The Inflation Spiel From Paul Krugman

Keynesian high priest (and Nobel awardee) Paul Krugman appears to be conditioning the public of a possible turnaround in his outlook!

He writes,

The Fed could directly finance the government by buying debt, or it could launder the process by having banks buy debt and then sell that debt via open-market operations; either way, the government would in effect be financing itself through creation of base money. So?

Well, the first month’s financing would increase the monetary base by around 12 percent. And in my hypothesized normal environment, you’d expect the overall price level to rise (with some lag, but that’s not crucial) roughly in proportion to the increase in monetary base. And rising prices would, to a first approximation, raise the deficit in proportion.

So we’re talking about a monetary base that rises 12 percent a month, or about 400 percent a year.

Does this mean 400 percent inflation? No, it means more — because people would find ways to avoid holding green pieces of paper, raising prices still further.

I could go on, but you get the point: once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation. And no amount of talk about actual financial flows, about who buys what from whom, can make that point disappear: if you’re going to finance deficits by creating monetary base, someone has to be persuaded to hold the additional base.

At this point I have to say that I DON’T EXPECT THIS TO HAPPEN — America is a very long way from losing access to bond markets, and in any case we’re still in liquidity trap territory and likely to stay there for a while.

Krugman admits that the Fed can directly “finance the government by buying debt” and indirectly “launder the process by having banks buy debt” which can cause HIGH inflation.

But yet he engages in subtle sophism by saying this won’t happen for as long as the US has access to bond markets—”very long way from losing access to bond markets”.

Obviously losing access to bond markets isn’t the issue, if the Fed continues to buy US debts!

And that’s exactly what the Quantitative Easing (QE) programs are for. And QE represents no more than a shell game. In other words, such shell game is happening NOW!

Here is the statement of the US Federal Reserve announcing QE 2.0 last November (CNN Money)

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

The point is as Krugman continues to talk of inflation he prepares the public for that dramatic announcement where he’d probably mimic his idol, “When the facts change, I change my mind. What do you do sir?”

This should represent another MAJOR failure of the macroeconomic paradigm.

Graphic: Rule Of Law

Again from the ever creative mind of Jessica Hagy, a wonderful graphic depiction of social cooperation based on the rule of law. (From Indexed Be Nice; Stop plundering and looting)

Markets In Everything: Booming Sales of Underground Shelters

Markets always find ways to address people's demand for almost anything, such as demand for safety from fear of catastrophe or war.

The video below (from CNN/Mark Slavo) shows of the booming sales for bunker shelter....

The Politics Behind The UN’s No Fly Zone On Libya

The Economist has a dainty interactive graph which spells out on the diversified political incentives (interests) by nations that has participated in enforcing the UN’s No Fly zone

FRANCE and Britain led the diplomatic push for military action against Libya. The Arab League's vote, on March 12th, to call on the United Nations to enforce a no-fly zone was crucial in securing international legitimacy. The Americans were initially hesitant but were eventually won around. So much is familiar to observers of the unfolding Libya story.

Press on the country and the explanation appears.

In my view, the biggest incentive is this…

Graph also from the Economist

Outside the Arab League, perhaps the strongest incentive to intervene in Libya’s internal strife has been about oil geopolitics.

The other possible reason could be due to the earlier faux pas in foreign policy by some of the major participants.

Celebrating The Declining Influence of Luddism and Blogging

I will be blogging a little lot less over the coming days as two of my children will be having their graduation rites and I will be entertaining my mother who is a resident of Hong Kong and who also came to attend these ceremonies.

Nevertheless here is a quote from Professor Don Boudreaux on the declining influence of Luddism (bold emphasis mine)

This year marks the 200th anniversary of the birth of Luddism. In the early 19th century, many Brits worried that increasing mechanization of the textile industry posed an unfair disadvantage to flesh-and-blood workers. Many of these technology skeptics, known as "Luddites," destroyed machinery in an effort to protect flesh-and-blood workers from the competition of Technologia's workers.

Luddism, thankfully, is today embraced only by a small group of delirious romantics longing for imaginary pastoral bliss.

Hopefully, protectionism will soon go the way of Luddism, freeing us from the superstition that trade with foreigners is less enriching than is trade with fellow citizens.

