Do Central Banks Uphold Or Undermine Free Market Principles?

When I read Professor Art Carden’s statement from this article,

Far too often, people use terms like "capitalism" and "socialism" sloppily, either because they don't understand them or because the words make for cheap but effective (albeit inaccurate) political rhetoric. The Great Conversation suffers because of it.

It struck me that many arguments supposedly for the so-called advancement of the political philosophy of libertarianism, free markets and or classical liberalism have precisely been anchored on this—rhetoric misrepresented as principles.

And this is exactly the essence of my last article, The Middle Of The Road Policy Of A Local Free Market Group. Where I was earlier disappointed about the issue of principles, I was even more dismayed by the responses.

Given the benefit of the doubt that perhaps my article or my “spin” could have lacked clarity, or that specialization may have lead to the misunderstanding of my message, my argument against the positive relationship between central banking and the free market was certainly not about utility nor was it about market failure.

By utility, I mean it would seem misguided to compare what is essentially is a monopoly—operating on the power of coercion, funded by taxpayer resources and whose decision making process by the authorities are (externality) risk borne by the taxpayers—with private and semi-private enterprises operating mostly on a competitive environment.

By market failure, the standard statist ‘Paul Krugman’ tactic—throw up a strawman, assail or shoot it down with econometric gibberish or economic models, and declare “market failure”, thus justifying government intervention—eludes the question about this relationship between free markets and the central bank.

The fact that the local central bank began only in the Philippines in 1949, goes to show that even in our colonial past the nation has survived without it, thereby, disproving the presumed sine qua non nature of central banking to the local economy.

As my colleague Paul How writes in his 'as-yet unpublished manuscript', the “Philippine Banking And The Business Cycle” about how the domestic monetary system operated, (bold emphasis mine)

During the 19^th century, the monetary system had a gold standard in place, where each monetary note was presumed to redeem a fixed amount of gold...

Clearly, people, in their private capacity, preferred the use of a medium of exchange whose value was based not on government decree but on the amount of rare metals contained in the item. Even after the Spanish handed the Philippines over to the United States in December 1898, Filipinos continued using the Mexican coin, much to the chagrin of US officials keen on imposing their culture on the new colony’s inhabitants.

Where half of our transactions are settled for by money which is issued by an institution owned and controlled by the government, this extrapolates to half of our trading activities under the indirect purview of the government. Thus it is very important to put in question the role of such institution under the Free Market precept.

Ultimately, what for stands as the most important issue is through this question:

Do central banks promote or undermine the Free Market Principles?

This brings us back to definition. A free market, according to Wikipedia, is a market in which there is no economic intervention and regulation by the state, except to enforce private contracts and the ownership of property.

If freedom to contract and private property rights are the key pillars of free market principles as stated by such definition, do central bank activities promote these?

As a side note, under classical liberalism I would not say that free market is the absence of intervention or regulation, but instead a free market is self regulated by (mostly non-state) institutions operating under the rule of law.

Nevertheless the entire concept of freedom to contract and private property or even the rule of law are put into a test under the central bank’s operations: (bold highlights under below quotes are my emphasis)

1. Inflation of the monetary system

Thus, credit expansion unavoidably results in the economic crisis. In either of the two alternatives, the artificial boom is doomed. In the long run, it must collapse. The short-run effect, the period of prosperity, may last sometimes several years. While it lasts, the authorities, the expanding banks and their public relations agencies arrogantly defy the warnings of the economists and pride themselves on the manifest success of their policies. But when the bitter end comes, they wash their hands of it.

The artificial prosperity cannot last because the lowering of the rate of interest, purely technical as it was and not corresponding to the real state of the market data, has misled entrepreneurial calculations. It has created the illusion that certain projects offer the chances of profitability when, in fact, the available supply of factors of production was not sufficient for their execution. Deluded by false reckoning, businessmen have expanded their activities beyond the limits drawn by the state of society’s wealth. They have underrated the degree of the scarcity of factors of production and overtaxed their capacity to produce. In short: they have squandered scarce capital goods by malinvestment.

Ludwig von Mises, The Causes of Economic Crisis,

Does price signalling distortion, reduction of purchasing power of money and capital consumption from these forces represent as free market principle? The same question should all be applied on the following aspects shown below.

2. The nature of central bank’s fractional reserve system

As Huerta de Soto points out, the problem of the tragedy of the commons always appears when property rights are defined improperly. In the case of fractional reserve banking, bankers can infringe on property rights because it is not clearly defined who owns the deposit.

When customers make their deposits, the promise is that the deposit is always available for withdrawal. However, the deposits, by the very definition of fractional reserve banking, are never completely available to all customers at one time. This is because banks will take a part of these deposits and loan them out to other customers. In other words, they issue fiduciary media. By issuing more property titles than property entrusted to them, the banks violate the traditional property rights of their customers. (One of the most important contributions of Huerta de Soto's exhaustive book is to demonstrate how banking developed historically and that fractional reserve banking evolved as a perversion of deposit banking.)

Philipp Bagus, The Commons and the Tragedy of Banking

3. Externality costs from the knowledge problem

The odds that 19 men and women (a.k.a. the Federal Open Market Committee) will be able to select the overnight interest rate that keeps the U.S. economy growing at its potential in perpetuity are next to nil.

