Why We Should Be Wary of the Confirmation Bias

From the prodigious Matt Ridley writing at the Wall Street Journal,

One of the alarming things about confirmation bias is that it seems to get worse with greater expertise. Lawyers and doctors (but not weather forecasters who get regularly mugged by reality) become more confident in their judgment as they become more senior, requiring less positive evidence to support their views than they need negative evidence to drop them.

The origin of our tendency to confirmation bias is fairly obvious. Our brains were not built to find the truth but to make pragmatic judgments, check them cheaply and win arguments, whether we are in the right or in the wrong.

I find this very relevant, especially the last sentence. Debates at social network sites seem as testament to these.

Will North Korea Pursue Economic Liberalization?

This should signify as a wonderful development if this would materialize.

From Reuters,

Impoverished North Korea is gearing up to experiment with agricultural and economic reforms after young leader Kim Jong-un and his powerful uncle purged the country's top general for opposing change, a source with ties to both Pyongyang and Beijing said.

The source added that the cabinet had created a special bureau to take control of the decaying economy from the military, one of the world's largest, which under Kim's father was given pride of place in running the country.

The downfall of Vice Marshal Ri Yong-ho and his allies gives the untested new leader and his uncle Jang Song-thaek, who married into the Kim family dynasty and is widely seen as the real power behind the throne, the mandate to try to save the battered economy and prevent the secretive regime's collapse.

The source has correctly predicted events in the past, including North Korea's first nuclear test in 2006 days before it was conducted, as well as the ascension of Jang.

The changes could herald the most significant reforms by the North in decades. Previous attempts at a more market driven economy have floundered, most recently a drastic currency revaluation in late 2009 which triggered outrage and is widely believed to have resulted in the execution of its chief proponent.

"Ri Yong-ho was the most ardent supporter of Kim Jong-il's 'military first' policy," the source told Reuters, referring to Kim Jong-un's late father who plunged the North deeper into isolation over its nuclear ambitions, abject poverty and political repression.

The biggest problem was that he opposed the government taking over control of the economy from the military, the source said, requesting anonymity to avoid repercussions.

North Korea's state news agency KCNA had cited illness for the surprise decision to relieve Ri of all his posts, including the powerful role of vice chairman of the ruling party's Central Military Commission, though in recent video footage he had appeared in good health.

Ri was very close to Kim Jong-il and had been a leading figure in the military. Ri's father fought against the Japanese alongside Kim Jong-il's late father Kim Il-sung, who founded North Korea and is still revered as its eternal president.

The revelation by the source was an indication of a power struggle in the secretive state in which Kim Jong-un and Jang look to have further consolidated political and military power.

Kim Jong-un was named Marshal of the republic this week in a move that adds to his glittering array of titles and cements his position following the death of his father in December. He already heads the Workers' Party of Korea and is first chairman of the National Defence Commission.

Observe that despotic or totalitarian regimes, in realization of the futility of their centralized political institutions, have slowly been giving way to globalization.

However this runs in contrast to formerly free (developed) economies who seem to be progressively headed towards fascism if not despotism.

The opposite path of political directions represents the major force that will drive wealth convergence.

Quote of the Day: Constructing Freedom-Oriented institutions

From libertarian Wendy McElroy at the Laissez Faire Books, (bold original)

What is an institution?

An institution is any stable and widely-accepted mechanism for achieving social and political goals. Traditional institutions of society include the family, court systems, the free market, and churches. Institutions generally evolve over time to reflect the history and dynamics of a culture. For example, the institution of common law evolved on a grassroots level to meet the demand for justice by average people. Equally, the institutions of money and the market arose to satisfy human need and desire for goods.

As those needs and desires change, so do the institutions. Sometimes the change occurs due to conscious human design. Trial by a jury of one’s peers, for example, was a procedure consciously designed to maximize the justice of verdicts. This court procedure weathered the test of time well enough to now be viewed as a cornerstone of Western jurisprudence. When institutions are responsive and grassroots in nature, they become such a natural part of human progress that they change in a spontaneous manner, as in the continuing evolution of language. Like the free market, they strongly encourage peaceful interaction because that is what benefits the vast majority of people.

The political system is the institution upon which libertarians focus. They commonly observe that politics ‘institutionalizes corruption’; political structures and procedures encourage bad results like the personal malfeasance of elected figures. A large reason for the corruption is that the political system is not responsive, not grassroots. As a static institution, it serves the embedded interests of an elite class rather than the dynamic ones of the average person. (The elite class consists of politicians and those with political pull.) What libertarians call ‘corruption’ is what the elites call ‘profit’. They have consciously sculpted the institution to increase their profits through such procedures as non-transparency.