As people get to realize and adapt more of what represents as a genuine workable way to prosperity via free trade, protectionism grounded on the fantasies of Luddism will hopefully fade away too.

Video: Understanding The Difference Between Private and Public Enterprises

Dr. Robert Murphy explains the fundamental difference between private businesses and public enterprises.

Falling US Home Sales Points To QE 3.0

The Reuters reports,

Sales of new U.S. homes sank to a record low in February and prices were the weakest since December 2003, showing the housing market slide was deepening.

The Commerce Department said on Wednesday sales of new single-family homes dropped 16.9 percent to a seasonally adjusted 250,000 unit annual rate, the lowest since records began in 1963, after a 301,000-unit pace in January.

The following charts from Northern Trust....

As I earlier wrote

Under enfeebled housing conditions, a failure to continue with the QE amplifies the risks of falling housing prices thereby jeopardizing the fragile state of the US banking system

Looks like Quantitative Easing (QE) 3.0 is underway

Global Equity Markets: China Grabs Second Spot (In Terms Of Market Cap)

In February of this year, China surpassed Japan as the second largest economy in the world.

Recent events have likewise altered China’s ranking in the global equity markets (in terms of market capitalization) where China has snatched the second place from Japan.

The US remains on top as the largest equity market in the world, but has seen a steady decline in terms of market share. Most of this decline has been due to the outperformances of many emerging market bourses.

According to Bespoke Invest, (table and charts from Bespoke)

Japan's stock market declined nearly 20% in the days immediately following the tragic earthquake that hit the country on March 11th. While Japanese equities have bounced back a bit, the fall allowed China to surpass Japan in terms of percentage of world market cap.

...As shown, the US continues to hold onto the number one spot by a wide margin at 30.43%. Japan had the second largest market cap in the world at the start of the year, but China has now surpassed Japan and currently ranks second. China currently makes up 7.38% of world market cap, while Japan makes up 7.05%. The UK ranks fourth at 6.49%, followed by Hong Kong (4.77%), Canada (4.38%), and France (3.59%).

The following charts depict on the long process of how China surpassed Japan...

Basically the divergent performances can be seen as Japan’s stagnation vis-a-vis the Chinese juggernaut.

China’s elevated ranking in the global equity markets has aligned with her economic standing relative to the world--a manifestation of shifting wealth distribution.

Rising Inflation Expectations: Why Macro Economists Can’t See It Coming

This is an example why macro-models used by mainstream experts don’t get it.

From the Wall Street Journal Blog (bold emphasis mine)

The Federal Reserve expects higher price pressures to be “transitory.” But other economic players aren’t so sure.

A new survey of finance professionals done by J.P. Morgan shows core inflation expectations are rising around the world.

In the U.S. specifically, the mean response is that core inflation, as measured by the consumer price index excluding food and energy, will be running 1.8% a year from now. That is up from 1.4% when the survey was last done in November and up from February’s actual reading of 1.1%. The survey polled about 750 respondents, with about 40% from North America.

The report notes the recent jump in oil prices and the longer-running increase in commodity prices may be skewing responses. But the report notes core inflation rates have already been rising in the U.S. and the U.K.

Duh?!

Core inflation expectations have long been rising around the world! Don’t these experts see that the REVOLTS in the Middle East have partly been triggered by record food prices??!!!

Chart from Business Insider

Next, price pressures are “transitory”???!!!

The IMF even says that people should get used to high food prices for all other reasons except macroeconomic government policies. The IMF is part of mainstream macro.

From the Bloomberg,

Consumers should get used to paying more for food, after prices rose to a record, because farmers will take years to expand production enough to meet demand and drive down costs, the International Monetary Fund said.

People in developing countries are becoming richer and eating more meat and dairy, meaning more grain for livestock feed and land for grazing animals, Thomas Helbling, an adviser for the IMF’s research department, and economist Shaun Roache wrote in an article. Rising demand for biofuels and bad weather also tightened supply, they said.

“Rising food prices may be here to stay,” Helbling and Roache wrote in the article published in the agency’s Finance & Development magazine. “The main reasons for rising demand for food reflect structural changes in the global economy that will not be reversed.”

True, food prices signify a minor component in the household expenditure pie for developed economies. But that doesn’t mean that rising oil, food and commodity prices won’t spillover to the rest of the economy. Eventually they will!