There would be a huge outcry if the Fed set the price of oil or copper or soybeans. Yet we accept the central bank as a price setter, a monopolist, when it comes to the interbank lending rate.

Caroline Baum Capitalism Still Has Legs That Are Long and Sexy

3. Operates from an environment of arbitrary rules

The concept of the rule of law in jurisprudence and political philosophy has several dimensions. At its core is the classical liberal principle of nondiscretionary governance that stands in contrast to the arbitrary or discretionary rule of those people currently in authority. In shorthand, either we have the rule of law or we have the rule of authorities. Under the rule of law, government agencies do nothing but faithfully enforce statutes already on the books. Under the rule of authorities, those in positions of executive authority have the discretion to make up substantive new decrees as they go along, and to forego enforcing the statutes on the books.

Dr. Lawrence H. White Rule of Law or the Rule of Central Bankers?

Think currency interventions in behalf of exporters and OFWs at the expense of importers and consumers via elevated prices of goods and services.

4. Operate on persistent political pressures

To put it into the hands of an institution which is protected against competition, which can force us to accept the money, which is subject to incessant political pressure, such an authority will not ever again give us good money

Friedrich August von Hayek A Free-Market Monetary System

5. Choosing winners and losers

The real reason for the adoption of the Federal Reserve, and its promotion by the large banks, was the exact opposite of their loudly trumpeted motivations.

Rather than create an institution to curb their own profits on behalf of the public interest, the banks sought a Central Bank to enhance their profits by permitting them to inflate far beyond the bounds set by free-market competition.

Murray N. Rothbard, The Case Against the Fed

6. Crony Capitalism

The answer was the same in both cases: the big businessmen and financiers had to form an alliance with the opinion molding classes in society, in order to engineer the consent of the public by means of crafty and persuasive propaganda.

Murray N. Rothbard, The Case Against the Fed

7. Promote Government Expansion

While, as we shall see presently, government's exclusive right to issue and regulate money has certainly not helped to give us a better money than we would otherwise have had, and probably a very much worse one, it has of course become a chief instrument for prevailing governmental policies and profoundly assisted the general growth of governmental power. Much of contemporary politics is based on the assumption that government has the power to create and make people accept any amount of additional money it wishes. Governments will for this reason strongly defend their traditional rights. But for the same reason it is also most important that they should be taken from them.

A government ought not, any more than a private person, to be able (at least in peace-time) to take whatever it wants, but be limited strictly to the use of the means placed at its disposal by the representatives of the people, and to be unable to extend its resources beyond what the people have agreed to let it have. The modern expansion of government was largely assisted by the possibility of covering deficits by issuing money-usually on the pretence that it was thereby creating employment. It is perhaps significant, however, that Adam Smith [54, p. 687] does not mention the control of the issue of money among the 'only three duties [which] according to the system of natural liberty, the sovereign has to attend to'.

Friedrich August von Hayek Denationalization of money

In my view, the fundamental case for free market capitalism begins with sound money and sound banking institutions (whether it is a 100% gold reserve or a free banking standard).

Quote of the Day: Popular or Workable?

From my favorite marketing guru, Seth Godin

The thing that makes it popular...

might be precisely the thing that keeps it from working….

There are a hundred ways you and your organization can become more popular, earn more clicks, generate more comments... but is popular what you're after?

In terms of the markets and of the political economy I vote on ideas that are workable.

Video: How Wealth Is Derived From Mutually Beneficial Free Trade

Trade is human action: we do this everyday with the aim at attaining better life and live past self sufficiency which characterized the lives of our primitive ancestors.

Trade today is mostly voluntary, it is done by individuals at the community level or provincial or regional or at the national level. The difference in the trading environment depends on the degree of trade freedom, which are mostly shaped by the governing political policies.

Because trade appears as a mundane activity, its manifold benefits seem as hardly sentiently appreciated by the public. In short, the benefits of trade are frequently underappreciated.

And when trade is framed as an aggregate, i.e. substituted with statistics and accounting figures, trade becomes subject to waffling political talking points, and importantly, loses its human touch. Trade, then, becomes subject to acrimonious disputes, many of which results to perverse laws that curtails trade--and prosperity.

The following video, from LearnLiberty.org, presents Professor Art Carden who discusses the basics of free trade from the perspective of the LAW OF COMPARATIVE ADVANTAGE (also known as the law of comparative costs) and how free trade leads to prosperity.

Comparative advantage deals with achieving efficiency out of relative opportunity costs or according to wikipedia,

In economics, the law of comparative advantage refers to the ability of a party (an individual, a firm, or a country) to produce a particular good or service at a lower opportunity cost than another party. It is the ability to produce a product with the highest relative efficiency given all the other products that could be produced.

Self Promotion: Prudent Investor Newsletters Referenced By Money.co.uk

Here is a little self-promotion.

A UK based financial website Money.com.uk wrote me to say that my article had been referenced for their 2010 year end review.

Click on the site here or on the truncated picture from their website below.

Press the May 2^nd heading “Greece and Package Settled Upon”.

And press “read more” at the right column which redirects the link to my site.

Ms. Sophie Lamble of Money.co.uk writes,

Of all the articles covering that particular event, we found yours to be the most concise and well-written – for this, I’d like to express my appreciation and sincere hope that the great work continues on Prudent Investor Newsletters. I’m sure our readers will agree and find the extra information useful.

