demand’ or the rejection of the proposed reduction in social spending programs is pure hooey. While part of the adjustments (reductions) will reflect on the fiscal side, the offsetting (expansionary) part will be the support for the banking system which benefits from such bailouts.

And we should expect to see more of this.

Central banks will use to its hilt their ‘magic wand’. The power to control money signifies an immense privilege, political and economic. It’s not a privilege that would be easily sacrificed by the bureaucracy.

Nonetheless the degree of monetary inflation will always be relative.

Besides, throughout history people flee their currency not because of fiscal austerity or discipline or bankruptcy, but because of rampant debasement or from war.

Russia’s Putin even suggests that Russia may join the Eurozone.

This from the Bloomberg

Russian Prime Minister Vladimir Putin said Friday he was confident in the euro despite Europe's debt crisis and said his country might even join the currency block itself one day.

Putin also sharply criticized the dollar's dominance as a world reserve currency.

Despite the problems in some heavily indebted eurozone countries, the euro has proven itself "a stable world currency," Putin said.

"We have to get away from the overwhelming dollar monopoly. It makes the world economy vulnerable," he told a gathering of business leaders in Berlin through a translator.

In short, like earlier said, Euro bears will be proven wrong again.

And as we earlier wrote, hardline stance by policymakers will crumble in the face of market pressures. Again current developments appear to be validating my view.

This from Bloomberg,

European finance leaders backed a Franco-German compromise on post-2013 sovereign bailouts that waters down calls by German Chancellor Angela Merkal for investors to assume losses and share the costs with taxpayers.

The paper money system is fundamentally deeply flawed. But one system is more flawed than the other. Eventually, like in all historical accounts, the whole system collapses and reverts to the commodity system or a replica of it.

This time won’t be different.

Markets Make Opinion

On a year to date basis, Figure 1 demonstrates how Asian equity markets have been performing.

Figure 1: Asian Equity Markets: Divergent Actions (stock charts.com)

And based on the big picture, as we have earlier argued[1], Asian equity markets appear to be in a profit taking mode rather than suffering from a major reversal.

And what media says about the supposed causal linkages does not match with the actions of the equity which appears to give credence to my case.

First of all, the market leaders, the major bellwethers of Philippines (light green), Thailand (light blue) and Indonesia (fushia) has been retrenching way ahead of the Ireland crisis or China’s struggle with inflation or the North Korea incident.

Second, the South Korean bellwether the KOSPI appear to be either peaking out or transitioning towards a consolidation phase even amidst the recent unfortunate military encounter with her communist neighbour (see red arrow).

Considering the heightened degree of risks from an escalation to an all out conflagration, the KOSPI lost only 2% over the week. In other words, the Korean markets have not been jolted in as much as the news coverage had portrayed it, given the ‘surprise’ factor from the shelling of South Korea’s Yeonpyeong Island. Another way to say it is that the event risk form the Yeonpyeong incident seems to have been largely discounted (based on last week’s actions).

Third, Taiwan (violet) and Japan’s (orange) markets seem to be jaded to these adverse current events as their respective markets continue to tread higher.

So overall, the stark divergences in the performances of Asian equity markets refute arguments attributing most of the current infirmities in the region’s equity markets to recent events. This is what is known as the available bias.

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[1] See Tumult In Global Markets: It Is Just Profit Taking, November 14,2010

Will A War Break Out In The Korean Peninsula?

``The market economy involves peaceful cooperation and bursts asunder when people, instead of exchanging commodities and services, are fighting one another.”- Ludwig von Mises

I doubt so.

Not unless the North Korean political leadership have gone bonkers and take upon a suicide mission that would put to risk their political privileges.

Yet the Kim Jong-il regime is a prime example of what mercantilism and protectionism leads to—absolute despotism. A centrally planned economy led by a tyrant, who sees the nation as his personal fiefdom.