Chart from Northern Trust

When models try to isolate variables from people’s action (like isolating food and energy from inflation index as shown above-right window), then experts tend to underestimate real social activities, like inflation.

People do not act based on one or two or select variables. Our actions are bundled, as I previously wrote

We cannot isolate one variable from the other. People’s actions are responses to an ever dynamic “bundled” environment shaped by laws, markets, culture, environment, etc...

Bottom line: macroeconomics tends to deal with superficial issues that are bottled up in laboratory environment models rather than lay blame on what truly causes CPI inflation—inflationism (low interest rates and money printing) and interventionism (price controls, subsidies and etc..).

Quote of the Day: The Failure of Macro Economic Policies

From Columbia University Professor Joseph Stiglitz writing on the IMF Blog, (bold emphasis his) [hat tip: Greg Ransom]

The most remarkable aspect of the recent conference at the IMF was the broad consensus that the macroeconomic models that had been relied upon in the past and had informed major aspects of monetary and macro-policy had failed. They failed to predict the crisis; standard models even said bubbles couldn’t exist—markets were efficient. Even after the bubble broke, they said the effects would be contained. Even after it was clear that the effects were not “contained,” they provided limited guidance on how the economy should respond. Maintaining low and stable inflation did not ensure real economic stability. The crisis was “man-made.” While in standard models, shocks were exogenous, here, they were endogenous.

In short, math models fail to predict the complexities of human action.

The Daily Show Explains US Foreign Policy On Libya

Hilarious but politically poignant stuff from Jon Stewart (HT Bob Murphy)

The Daily Show - Odyssey Dawn - Unconstitutional War
Tags: Daily Show Full Episodes,Political Humor & Satire Blog,The Daily Show on Facebook

Seth Godin On The Diminishing Force Called Gatekeepers

From my favourite marketing guru Seth Godin, (bold highlights mine)

Amanda Hocking is making a million dollars a year publishing her own work to the Kindle. No publisher.

Rebecca Black has reached more than 15,000,000 listeners, like it or not, without a record label.

Are we better off without gatekeepers? Well, it was gatekeepers that brought us the unforgettable lyrics of Terry Jacks in 1974, and it's gatekeepers that are spending a fortune bringing out pop songs and books that don't sell.

I'm not sure that this is even the right question. Whether or not we're better off, the fact is that the gatekeepers--the pickers--are reeling, losing power and fading away. What are you going to do about it?

Read the rest here.

Whether applied to commerce, music or politics, the forces of technology aided decentralization appear to be rapidly eroding the power of centralized “gatekeepers”.

Gaddafi Financing Libya’s War With Gold

If there is one way to go around sanctions, then having a pile of gold could make the difference. Well, that’s how Libya’s Muammer Gaddafi has reportedly been able to finance his war.

From the Financial Times,

The international community has hit Muammer Gaddafi with a raft of sanctions and asset freezes aimed at cutting off his funding. But the embattled Libyan leader is sitting on a pot of gold.

The Libyan central bank – which is under Colonel Gaddafi’s control – holds 143.8 tonnes of gold, according to the latest data from the International Monetary Fund, although some suspect the true amount could be several tonnes higher.

Those reserves, among the top 25 in the world, are worth more than $6.5bn at current prices, enough to pay a small army of mercenaries for months or even years.

While many central banks hold their gold reserves in international vaults in London, New York or Switzerland, Libya’s bullion is in the country, said people familiar with the country’s activities in the gold market.

As I earlier pointed out, part of gold role’s in the Middle East crisis has been as “alternative ways to shelter assets”.

More from the same article,

The political turbulence in the Middle East – besides boosting the price of gold to a record $1,444 a troy ounce – has highlighted the property that has for centuries made gold so appealing to criminals, investors and dictators alike: it does not rely on a government for its value.

Following the revolution in Egypt, the country banned gold exports for four months in order to prevent officials of the former government from moving their wealth abroad.

At the same time, Iran has been quietly stocking up on gold in recent years, in an apparent attempt to shift away from the US dollar and thus protect its reserves from risk of seizure. Other significant buyers of gold include China, Russia and India.

Maverick governments are learning to see the role of Gold as an anti-establishment currency.

More signs of Gold gradually reacquiring its lost role as money.