Thanks Sophie and the Money.co.uk.

Middle East Stock Market Meltdown: Likely Driven By (Political Economic) Insider Selling

I wouldn’t deny that the meltdown in Saudi stocks, which had been down for 21% for 13 consecutive days have been politically driven. This applies to most bourses in the region too.

But before my explanation let’s go to some expert opinion or mainstream reporting.

According to Bespoke Invest (also the source of the chart above) [emphasis added]

Back in late January, the TASI saw a one-day decline of over 6% on 1/29 when tensions began to escalate in Egypt. When things settled down in Cairo, the TASI rebounded back above its 50-day moving average, but it then began to roll over again when tensions moved to Libya. Watching the charts must be a popular past time in Saudi Arabia, because once the index broke below its January lows, the bottom literally fell out of the index. With the March 11th Day of Rage coming up in Saudi Arabia next week, are traders in this market anticipating a replay of Egypt or Libya?

The Wall Street Journal adds, (emphasis added)

Large scale instability in North Africa and protests in neighboring countries [Bahrain, Oman, Yemen] have culminated in a significant selloff as investors are growing increasingly concerned that protests and subsequent instability could ultimately reach the Saudi market," said an analyst at Riyadh-based NCB Capital. "We firmly believe that fears of instability reaching the Saudi market are overdone, despite reports of calls for demonstrations in the coming days."

Saudi Arabia recently introduced a number of nonpolitical changes, estimated to cost around $36 billion, but there have still been signs of domestic discontent since Tunisia's popular uprising in January.

While foreign investors continued to cut their equities exposure to the region, the selling was mainly retail-driven—exacerbated by margin calls and redemptions at local Saudi funds, traders said.

The reason I’m not gonna deny this politically instigated collapse as a valid driver is that the declines have been far stretched or extended than the counterparts in non-MENA emerging market bourses. This implies something more than meets the eye.

I might add that, aside from foreign investors, importantly, I suspect that the insiders (meaning those economic and political agents whose stakes had been built around the current regimes over the years) could have been liquidating their stakes in fear, that in the event these People Power revolts become successful, the new administrations would resort to the sequestration or a freeze on their assets to appease the incensed populace or as indemnity for their political misconduct.

This has already happened to former Egypt President Hosni Mubarak, whose assets have been frozen by the Egyptian government, while other foreign banks as the Swiss appear to be headed for the same route as seen with its scrutiny of Tunisia’s deposed president Zine al-Abidine Ben Ali’s transactions.

So the likelihood would be for these embattled political economic agents to scramble and exit from conventional asset holdings, and subsequently, divert their assets outside of the region.

So yes, insider selling could likely be a crucial factor in the current market actions, while foreign selling and panicking retail investors have all combined to worsen these conditions.

The Bloomberg GCC 200 Index, a capitalization weighted index of the top 200 equities in the GCC region based on market capitalization and liquidity, reveals of the broad market declines of major Middle East stocks as the People Power movements ripple across the region.

And possibly gold and other commodities could signify as alternative ways to shelter the assets of these insiders.

How To Reform The Global Debt Biased Economic System

Harvard economist Kenneth Rogoff argues that the world’s problem has been “rooted in excessive concentrations of debt” and that the fix should focus on rebalancing debt into equity. I agree.

Mr. Rogoff writes,

But policy-induced distortions also play an enormous role. Many countries’ tax systems hugely favor debt over equity. The housing boom in the United States might never have reached the proportions that it did if homeowners had been unable to treat interest payments on home loans as a tax deduction. Corporations are allowed to deduct interest payments on bonds, but stock dividends are effectively taxed at the both the corporate and the individual level.

Central banks and finance ministries are also complicit, since debt gets bailed out far more aggressively than equity does.

I’d like to add that this is exactly why central banks exist: they have been designed to finance and bailout the government and or her agencies (mostly by inflation), aside from promoting “consumption” debt as path to economic growth. As for the latter, don’t you see the excessive focus by the mainstream on “employment” based on “consumer spending”?

And these composite policies, all this time, has favored or privileged the central bank supported banking industry cartel.

Since the political leadership (governments) has also benefited from these arrangements, then obviously even administrative or tax policies had been molded into a “debt” bias—which incidentally becomes a feedback loop mechanism (more government spending more inflationism by central banks).

And that’s how boom bust cycles have been playing out.

And as earlier discussed in The Myth Of Risk Free Government Bonds even bank capital regulatory requirements have been tilted towards incentivizing these institutions to hold on to “less risky” government debts.

That’s because institutional holdings on “short term” government securities, under Basel Accord, which were considered as “risk free”, were not required of capital in contrast to holdings of corporate bonds. So major institutions were incentivized to fund governments, from which politicians capitalized on, and which only bloated their nation’s respective fiscal balance sheets.

But the recent crisis has only been exposing the “nudity” of the fabled risk free “emperor”.

I would say that this systemic debt bias has been intrinsic for the paper money system build around the welfare-redistributive state.

And parallel to this been the unseen incentives that drives governments and their respective central banks to gain political capital (via extended tenure and via expanded government control over the political economy) by selling “something out of nothing” to voters via the welfare state—and to reemphasize, all of which have been propped up and funded by the debt based central banking system.