Such totalitarian state has engendered massive poverty represented by rampant shortages of many goods and services which includes the rationing of electricity that has personified what “earth hour” truly means[1].

And in spite of the North Korea’s vaunted war machinery, wherein much of the misallocation of the nation’s resources had been directed, the North Korean army is in a state of dilapidation and obsolescence: they seem ostensibly good for parades and for taunting, but not for real combat.

A clue from CNN[2],

The main weakness of the North's military is a chronic shortage of computers, modern command and control and electronic warfare assets -- in other words, much of what makes up the 21st-century battlefield. At the same time, South Korea has used its economic strength to modernize its armed forces: for example, building three $1 billion Aegis-class destroyers to counter ballistic missiles...

To compensate for obsolescence, the North deploys boots on the ground in great numbers. Jane's estimates that its standing army numbers just over 1 million personnel, with reserves estimated at more than 7 million. But North Korean soldiers are poorly fed, according to analysts and reports from defectors, and rarely train due to scarcity of fuel and ammunition.

Thus, based on socio- political-economic and military calculations, the North Koreans are unlikely to pursue a path of war, because the odds are greatly against them. And their political leadership is aware of this.

The NoKors can only use political brinkmanship as leverage to extract economic concessions from other countries for the benefit of the ruling political class. This essentially is the geopolitics of blackmail[3]—the desire to extend the politics of plunder channelled through the taxpayers of other nations.

Yet there may be other possible reasons for such showcase of aggression.

This could be a diversion from internal troubles.

Recently, to arrest growth of the underground ‘capitalist’ economy, the Kim regime massively devalued her currency that reportedly triggered widespread political unrest[4]. And one way to rally public support or ease political discontent could be to divert the public’s attention via a strawman: conjuring a phony threat and an enemy as seen through the military provocation of her South Korean neighbour in the name of defence.

Another related factor could be the succession of Kim Jong-il’s son, according to the English Chosun[5],

The North's uranium enrichment program and provocations are part of efforts to puff up the image of North Korean leader Kim Jong-il's son Jong-un in line with the Songun or military-first doctrine.

Other reasons reportedly included a supposed power struggle among factions in the ruling class or an attempt by the Kim regime to intervene in South Korean politics so as to “gain control over inter-Korean relations”[6].

Vetting On China’s Role

So aside from derangement, the only likely way for Kim Jong-il’s North Korea to pursue an all out war would be under the consent or the prodding of its patron and ally China.

Much have been said about the strategic position of the Korean peninsula as historical staging point for expansionism and for North Korea’s role as a buffer against a ‘policy of encirclement’ against perceived enemies of the West. But such an argument misleads when applied today.

While it is true that China and the North Korea has shared political experiences such as in the Korean War[7], where the two nations (along with USSR) engaged a common enemy—the Allied forces led by the US, China then was led by communist Mao Zedong’s People’s Liberation Army.

Today, China remains an avowed ‘communist’ but dons the ‘capitalist’ clothes. This means that the governing political economic framework which drives geopolitical or foreign policymaking considerations are far distinct than during the olden days.

While China may lend vocal support for her ally, she would be less interested to promote geopolitical antagonism that may undermine her interests.

One must be reminded that the success of China has been in the opening of her economy to the world. And this arises partly out of the politics carved from China’s idiosyncratic geographic landscape, which according to Stratfor’s George Friedman[8],

China is an island. We do not mean it is surrounded by water; we mean China is surrounded by territory that is difficult to traverse. Therefore, China is hard to invade; given its size and population, it is even harder to occupy. This also makes it hard for the Chinese to invade others; not utterly impossible, but quite difficult. Containing a fifth of the world’s population, China can wall itself off from the world, as it did prior to the United Kingdom’s forced entry in the 19th century and under Mao Zedong. All of this means China is a great power, but one that has to behave very differently than other great powers.