Japan’s Calamity: Costliest Disaster Ever

Japan’s recent 1-2-3 calamity has been reported to be the costliest disaster ever.

The Economist writes,

JAPAN is still reeling from the earthquake and tsunami that struck its north-east coast on March 11th, with the government struggling to contain a nuclear disaster and around 10,000 people still unaccounted for. Provisional estimates released today by the World Bank put the economic damage resulting from the disaster at as much as $235 billion, around 4% of GDP. That figure would make this disaster the costliest since comparable records began in 1965. The Indian Ocean tsunami in 2004, which caused some 250,000 deaths, does not feature on this chart. Economic losses there amounted to only $14 billion in today’s prices, partly because of low property and land values in the affected areas.

This is an example where the losses from natural disasters are narrowly viewed in monetary terms. I am not sure if the estimates have quantified casualties in money terms (any estimates will likely be inaccurate and underestimate the value of human lives)

While the $ based losses may be huge, Japan’s disaster seems only a fraction of the 2004 Indian Ocean tsunami in terms of deaths.

For me, lives lost, injuries, displacement and trauma from the disasters are more important (or cost more) than $ based property damages.

Reinventing Nuclear Energy: Thorium

Prolific author Matt Ridley is for Thorium, in lieu of Nuclear reactors. (From Wall Street Journal-all bold highlights mine)

Against this formidable competitor, uranium will struggle for many years to come—especially with the extra cost and political handicap that Fukushima is bound to add. So nuclear needs to reinvent itself. Because nuclear reactors were developed by governments in a wartime hurry, the best technological routes were not always taken. The pressurized-water design was a quick-and-dirty solution that we have been stuck with ever since. Rival ideas withered, among them the thorium liquid-fuel reactor, powered by molten fluoride salt containing thorium.

Thorium has lots of advantages as a nuclear fuel. There is four times as much of it as uranium; it is more easily handled and processed; it "breeds" its own fuel by creating uranium 233 continuously and can produce about 90 times as much energy from the same quantity of fuel; its reactions produce no plutonium or other bomb-making raw material; and it generates much less waste, with a much shorter half life until it becomes safe, so the waste can be stored for centuries rather than millennia.

A thorium reactor needs neutrons, and both ways of supplying these subatomic particles are relatively safe. They can be introduced with a particle accelerator, which can be turned off if danger threatens. Or they can be introduced with uranium 235, which in this process has a much lower risk of an uncontrolled reaction than it does in today's nuclear plants. The fuel cannot melt down in a thorium reactor because it is already molten, and reactions slow down as it cools. A further advantage of this design is that the gas xenon is able to bubble out of the liquid fuel rather than—as in normal reactors—staying in the fuel rods and slowly poisoning the reaction.

Nobody knows if thorium reactors can compete on price with coal and gas. India has been working on thorium for some years, but the technology is as different from today's nuclear power as gas is from coal, and very few nuclear engineers even hear about liquid fuel during their training, let alone get to work on it.

New technologies always struggle to compete with well-entrenched rivals whose costs are already sunk. The first railways couldn't rival canals on cost or reliability, let alone lobbying power.

Now is the time to start to find out about thorium's potential.

At the end of the day, energy is about economics.

Video: Hans Rosling On How The Washing Machine Enhances Our Lives

Fascinating talk by Hans Rosling. (hat tip: Steve Horwitz)

Video: A History of Central Banking

Here is a short video on the history of Central Banking from Cato’s Dan Mitchell...

Here is the list of US and world financial crisis from Misis.org wiki (click on the link to redirect you to the page)

Here is a graph of the number of banking crisis worldwide post the Nixon Shock or the End of the Bretton Woods standard (from the World Bank)

The reason I had to include these is to illustrate how central banks have fundamentally failed to contain panics-the rationalized role for their existence.

Are Dictatorships Bullish For the Markets?

Dictatorships are bullish for the markets, David Kotok of Cumberland Advisers says so, (bold highlights mine)

In the reality check currently underway, the seats of power (Sultans-Kings-Sheiks-or their sons) do not easily yield that power to kids with stones and Facebook. The king must either be outgunned (Libya) or he wins and the kids are punished harshly. In Saudi Arabia, Bahrain and elsewhere in MENA we are witnessing an outcome that is a blend of policy discussed in two classics. For details, see Metternich and what is called “Realpolitik.” For profiles of the victors in MENA, visit Machiavelli’s “The Prince.” In MENA, bullets triumph over ballots.