In other words, for the world economic-financial framework—estimated at some $200 trillion, and which have been configured or evolved around these embedded incentives—to be able to shift from a debt to equity bias, would require an overhaul of the monetary system first and the political systems next.

Otherwise, the markets, like it or not, will do the radical debt-to-equity makeover for us.

Why The Best and The Brightest Don’t Fit Into Public Service

Author and Economic Professor Steven Landsburg writes,

The main reason to hold down public salaries/benefits is not to save money for the taxpayers. I have no a priori reason to care any more (or less) about the taxpayers than I do about the public employees themselves. Instead, the main reason to hold down public salaries/benefits is to avoid drawing the “best and the brightest” away from more productive careers into public service.

More thoughts:

Aside from the crowding out effect, “best and the brightest” into public service translates to more fatal conceit (or the presumption that the knowledge they have is better than the markets). This subsequently impels them to boldly dabble or experiment with more interventionist policies at the cost and risk of the taxpayers. In other words, they tend to find new creative ways to pick on someone else's pocket.

In addition, “best and the brightest” also means figuring out cunning ways to game the political economic system (corruption, arbitrages, cronyism).

Hong Kong’s Vicious Inflation Cycle

Even supposed free market economies are susceptible to the follies of “free lunch” politics

From the Bloomberg, (bold highlights)

Hong Kong’s financial secretary caved in to protests over plans to bolster residents’ pension funds, opting to hand out cash and tax rebates that a week ago he said would stoke inflation.

John Tsang said he will give HK$6,000 ($770) to permanent residents aged 18 or above, abandoning a Feb. 23 budget plan to inject the same amount into their pension fund accounts after polls showed the government’s popularity slumped. The government also plans to give the 38 percent of the workforce that pays income tax a 75 percent rebate capped at HK$6,000.

“The fact that half a year of hard work preparing the budget can be thrown away and started again shows populism and not rationality dictates the policy-making process,” said Ivan Choi, a lecturer at the Chinese University of Hong Kong’s government and politics department. “The government will pay for the damage done to its integrity.”

Political parties attacked Tsang for failing to do enough to alleviate the impact of soaring food and housing costs. Asian governments are grappling with inflation fueled by rising commodity costs and capital flows from developed economies drawn by the region’s faster economic growth.

Tsang said when he announced his budget a week ago that battling inflation and getting ahead of a property bubble are his government’s main tasks this year. The cash handouts and tax rebates will cost the government about HK$40.5 billion, a government spokesman Patrick Wong said today. The pension handout was to cost the government HK$24 billion.

Politicians and the bureaucracy always attack the symptom rather than the cause. Politicians and the bureaucracy will not address the primary cause which is the inflationist “bubble” or “wealth effect” policies implemented by both the Hong Kong government and the implied transmission of the US Federal Reserves policies via the US pegged Hong Kong Dollar.

And inflation will be fed by more inflation, which eventually will be countered by price controls leading to more imbalances, and more political accommodation via inflation—until the whole process implodes.

This is just another example depicting how central planning, whether executed by the government or the central banks, does not contribute to the upholding of free market principles.

As the Ludwig von Mises wrote,

An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.

The Santa Claus principle will end with the collapse of the present monetary system.

Exploding Global Tablet Shipments: More Signs of The Third Wave

More signs of the evolving technology advances that should influence our lives.

From the Economist,

APPLE is due to launch a new version of its popular iPad on March 2nd. The company sold some 15m iPads in 2010, the year in which the device was launched, and according to one forecast it could sell more than 40m of them in 2011. But other tablet computers, in particular those based on Google's Android operating system, are expected to erode its share of a fast-growing market. In 2010 iPads accounted for about 80% of total tablet sales; by 2015 Apple's market share could fall below 40%.

Outside the context of the providers and their market shares, if you look at the forecasts, in 4 years tablet shipments are about to explode by nearly 5 times with the gist of the growth coming from tablets based on mobile technology (as we dealt with here)

The internet based “third wave” knowledge revolution is indeed accelerating.

The Philippine Government’s War Against Facebook

The Philippine government has initiated its stealth war against social media.

From the Philippine Inquirer,

Be wary of foreigners suddenly “liking” you on Facebook or other social networking sites, an official of the Philippine Drug Enforcement Agency (PDEA) advised netizens.

PDEA spokesperson Derrick Carreon said many drug mules or persons used to transport drugs through international borders were befriended and recruited online.

The Philippine government is on a slippery slope towards social media censorship and has used its war against drugs as justification.

It’s best to know that there are two different issues: war against drugs and war against social media.

Slippery slope simply means the government uses the war on drugs as a launching pad to expand political control over social media. They start with “warnings” first. Later this will be buttressed with statutes. Interventionism begets interventionism.

The war against social media is aimed at restricting the flow of information that runs against the interest of the government—via censorship.

Governments have been reeling from spontaneous People Power movements abroad fueled by social media, thus sees this information medium as a threat which must be neutralized.

For now, the so-called “warnings” are directed at the recruitment of drug Mules or carriers.

Shown below from PDEA (2008),

Drug mules have been exploding, the chart has not been updated. Yesterday’s TV news program reported 600+.