In other words, the geographic limitations of China have led to the experiment with communist isolationism which apparently ended as a grand failure, and thus, the epiphany by the present leadership to adapt an alternative option—globalization.

This also only implies that it isn’t in China interest to see world trade stymied by militant or belligerent foreign policies. Hence, in my view, the chances that China would support North Korea’s tantrums would seem small.

Bottom line: In my view, Korea’s stock markets could be accurately reflecting on the assessment that a broad based deterioration in the geopolitical conditions in the Korean Peninsula could be contained.

Said differently, though we can’t rule out fatuousness from hubris, the odds are against this.

Tenuous Relationship Between Wars And Market Collapses

Yet wars don’t necessarily lead to collapsing markets.

Figure 2: S & P 500 and The Invasion of Iraq

The Invasion of Iraq in March 20 to May 1, 2003 didn’t cause a downside collapse, instead the Gulf War of the new millennium coincided with inflating markets (red circle Figure 2). One might be tempted to link the war as having a positive effect, but this would be misguided, because it was the US Federal Reserve’s low interest rate policies that fuelled the inflation of the marketplace.

Nevertheless, past performance may have not lead to the same outcome.

Should a war occur, such event risk would depend on the participants involved and their degree of involvement. And given the above circumstance, and the deepening world acceptance of globalization, it is less likely that a war at the Korean Peninsula would escalate into a world war.

So for bears selling the war as an excuse to allege for, or predict, a market collapse, they are likely misreading and misdiagnosing the events and are most likely wrong.

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[1] See Earth Hour: North Korean Version March 31, 2010

[2] CNN.com North Korea's military aging but sizable, November 25, 2010

[3] See North Korea: The Geopolitics of Blackmail, November 24,2010

[4] See The Road To Serfdom In North Korea, June 21, 2010

[5] English Chosun, Why Did N.Korea Attack?, November 28, 2010

[6] Ibid

[7] Wikipedia.org Korean War

[8] Friedman, George Chinese Geopolitics and the Significance of Tibet, Stratfor.com April 15, 2008

Ireland’s Bailout Will Be Financed By Monetary Inflation

``This is what the phrase "lender of last resort" really means: the creation of fiat money by the central bank. It means breaking the normal rules of the fiat money game. It means bailouts.”- Gary North

A short note on Ireland financial crisis.

This from the Bloomberg[1],

European finance ministers are racing to conclude an international rescue package for Ireland before markets open to stop the country’s financial crisis from spreading to the rest of the euro region.

Prime Minister Brian Cowen’s government is finalizing a bailout agreement that may amount to 85 billion euros ($113 billion) after more than 50,000 people took to the streets of Dublin yesterday to protest budget cuts. As Ireland’s crisis spreads to Portugal and Spain, investors are looking for details on the interest rate Ireland will pay on its loans and the fate of senior bondholders in the country’s banks.

It is quite nonsensical to believe that the Euro will be sacrificed for the misguided notion that austerity will compel for its disintegration as previously argued[2]. As shown in the said article, Eurozone governments have been using market actions to justify interventionism via bailouts.

I am reminded of the institutional incentives borne out of government’s control of the monetary and banking system, as the great Professor Ludwig von Mises wrote[3], (bold emphasis mine)

But today credit expansion is an exclusive prerogative of government. As far as private banks and bankers are instrumental in issuing fiduciary media, their role is merely ancillary and concerns only technicalities. The governments alone direct the course of affairs. They have attained full supremacy in all matters concerning the size of circulation credit. While the size of the credit expansion that private banks and bankers are able to engineer on an unhampered market is strictly limited, the governments aim at the greatest possible amount of credit expansion. Credit expansion is the government's foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make-everybody prosperous.

However this time we are dealing with the bailout on claims on sovereign assets, mostly for the benefit of the creditors or bondholders, which apparently are mostly held by the Euro banking system (see figure 3).