Okay, freedom loses. Kids die. It is a sad day for those of us who wish it were otherwise.

But for markets, it becomes a bullish outcome. Markets like stability and predictability. Markets know that kings with armies are stable and reliable. The players in these markets would not like to be born to the common class in those countries. These players like their life in freedom.

First of all, it’s rather sad and unfortunate to hear the hue of schadenfreude undergird such seemingly ‘prejudiced’ statements. These are what give capitalism a bad reputation. [Actually what Mr. Kotok cheers for is a crony based capitalism-dancing with dictators]

Second, is Mr. Kotok suggesting that “kings with armies” represent as stable political economic arrangements? If so, then why the chain of revolts?

Below is an interactive graph from the Economist of some possible factors that may have influenced the MENA revolts

Where dictators corner the resources of a nation at the expense of the majority, does Mr. Kotok honestly expect their constituents to remain forever docilely repressed?

You guys are so fortunate NOT to be on their places!

Three, markets have not been as cooperative with the Cumberland team, since they declared that they went to raise cash holdings from the emergence of MENA’s political uncertainties.

Yet it’s more of Japan’s natural disaster issues that have rocked the boat more than the MENA issues.

Thus seeing the market’s uncooperativeness, the Cumberland shifts from bearish to fully invested.

Fourth, the issue of “Realpolitik” have not been resolved.

The Saudi-led intervention in Bahrain has not entirely quelled dissent.

Politics represents an ongoing process. Thus, whatever short-term gains achieved by the present coercive actions of the consortium of dictators may or may not last.

Today’s defection of Yemen’s key army commanders partially rebuts the idea that incumbents “do not easily yield that power to kids with stones and Facebook”. Maybe not easily, but this only shows that “facebook and kids with stones” have the power to turn the army on their sides.

Don’t forget armies are composite of people---who can be swayed by influences (like networks-families, friends or culture-religion).

As a saying goes... It’s not over till the fat lady sings.

Like it or not, “Kids with stones and Facebook” will play a far crucial role in shaping the geopolitical context than most experts would expect.

Managing Risk and Uncertainty With Emotional Intelligence

If your emotional abilities aren't in hand, if you don't have self-awareness, if you are not able to manage your distressing emotions, if you can't have empathy and have effective relationships, then no matter how smart you are, you are not going to get very far.-Daniel Goleman, Emotional Intelligence

Markets thrive on information. Information is processed as knowledge. Thus knowledge which coordinates people’s actions through prices, determines the risk-reward tradeoff.

Amgydala’s Fight or Flight Response[1]

When uncertainties or the prospect of peril emerges, our brain’s amygdala responds by impelling us either to fight or to take flight. That’s because our brain has been hardwired from our ancestor’s desire for survival—they didn’t want to be the next meal for predators in the wild.

Applied to the present state of the markets, the legacy of our ancestor’s base instincts still remains with us.

Yet in face of market turmoil, some would say “when in doubt get out”. But that’s an absurd statement to begin with.

First, there is hardly any market that operates without a doubt. Markets exist exactly with the aim to reduce such uncertainties, risk and or doubts.

As the great Ludwig von Mises pointed there is nothing certain, and everything is subject to speculation[2]

Future needs and valuations, the reaction of men to changes in conditions, future scientific and technological knowledge, future ideologies and policies can never be foretold with more than a greater or smaller degree of probability. Every action refers to an unknown future. It is in this sense always a risky speculation.

Two, the sheer prospects of black swan event (low probability, high magnitude impact) like Japan’s nuclear crisis always lurks somewhere.

Again, our understanding is always based on incomplete knowledge.

In contrast to the act of taking flight, doubts are where profits reside.

It’s basically a battle between the emotional and the rational. This is magnificently encapsulated by the Wall Street axiom “Bears and Bulls make money Pigs get slaughtered”.

Pigs get slaughtered because they depend on the amygdala to direct their actions. In short, when emotions hijack our rationality then we react senselessly and increase our risks.

Emotional Phases of Investing

The chart above illustrates how overconfidence or extreme depressions mark the inflection points of major market trends. In other words, when the consensus reveals certainty about a specific trend, that’s the time to take the classic contrarian stance—stay on the opposite side of the trade!