The propaganda: social media will be a major tool for the growth of drug abuse, thus must be controlled. Creeping government interventionism starts with public conditioning by indoctrination.

The Philippines is now among the top 10 major Facebook users (checkfacebook).

This means that the sin of 1,000 or less, will be used as an excuse to control the activities of 22 million Filipinos. As usual, interventionists apply the fallacy of composition to justify their actions.

Yet PDEA does NOT explain why from 20,000 reported cases of drug abuse in 1972, in 2004, the year Facebook was launched, drug usage has exploded to 6.7 million. (PDEA timeline)

The Philippine population in 1972 was 38.7 million, in 2004, the number of Filipinos grew to 83.9 million: this means about 8% of Filipinos are drug users (as of 2004), despite the statutes RA 9165, EO 218.

In short, drug trade and use has been flourishing in spite of Facebook. Facebook as a social medium functions as aggravating factor rather than the root cause.

However, Facebook will likely bear the brunt of the government [regulatory] failure (drug war) and the attempts to curtail the freedom of speech and expression.

MENA Revolts: Unfit For Democracy?

One of the most bigoted statements I’ve recently heard is that countries like the MENA are unfit or unprepared for democracy.

I’m glad to see New York Times’ Nicolas Kristof take up the cudgels against such arrogance.

Mr. Kristof writes,

“this line of thinking seems to me insulting to the unfree world. In Egypt and Bahrain in recent weeks, I’ve been humbled by the lionhearted men and women I’ve seen defying tear gas or bullets for freedom that we take for granted. How can we say that these people are unready for a democracy that they are prepared to die for?

“We Americans spout bromides about freedom. Democracy campaigners in the Middle East have been enduring unimaginable tortures as the price of their struggle — at the hands of dictators who are our allies — yet they persist.”

People who say this seem to think that the world owes them their privileges. They suffer from chronic delusions.

As Bill Bonner aptly writes,

World improvers are nice peo­ple. But they are ego­tis­ti­cal morons. They always want the best for humankind. How do they know what’s best for peo­ple on the other side of the planet? Well, they don’t. But they’re vain enough to assume that every­one wants to be like they are.

Exactly. World improvers are consumed by the conceit of the having to know better (when they don’t). And likewise believe that they hold the upper ground in the moral standings (again when they don’t) against the people of these nations.

They’re dead wrong.

As Mr. Kristof points out, people are actually risking life and limbs in pursuit of toppling the current political order to attain freedom.

Do these improvers honestly think that the lives of these revolutionaries are so cheap? Or that people revolting actually don’t know about what they’re doing? Or that these hapless people are better off living under tyrants?

Today’s MENA revolutionaries may not have a good grasp of what freedom really is, but this does not in anyway justify world improvers to make prejudicial claims about which nation deserves or don’t deserve democracy. “Judge not, that you be not judged.” says the Bible (Matthews 7:1)

We, in the Philippines, had our own experience of ousting a tyrant and an abusive leader. We just celebrated the 25^th anniversary last February 25^th.

Despite the less than idealistic outcome, as crony capitalism still plagues the country, chaos certainly has not been the outcome of the post-People power socio-political environment. Democracy, despite my protestations, has been a revered process here. The 2010 Presidential elections was marked by a high 75% voter turnout.

Also post-communist People Power revolutions in Romania, Georgia, Ukraine and others also did not turn these countries into failed states either.

And as human beings, we are no different from those in MENA despite cultural or religious variances—we all operate under the laws scarcity.

We have to be reminded that in contrast to the previous eons, today’s MENA revolutions have not been driven by ideology or by religion but about economics.

The outcome of these revolts may not end up entirely as a libertarian utopia, but this is just a step in the ongoing process towards decentralization.

I close anew with Nicolas Kristof, (bold highlights mine)

In the 21st century, there’s no realistic alternative to siding with people power. Prof. William Easterly of New York University proposes a standard of reciprocity: “I don’t support autocracy in your society if I don’t want it in my society.”

That should be our new starting point. I’m awed by the courage I see, and it’s condescending and foolish to suggest that people dying for democracy aren’t ready for it.

Indeed.

Proof of The Austrian Business Cycle: US Car Sales Rise On East Credit

More proof of the Business Cycle (Austrian) at work.

From the New York Times, (bold emphasis mine)

After radically scaling back auto lending during the financial crisis, banks and the lending arms of the automakers have started to issue loans more aggressively. Borrowers of all types are now finding it much easier to obtain a loan compared with a few months ago.

Even car buyers with tarnished credit histories are getting financing, in some cases without making a down payment. More than 859,000 new cars were sold to consumers with a so-called subprime credit rating in 2010, a nearly 60 percent increase from the year before, according to CNW Marketing Research.

The revival of auto lending is emblematic of an increased appetite for risk in the American economy. Consumers, showing renewed confidence in the recovery, are opening their wallets again after putting off car purchases during the recession.

Banks, flush with deposits to lend out, have eased their standards for extending credit. And investors, who fled from the bond market during the throes of the crisis, are starting to snap up higher-risk debt as they seek higher yields.

Wall Street’s loan packaging business has once again become a crucial engine for supplying money to auto and credit card lenders — and it is happening much faster than most economists had predicted.

Well I told ya’ so...

Confusing Freedom With Collectivism

Sometimes experts are at a seeming loss of what’s been happening in the MENA region.