Figure 3 Bank of International Settlements: Exposures to PIIGS

According to the BIS[4], (bold highlights mine)

The integration of European bond markets after the advent of the euro has resulted in a much greater diversification of risk in the euro area. As of 31 December 2009, banks headquartered in the euro zone accounted for almost two thirds (62%) of all internationally active banks’ exposures to the residents of the euro area countries facing market pressures (Greece, Ireland, Portugal and Spain). Together, they had $727 billion of exposures to Spain, $402 billion to Ireland, $244 billion to Portugal and $206 billion to Greece.

French and German banks were particularly exposed to the residents of Greece, Ireland, Portugal, and Spain. At the end of the 2009, they had $958 billion of combined exposures ($493 billion and $465 billion, respectively) to the residents of these countries. This amounted to 61% of all reported euro area banks’ exposures to those economies.

As repeatedly argued here, redistributive policies have always been meant protect certain powerful interest groups. But they are camouflaged by the use of social welfare as cover and by the captured intelligentsia class in the provision of the technical rationalization.

Central banks, to quote Murray Rothbard[5], are ``governmentally created and sanctioned cartel device to enable the nation’s banks to inflate the money supply in a coordinated fashion, without suffering quick retribution from depositors or noteholders demanding cash. Recent researchers, however, have also highlighted the vital supporting role of the growing number of technocratic experts and academics, who were happy to lend the patina of their allegedly scientific expertise to the elite’s drive for a central bank. To achieve a regime of big government and government control, power elites cannot achieve their goal of privilege through statism without the vital legitimizing support of the supposedly disinterested experts and the professoriat. To achieve the Leviathan State, interests seeking special privilege, and intellectuals offering scholarship and ideology, must work hand in hand.”

The quote actually referred to the US Federal Reserve but can be applied universally.

Of course, the next question is how will these large scale sovereign bailouts be financed? The obvious answer by monetary inflation.

Again from Professor Rothbard[6], (bold highlights mine)

The Central Banks enjoy a monopoly on the printing of paper money, and through this money they control and encourage an inflationary fractional reserve banking system which pyramids deposits on top of a total of reserves determined by the Central Banks. Government fiat paper has replaced commodity money, and central banking has taken the place of free banking. Hence our chronic, permanent inflation problem, a problem which, if un checked, is bound to accelerate eventually into the fearful destruction of the currency known as runaway inflation.

So what we are basically seeing is a validation of the perspectives of these great Austrian economists which seem to be playing out or unfolding today in both the Euro and the US.

In short, what the mainstream mostly ignores is the political role played by the central banks on our global economy.

By the way, it would seem that I have been validated anew. I earlier said that the risks at the US housing markets could weigh on the balance sheets of the US banking system which has prompted the US Federal Reserve to pursue QE 2.0[7] despite tepid signs of economic recovery.

Figure 4: Federal Housing Finance Agency: Falling Home Prices

US home prices are reportedly falling anew[8].

Like in the US, inflating the monetary system have been designed to rescue the respective banking systems.

Austerity, hence, is a farce. US and European governments (and even Japan) will continue to inflate the system.

And like the US dollar, the Euro will be used as an instrument to achieve political goals but coursed through the central bank (ECB).

---

[1] Bloomberg, EU Ministers Meet to Find Agreement on Irish Bailout November 28, 2010

[2] See Ireland’s Woes Won’t Stop The Global Inflation Shindig, November 22, 2010

[3] Mises, Ludwig von Currency and Credit Manipulation, Chapter 31 Section 5 p.788

[4] Bank of International Settlements International banking and financial market developments BIS Quarterly Review June 2010

[5] Rothbard, Murray N The Origins of the Federal Reserve, Mises.org

[6] Rothbard, Murray N Central Banking: The Process of Bank Credit Expansion Chapter 11 Mystery of Banking p.176

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

[8] Bloomberg.com U.S. Home Prices Fell 3.2% in Third Quarter, FHFA Says, November 24, 2010

North Korea: The Geopolitics of Blackmail

Forbes columnist Gady Epstein writes, (bold emphasis mine)

North Korea’s shelling today of a South Korean island has reminded the world again of the perennial problem of what to do about the nuclear-armed state. This comes just days after we hear that North Korea has shown off an advanced uranium-enrichment facility, a reminder, too, of how dangerously resourceful this regime can be even as its people face another winter of food and electricity shortages.