As author and economist the late Peter Bernstein wrote[3], (bold highlights mine)

In their calmer moments, investors recognize their inability to know what the future holds. In moments of extreme panic or enthusiasm, however, they become remarkably bold in their predictions; they act as though uncertainty has vanished and the outcome is beyond doubt. Reality is abruptly transformed into that hypothetical future where the outcome is known. These are rare occasions, but they are also unforgettable: major tops and bottoms in markets are defined by this switch from doubt to certainty.

Three, when dealing with the financial markets, it is the Emotional Intelligence (EI)—or the argued ability, capacity, skill or, in the case of the trait EI model, a self-perceived ability to identify, assess, and control the emotions of oneself, of others, and of groups[4]--that is essential.

The management of the emotions is critical to weighing risk-reward tradeoff.

Psychologist and author Daniel Goleman offers 4 main ways to manage Emotional Intelligence:

-Self-awareness – the ability to read one's emotions and recognize their impact while using gut feelings to guide decisions.

-Self-management – involves controlling one's emotions and impulses and adapting to changing circumstances.

-Social awareness – the ability to sense, understand, and react to others' emotions while comprehending social networks.

-Relationship management – the ability to inspire, influence, and develop others while managing conflict.

Thus when the stream of information suggests that the ensuing problems, like Japan’s nuclear crisis, are becoming less uncertain, what then we have is a transformation of uncertainty (immeasurable risk) to a quantified risk environment (measurable losses). Thus, the market starts to discount the ‘negative’ information.

And that’s why the effect of calamities on the financial markets has usually had limited impact[5].

Let me add that the problems that beset Japan today has been one of technical (how to control the risk of contamination from the affected nuclear power and the disaster rehabilitation or rebuilding) more than about sociology (social relations).

This makes the ongoing interventions in the Middle East by the Saudi Arabia-led GCC forces on Bahrain[6] and UN sanctioned military strikes in Libya[7] as having the probability of more lasting adverse impact than Japan because the MENA events represents social problems.

What would pose as the uncertainty factor would be the consequences or the possible unforeseen events from these interventions, e.g. how will Iran (Shiite) respond to Saudi’s (Sunni) aggressive actions given the sphere of influence conflict between Islam sect Shia-Sunni? Will Iran’s response be benign or will it provoke or parlay into a regional armed conflict which should drag the entire world with it?

The point here is to distinguish the source of uncertainty and ascertain how will it be resolved or dealt with. The events in itself do not constitute as market risks, it is the chain of 'stimulus-response' and 'action-reaction' based on the interpretations of the consequences of these events that constitutes as uncertainties or risks.

I close this with a quote from the great Professor Ludwig von Mises[8], (bold highlights mine)

In the real world acting man is faced with the fact that there are fellow men acting on their own behalf as he himself acts. The necessity to adjust his actions to other people's actions makes him a speculator for whom success and failure depend on his greater or lesser ability to understand the future. Every action is speculation. There is in the course of human events no stability and consequently no safety

---

[1] Royal Air Force, On Field Discipline 2004

[2] Mises, Ludwig von VI. UNCERTAINTY: Uncertainty and Acting Chapter 6 Section 1, Human Action

[3] Bernstein Peter, quoted from A Study Of Market History And Valuation Through Graham And Buffett And Others By John Chew, istockanalyst.com

[4] Wikipedia.org Emotional intelligence

[5] See Will Japan’s Earthquake-Tsunami Be Market Bearish Or Bullish? March 13, 2011

[6] See Saudi Arabia Led GCC Intervention In Bahrain March 15, 2011

[7] See Fearing A Slap On The Face, UN Sanctions A No-Fly Zone, March 18, 2011

[8] Mises, Ludwig von VI. UNCERTAINTY: Case Probability; Chapter 6 Section 4 Human Action

Market’s Addiction To Inflationism As Seen In The Currency Markets

Exchange-rate policies produce the usual spiral of interventionism: the de facto consequences tend to diverge from the original intentions, prompting further rounds of doomed interventions. This interventionist escalation is not only limited to an incessant repetition of the same failed policies, but the errors committed in one policy area also affect other parts of the economy. Thus, it is only a matter of time until errors of monetary policy lead to fiscal fiascos, and exchange-rate interventions lead to trade conflicts.- Dr. Antony P. Mueller

The markets loudly cheered on Japan’s aggressive engagement of her version of quantitative easing. Even more ecstatically to the joint intervention by the G-7 on the currency market to weaken the Japanese Yen.