PIMCO’s Mohamed El Erian at the Reuters writes,

Post-regime change countries, such as Egypt and Tunisia, are working hard to complete their revolutions and to ensure an orderly and complete transition to greater democracy and individual freedoms. Success lies in the following factors: defining a vision and associated action plan which command sufficient popular support; coordinating simultaneous progress on related economic, political and social issues; and implementing appropriate mid-course corrections as needed.

If “greater democracy and individual freedoms” means sovereignty of the individual over government then how does “defining a vision and associated action plan” happen?

Individual “plans” are much different than from those of the central planners, for the fundamental reason that the individual views the world differently and has priorities, values and preferences that are unique, thereby the individuals “plans” according to their perceived ‘unique’ interests. In short, one’s actions are one’s own.

However, since governments are composite of people, except that they are mandated to use the power coercion over the others, then “defining a vision and associated action plan” would be inconsistent with the individual sovereignty.

That’s because so-called “plans” spring from the perspective, values, preferences and priorities of the central planners and not from the collective individuals.

In essence, “greater democracy and individual freedoms” under the above context would represent a sham.

As Henry Louise Mencken once wrote, "For every problem there is one solution which is simple, neat, and wrong."

MENA’s Third Wave-Knowledge Revolts

The Heritage Foundation partly channels Alvin Toffler’s Third Wave and what I have called as the Hayekian knowledge revolution via the web/internet as previously discussed here.

Heritage’s Conn Carroll writes, (bold highlights mine)

The first wave of revolutions in the region came in the middle of the last century and was made up of nationalist revolts against European colonialism. The next wave, the Islamist revolt, came a generation later, upending corrupt monarchies and nationalist regimes set up after the colonial era. Each of these movements—nationalist and Islamist—pretended to be “pan” movements of some kind. But they never caught on because their universal claims were myths, undermined by tribal, religious, and nationalist divisions. The third wave we are witnessing today is completely different. Heritage Foundation Vice President and former Assistant Secretary of State Kim Holmes explains:

“Arab nationalism was largely an elite phenomenon that drove and exploited popular sentiments. Islamism is driven by clerics and political ideologues like the Muslim Brotherhood who likewise exploit peoples’ religious beliefs and social resentments. The current third wave of revolt is truly a bottom-up, people driven movement. It’s driven not by nationalism, Islamism or any other 20th Century “ism,” but by a 21st Century socially linked-up mass movement of people who are sick of corruption, the lack of representative government, and being poor. … Despite the unique national and tribal features of each movement, it is united by the same emotional revulsion to the ruin and corruption created by the first two waves of revolution in the Middle East. The people of Libya are no less disgusted with Qadhafi than the people of Iran are with Ahmadinejad. One may be largely Sunni Arabs and the other Shiite Persians, but both are utterly finished with the ideologies, pretentions, and results of the Middle East’s first two failed revolutions.”

The evolving political order in the Middle East can somewhat be viewed in the context of the developmental stages of the global economy.

The first wave’s “nationalist revolts against European colonialism” can be paralleled to the closure of agriculture based economy, where colonialism signified as the political economy of conquest and plunder.

The second wave’s “Islamist revolt” directed against the “monarchies and nationalist regimes” could be seen in lens of the industrial age, the age of centralization through mass production. Again these revolts perhaps reflected on the evolving desire to see a shift of political ‘centralized’ power from the failed nationalist model to an experiment with theocracies.

And the third wave’s “bottom-up, people driven movement” fundamentally an Étienne de La Boétie paradigm of grassroots based nonviolent revolution appears to represent a non-ideological backlash “sick of corruption, the lack of representative government, and being poor” against centralized institutions. And the internet has been a crucial force in providing the platform for information, inspiration and the spontaneous coordination and mobilization of these grassroots activities.

Of course one may argue that the old order (e.g. military) are the still dominant force and still would resist changes that has benefited them. While this is may be true, as all changes will be met by resistance, this ignores the point about the evolving character of how these revolutions have been taking place, which the Heritage have clearly explained.

As a caveat: since economic development varies from country to country and the timeline for these political transitions cannot be concretely established.

The Heritage Foundation raises the point that foreign policies applied by the US government have been outdated or obsolete.

I don’t think it is just the US government. I think this applies to all governments and to conventional or mainstream insights or analysis as many refuse to see how informational flows, mostly channelled through the social media, have significantly influenced the ongoing revolts against the old centralized political order.

The evolving economic order simply influences the political order. The point is that the current centralized institutions will undergo a flattening process or decentralization, which is what people power revolts have been about.

The presumption that people will simply revert to past models, simply ignores human action or the people’s capacity to LEARN and ADOPT to the changes in the environment and technology as manifested through evolving social interactions.

Another Example Of Financial Market-Real World Disconnect

People like to believe what they want to believe. Well, they are free to do so.

Here is another example of the blatant disconnect between the stock market and GDP. All charts from Tradingeconomics.com

Venezuela has still been in a recession but her stock market continues to climb.

Believing in the infallibility of conventional wisdom can mislead. Unknown to many, negative knowledge is a risk.