In totalitarian states where society have been enslaved by the ruling political class and the bureaucracy, the state can only survive by predation.

Lacking the resources to plunder from its own, totalitarian states resort to expanding the sphere of the politics of predation, through belligerent actions, with its more prosperous neighbors.

As libertarian journalist Frank Chodorov once wrote,

But, since the State thrives on what it expropriates, the general decline in production that it induces by its avarice foretells its own doom. Its source of income dries up. Thus, in pulling Society down it pulls itself down. Its ultimate collapse is usually occasioned by a disastrous war, but preceding that event is a history of increasing and discouraging levies on the marketplace, causing a decline in the aspirations, hopes, and self-esteem of its victims.

North Korea simply fits the bill. She simply wants to live off on a free lunch through the politics of blackmail even if the desperately poor nation knowingly can’t win a full scale war.

And only through poltical brinkmanship can she be able to extract concessions.

As the Wall Street Journal writes,

The purpose is transparently to frighten the West into concluding that there is no alternative to paying off Pyongyang, lest it sell a bomb to al Qaeda or Iran. A far better policy would be a united international effort to further isolate the Kim dynasty with a goal of regime change. Only changing the government will end the North's nuclear threat and liberate its citizens from that prison state.

Of course desperate situations can lead to desperate outcomes, something which Mr. Chodorov predicted.

Nonetheless, Bastiat was right, if goods don’t cross borders armies will. Totalitarian (or despotic) states who do not respect property rights and the rule of law will eventually collapse either from internal political strife (as a consequence of economic cataclysm) or through war.

Bottom line: North Korea is a great example how closed economies (protectionism and mercantilism) through an absolutist predatory state (totalitarianism, communism and fascism) can lead to societal failure or dystopia.

Thanksgiving Day Treat: Turkey Inflation

From Wall Street Journal Blog

35%: The increase in the price of whole turkeys, from their pre-recession level

The Peak Oil Myth

Here are my thoughts on Peak oil

While peak oil (via Hubbert Peak Theory) may be a valid engineering theory, it is a poor economic concept for the simple reason that engineering theories (like quant models) do not capture people’s behaviour.

Let us learn from the history of oil as narrated by investment guru Steve Leuthold

500 Years Ago… England

First let’s go back about 500 years. During the Renaissance, wood was the critical energy component in England and other European economies, much as fossil fuel is today. Wood was the primary provider of heat, light, and food preparation. However, England, having chopped down most of its trees became a large wood importer, primarily from the Scandinavian countries.

Of course prices rose as wood became more scarce causing domestic brewers, bakers, and others to go out of business hit by lower priced imports from wood rich countries. The English citizenry rebelled, having to pay exorbitant rates for wood to heat their homes, light their nights, and cook their food. Thus in 1593 and again in 1615, Parliament enacted energy conservation legislation, including limiting the use of wood in construction and mandating the use of bricks (but it took more wood to bake the bricks than to build wood structures).

From 1600 to about 1650 the price of firewood soared 80%. Then in a single year the price of wood jumped another 300%. Some families were forced to burn furniture and even parts of their houses to survive the winters. Back then, there were no government wood subsidies for freezing families.

The Wood To Coal Transition

In the early 1600s, people were aware coal was an alternative energy source. But prior to the huge rise in wood, coal was far too dirty and expensive. Chopping down trees was easier and cheaper than hacking the coal out from underground. But, as the coal industry grew, mining sophistication and technology reduced the extraction costs and as coal supplies rose prices fell.