As I earlier pointed out, there is little relevance between Japan’s money printing and the containment of the radiation risk[1], as well as, the weakening of the Yen which may, on the contrary, even harm the recovery process, as a weak currency would increase the prices of imports which Japan sorely needs for her public works[2].

Yet this is exactly what I have been driving about since time immemorial, the global financial markets addiction to inflationism.

It’s not clear how effective such interventions work. The last time Japan intervened massively in the currency markets in 2004 (£150 billion[3]) as shown in the above chart[4] the result was an apparent failure.

To add, this week’s market meltdown, despite manifesting some signs of 2008 or across the board selloff, lacked the traditional safehaven features: the US dollar (USD) hardly rallied (red circle below the YEN) while the rally in US treasuries (UST) had likewise been unimpressive!

Meanwhile the Euro (XEU) substantially firmed while the Yen (XJY) soared by 3.3% on Wednesday March 16^th! But the Yen gave up much of its gains on Friday following the G-7 announcement.

Reports say that the repatriation trade has been exaggerated.

According to the Finance Asia[5],

Japanese insurers are well-hedged at about 70% and have huge holdings in government bonds, which they could easily sell if they needed yen. And the industry is reinsured by the government anyway, so there is no shortage of yen in the insurance market.

The repatriation trade is, at best, premature, but the rumour of its existence was enough eventually to tip the market into a forced sell-off yesterday as dollar/yen sank below 80.

Mrs Watanabe, the archetypal Japanese housewife, typically holds a long position in US dollars. By Tuesday, those positions reached an all-time peak and, with dollar/yen parked close to 80, foreign speculators anticipating repatriation flows started to sell in the early hours of yesterday morning as trading moved from New York to Tokyo and liquidity was exceptionally low.

It is unclear if these reports are accurate and dependable, but it would seem that the steep overnight climb of the Yen has been unwarranted.

And thus, the markets natural response has been to sell down the Yen down which apparently has been exacerbated by the G-7 intervention.

Furthermore, critical credit markets hardly budged.

US Cash indices and 3M Libor OIS spread for both the US and the Euro, had seen little signs of anxiety in the face of the meltdown.

All these simply evince of a knee jerk fear premium.

In addition, the European Financial Stability Facility [EFSF] has been reinvigorated which may have given some legs to the Euro. According to the Danske Bank research team[6],

The negative events seem to have overshadowed the positive news that EU leaders agreed on new terms for the EFSF. The lending capacity of the existing facilities has been increased to EUR500bn and the EFSF has been allowed to purchase bonds in the primary market. This could prove a substantial help for Portugal. In addition, the interest rate has been lowered for Greece and the maturity extended after Greece agreed to sell state owned assets worth EUR50bn. The moves by the EU leaders were ahead of market expectations and are positive for peripheral spreads and therefore for the banking sector.

The actions of the Euro have basically been fulfilling what we have been saying throughout 2010[7].

Bottom line:

The current environment has clearly departed from the 2008 episode.

Moreover, like Pavlov’s dogs, financial markets have been elated by inflationism, which only means that current market trends can continue if governments continued to inflate.

---

[1] See Japan’s Disaster Recovery Program: Wishing Away Real Problems With A Tsunami of Money, March 15, 2011

[2] See Currency Intervention: Japan And The G-7 Aims To Boost Stock Markets, March 18, 2011

[3] Businss TimesOnline.co.uk Japan ends its £150bn currency intervention as economy firms, March 24, 2004

[4] Shedlock Mish Currency Intervention Madness, Japan Intervenes to Weaken the Yen, September 15, 2010

[5] Finance Asia, Mrs Watanabe, not repatriation, driving yen volatility, March 18, 2011

[6] Danske Bank, Weekly Credit Update, March 18, 2011

[7] See Ireland’s Woes Won’t Stop The Global Inflation Shindig, November 22, 2010; See Buy The Peso And The Phisix On Prospects Of A Euro Rally, June 14, 2010