Dealing With Financial Market Information

Ideas and only ideas can light the darkness. These ideas must be brought to the public in such a way that they persuade people. We must convince them that these ideas are the right ideas and not the wrong ones. The great age of the nineteenth century, the great achievements of capitalism, were the result of the ideas of the classical economists, of Adam Smith and David Ricardo, of Bastiat and others. What we need is nothing else than to substitute better ideas for bad ideas-Ludwig von Mises

Markets operate on a pricing system. And prices are manifestations of people’s actions guided and coordinated by information aimed at the efficient allocation of resources.

As the great F. A. Hayek wrote[1],

Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coördinate the separate actions of different people in the same way as subjective values help the individual to coördinate the parts of his plan.

The financial or capital markets (stock markets, bond, currency, derivatives, etc...) function the same way. They are information sensitive since they operate as intermediaries of savings and investments. Perhaps they even could even represent more information sensitivity than the real economy for the following reasons:

-Financial markets today are organized formal markets that are far larger than the economy

According to the table above from McKinsey Quarterly[2], despite the 2008 crisis, financial depth still accounted for 293% of the GDP (Here financial markets include equity, bank deposits, private and government debt)

-Financial markets are more globally integrated have been buttressed by the digital technology

-Financial markets are more liquid and volatile, and have been lubricated by the central banking based monetary system.

Of course not all information are equally useful or relevant.

There are information that are considered as useful or to quote Hayek anew “only the most essential information is passed on and passed on only to those concerned[3]” and that many information are not.

Furthermore information isn’t complete. They are dispersed, localized and account only for a portion of the system, writes author Peter L. Bernstein[4], (bold emphasis mine)

The past or whatever data choose to analyze, is only a fragment of reality. That fragmentary quality is crucial in going from data to a generalization. We never have all the information we need (or can afford to acquire) to achieve the same confidence with which we know, beyond a shadow of a doubt, that a die has six sides, each with a different number, or that a European roulette wheel has 37 slots (American wheels have 38 slots), again each with a different number. Reality is a series of connected events, each dependent on one another, radically different from the games of chance in which the outcome of any single throw has zero influence on the outcome of the next throw. Games of chance reduce everything to a hard number, but in real life we use such measures as “a little”, “a lot” or “not too much please” much more often than we use a precise quantitative measure.

Falsifying Popular Delusions

This brings us to the gist of what supposedly are useful information/ facts/ data sets for the financial markets.

Here is a great example, this isn’t being nostalgic for 2008 crisis but should be a thought provoking exercise

Information/Fact A

According to ABS CBN[5] (bold emphasis mine)

In a statement Sunday, the PSE reported that the combined net income of publicly listed firms dropped to P198.91 billion in 2008 from P281.54 billion in 2007, a banner year...

Lim noted, however, that revenues of listed firms grew 12.8 percent to P2.67 trillion from P2.37 trillion.

The recent data were culled from the latest financial statements submitted by 233 out of 246 listed companies. Of the 233 reporting firms, 159 posted net gains while the remaining 74 posted net losses.

Interpretation: Public listed companies were down from a RECORD highs in 2007 but remained overall positive. To add, 68% of publicly listed posted profits in 2008.

Information/Fact B

The above is the % change of the Philippine economy courtesy of tradingeconomics.com[6]

Interpretation: Like corporate profits, the Philippine economy slowed but did not suffer a recession in 2008.

Information/ Fact C

The Phisix closed at the end of 2007 at 3,621.6 and at the year end of 2008 at 1,872.85

Interpretation: The Phisix fell 48.28% in 2008!

Analysis:

Fact A partly reflected on Fact B because Fact A is part of the computation of Fact B, or corporate profits are part of the computation for the GDP[7]

Where the conventional wisdom is to generalize

Fact A (corporate profits) + Fact B (economic growth) = Fact C (rising stock markets),

then we see that three facts tells us the contrary

A+B ≠C

The conventional wisdom of A+B=C has been demonstrably falsified.

Let me add Fact D

According to Bloomberg at yearend of 2008[8],

The S&P 500 decreased 38.5 percent, the most since the 38.6 percent plunge in 1937, to 903.25 and sank to an 11-year low of 752.44 on Nov. 20. Volatility increased, with the index rising or falling 5 percent in a single day 18 times. The Dow Jones Industrial Average slumped 34 percent to 8,776.39 for the steepest drop since 1931.

Additional analysis: The Phisix did not suffer a recession or a crisis, yet the local stock market endured MORE losses compared to the epicentre or the source of the crisis—the US markets.

In short, there has been no meaningful correlation or even an established causation nexus between corporate profits and the economy relative to the stock market under the local setting.

Asymmetric Risk Taking

Why this matters?

Because any serious or prudent investors would attempt to pursue information or assimilate knowledge that are relevant or one that works, something which Nassim Taleb calls as “positive knowledge[9]”, and presumably ignore those that don’t.

Not every individual engaged in the stockmarket or the financial markets share the same incentives: instead of the primary pursuit for profits or returns, many are there for the adrenalin (thrill or the gambling tic) or to stimulate the dopamine “brain’s pleasure centers” (intellectual or ideological strawman), some are merely active for social purposes (signalling via talking points) or possibly to simply to keep busy.

The deviance from the pursuit of profits makes risk taking activities largely asymmetric.

Thus the demand for workable ‘positive’ knowledge in the financial markets would be proportional to the desire to generate real returns. We increase our profits by dealing with information or knowledge that will give us profits.