Coal was soon found to be a far superior industrial fuel and with vast improvements in coal mining productivity the price of coal kept falling. First iron production increased with quality improving. Then came steel and steam power. The Industrial Revolution was underway led by England, which was bigger, better and earlier than old Europe. England had become the world’s industrial revolution leader. The real catalyst was the Wood Crisis.

Over 150 Years Ago… United States

Now let’s go back about 200 years to the early 1800s. Once again it’s the beginning of another hugely important energy revolution. Since Colonial times, the primary source of illumination in the U.S. had been whale oil. But by 1850 the North Atlantic had almost been whaled out by New England’s whaling fleet. The shore price of whale oil doubled and then doubled again, even though new whaling technologies had maximized oil recovery from the whales that were taken.

The high whale oil prices were also making it profitable to harpoon smaller and smaller lesser yield whales.

The U.S. was growing fast while the North Atlantic with the whale oil field yielding less and less. At the time there were, on the East Coast, no known substitutes for whale oil. By 1848 prices had skyrocketed by 600%. Then in 1848 the shortage was temporarily alleviated by the discovery (and subsequent decimation) of the South Pacific whale herds. Whale oil prices temporarily moved lower. Yes, it was a long and expensive journey for the New England whalers exploiting the new whale oil find. A whaling expedition around the horn and back could take as much as two years.

By the advent of the Civil War even this new whale oil field was played out. Low grade whale oil was $1.45 a gallon by 1865, up from 23 cents in the 1840s. To put this in to perspective, in 1868 a complete dinner in a New York restaurant cost 19 cents. A customer could buy over seven dinners for the price of a single gallon of lighting oil. It cost restaurant owners more to light the place at night than they were paying for the food they served.

The Whale Oil To Kerosene Transition

An alternative energy source became essential as high prices, population growth and shrinking supplies of whale oil combined into a crisis for businesses in east coast cities such as New York, Boston and Philadelphia. Edwin Drake set out to find that alternative. In 1858 he first found it in Titusville, Pennsylvania.

The U.S. entered the Petroleum Age. By 1867, kerosene, refined from Pennsylvania crude broke the whale oil market. By 1900 whale oil prices had fallen 70% from their highs and whale oil lamps had become collector items. Kerosene prices, with production efficiencies, became cheaper and cheaper. More importantly, just as with the development of coal as an energy alternative 200 years earlier, a chain reaction of technological and economic development was triggered. Oil soon became the new foundation of the economy not merely the low cost provider of light at night.

Lessons gleaned from the history of oil

1. People (via supply and demand) adjust to prices, where high prices leads to conservation or substitution, e.g. the wood crisis that triggered a shift to coal, whale oil crisis that led to kerosene

2. commodities obtain values only when it becomes an economic good, e.g. oil was nothing or did not have value during the age of the wood and coal or whale oil.

3. technology enhances production.

We seem to be seeing a combination of the above dynamics playout today, where alternative energies such as the production of Shale oil has been vastly expanding

To quote University of Michigan’s Professor Mark Perry (chart from Professor Perry)

New, advanced techniques for drilling oil have revolutionized the domestic oil industry in North Dakota in ways that couldn't have even been predicted just a few years ago, and will likely also open up new oil production in other parts of the world in the near future (like the Alberta Bakken in Canada) that also would have been unimaginable before this year. That's one reason that "peak oil" is peak idiocy: it always underestimates the ultimate resource - human capital (i.e. human ingenuity and the resulting innovation, advances, new technology) - which is endless and boundless, and will never peak.

Let me add that the current high prices of energy and commodities are not only from the consumption model but also from the reservation demand model—where monetary inflation influences prices.

Of course, there are other factors involved, most of which have been government imposed: geographical access restrictions, trade restrictions, price controls, subsidies, cartels, tariffs and other forms of protectionism (aside from inflationism)