The famous Wall Street maxim, ‘bulls and bear make money but pigs get slaughtered’ are representative of market participants who see profits or returns as a secondary priority. Of course, everyone will likely say that they are in for profits but their subsequent actions will reveal of their unstated or subliminal priorities—or that actions should speak louder than words.

The great part in today’s marketplace is that the internet has allowed us vast access to information and on real time basis. This gives us the opportunity to screen information. And this also means that filtering information will tilt one into an information junkie to the risk of an information overload.

Again from Peter Bernstein[10], (bold emphasis mine)

We tend to believe that information is a necessary ingredient to rational decision making and that the more information we have, the better we can manage the risk we face. Yet psychologists report circumstances in which additional information gets in the way and distorts decisions, leading to failures of invariance and offering people in authority to manipulate the kinds of risk that people are willing to take.

In short information or facts can be tainted.

Agency Problem, Again

This brings us to the most sensitive part of information sourcing: the principal-agent or the agency problem

Economic agents or market participants have divergent incentives, and these different incentives may result to conflicting interests.

To show you a good example, let us examine the business relationship between the broker and the client-investor.

The broker derives their income from commissions while the investor’s earning depends on capital appreciation or from trading profits or from dividends. The economic interests of these two agents are distinct.

How do they conflict?

The broker who generates their income from commissions will likely publish literatures that would encourage the investor to churn their accounts or to trade frequently. In short, the literature will be designed to shorten the investor’s time orientation.

Yet unknown to the investor, the shortening of one’s time orientation translates to higher transaction costs (by churning or frequent trading). This essentially reduces the investor’s return prospects and on the other hand increases his risk premium.

How? By diverting the investor’s focus towards frequency (of small gains) rather than the magnitude. Thus, a short term horizon tilts the risk-reward scale towards greater risk.

Nassim Taleb has shown this in the analogy of the Turkey problem[11] as shown in the chart[12] above.

The Turkey is fed from day 1 and so forth, and as a consequence gains weight through the feeding process.

From the Turkey’s point of view such largesse will persist.

However, to the surprise of the Turkey on the 1,001th day or during Thanksgiving Day, the days of glory end: the Turkey ends up on the dinner table. The turkey met the black swan.

The turkey problem is a construct of the folly of reading past performance into the future, and likewise the problem of frequency versus the magnitude, both of which serves as the cornerstone for Black Swan events.

Going back, such conflict of interest may also apply to bankers too. Bankers are likely to publish literatures that goad their clients to use their facilities where the bankers earn from having more fees than focusing on the client’s interests of generating above average returns.

At the end of the day, for both cases the gullible investor ends up holding the proverbial empty bag.

So unless one is aware of such distinction, information embellished by statistics which may be construed as facts can instead represent promotional materials.

It is important to note that conflicts of interests emanating from the agency problem played a significant or crucial role during the bubble days that was also responsible for the last crisis[13].

In addition, the common practise of politicians and their apologists to present statistical facts to promote their interventionist agenda is another example of agency problems.

Most of these facts do not objectively represent the problems in a holistic sense, but instead are selectively chosen facts or data mined statistics that fits into their theories. These proposals are also usually wrapped in logical fallacies.

And most of their so-called solutions are usually framed with noble sounding intentions so that these will easily sell to the vulnerable voters. Little do the hapless voters know that such policies focuses on the short term are booby trapped with unintended consequences.

Conclusion: Ideas Have Consequences

Bottom line:

Ideas have consequences.

And so with ideas forged by false theories.

Prudent investors need to screen, test and falsify ideas and observe their validity rather than simply accepting them without due scrutiny. Failing to do so is to assume the risks of the proverbial Wall Street Pigs that have been the traditional fodder of Bears and Bulls.

Moreover, prudent investors should adapt on ideas that are likely to produce positive results over the long term at the same time reducing the prospects of being swallowed by black swan events.

In short, prudent investors need a critical and constructive mind to examine the usefulness of information as sources for ideas that underpins the subsequent action.

In addition, prudent investors must be vigilant with the source of information as this can reflect more of the interest of the information conveyor than that of the recipient.

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[1] Hayek, Friedrich von, The Use of Knowledge in Society

[2] McKinsey Global Institute Global Capital Markets Entering a New Era, September 2009

[3] Hayek, Friedrich von ibid

[4] Bernstein, Peter L. Against The Gods: The Remarkable Story of Risk, p 121

[5] Abs-cbnNews.com Listed firms' profits down 29% in 2008, May 31, 2010

[6] Tradingeconomics.com Philippines percent change in GDP at constant prices

[7] Bureau of Economic Analysis, National Economic Accounts

[8] InfiniteUnknown.net U.S. Stocks Post Steepest Yearly Decline Since Great Depression, Bloomberg.com December 31, 2008

[9] Taleb Nassim Nicolas Anti Fragility, How To Live In A World We Don’t Understand, Chapter 5, How (NOT) To Be A Prophet fooledbyrandomenss.com

[10] Bernstein, Peter Op. cit. P.278

[11] Wikipedia.org Black swan theory

[12] Kinsella Stephan, The Turkey Problem

[13] See Agency Problem: Examples, Risks and Lessons, December 25, 2009