In a sense, the embedded corruption of politics is good news for libertarians because it spotlights a basic truth about institutions. They can promote liberty or statism depending upon their structure, procedures and the embedded incentives. The Founding Fathers knew this. For example, they attempted to limit the government by constructing a tripartite system of checks and balances designed to prevent the centralization of power. The Bill of Rights created incentives toward liberty by laying down societal ground rules to be upheld by the Supreme Court. (Whether the best intentions of the Founding Fathers were doomed to defeat by the inherent nature of politics is debatable.)

The specific structures and procedures of any institution will determine the results it produces. As long as the procedures are followed, the motives of those participating in the institution are irrelevant. Elsewhere, I offered the example of a man who works in a candy factory with the intention of producing canned tuna. As long as he follows the workplace rules and procedures, however, he will produce candy. A police officer may want to promote libertarian justice but as long as he enforces the laws of a totalitarian state, he will produce injustice.

Equally, as long as everyone respects the rules of the free market, it will function as a mechanism of peace and prosperity even if some of its participants are ill intentioned human beings. You may buy goods from a man whom you would never allow into your home; he can detest your religion or skin color even as money peacefully changes hands. As long as the rules of the free market are observed, freedom itself is served.
The burning question now becomes: how do we construct institutions that encourage liberty?

Conclusion

There are two answers on how to construct freedom-oriented institutions. The first: do not to construct them at all. Allow them to evolve through the spontaneous interaction of individuals pursuing their own self-interest. This is how free markets function, families are created, free speech rings out… Many institutions require merely to be unobstructed.

But other institutions require some design beyond the “anything that is peaceful” rule. For example, a court system requires procedures of justice such as “innocent until proven guilty.” And, so, the second answer to designing institutions is: do so in as minimal a manner as possible and only to promote individual rights.

The Impact of Financialization on Economic Growth and the Austrian Business Cycle

Great stuff from the Bank of International International Settlements (BIS), where they come up with a study on the diminishing returns from the financial sector.

Stephen G Cecchetti and Enisse Kharroubi of the BIS concludes, (bold emphasis mine)

In this paper, we study the complex real effects of financial development and come to two important conclusions. First, financial sector size has an inverted U-shaped effect on productivity growth. That is, there comes a point where further enlargement of the financial system can reduce real growth. Second, financial sector growth is found to be a drag on productivity growth. Our interpretation is that because the financial sector competes with the rest of the economy for scarce resources, financial booms are not, in general, growth enhancing. This evidence, together with recent experience during the financial crisis, leads us to conclude that there is a pressing need to reassess the relationship of finance and real growth in modern economic systems. More finance is definitely not always better

In my view this BIS study exhibits tight relevance to, if not provides proof of the Austrian Business Cycle theory (ABCT)…

From the great Professor Murray N. Rothbard [Economic Depressions: Their Causes and Cure] (bold my comments)

The Ricardian analysis of the business cycle went something as follows: The natural moneys emerging as such on the world free market are useful commodities, generally gold and silver. If money were confined simply to these commodities, then the economy would work in the aggregate as it does in particular markets: a smooth adjustment of supply and demand, and therefore no cycles of boom and bust. But the injection of bank credit adds another crucial and disruptive element. For the banks expand credit and therefore bank money in the form of notes or deposits which are theoretically redeemable on demand in gold, but in practice clearly are not…

The banks, then, happily begin to expand credit, for the more they expand credit the greater will be their profits. This results in the expansion of the money supply within a country, say England. As the supply of paper and bank money in England increases, the money incomes and expenditures of Englishmen rise, and the increased money bids up prices of English goods. The result is inflation and a boom within the country.

But this inflationary boom, while it proceeds on its merry way, sows the seeds of its own demise. For as English money supply and incomes increase, Englishmen proceed to purchase more goods from abroad. Furthermore, as English prices go up, English goods begin to lose their competitiveness with the products of other countries which have not inflated, or have been inflating to a lesser degree. Englishmen begin to buy less at home and more abroad, while foreigners buy less in England and more at home; the result is a deficit in the English balance of payments, with English exports falling sharply behind imports. But if imports exceed exports, this means that money must flow out of England to foreign countries. And what money will this be? Surely not English bank notes or deposits, for Frenchmen or Germans or Italians have little or no interest in keeping their funds locked up in English banks. These foreigners will therefore take their bank notes and deposits and present them to the English banks for redemption in gold — and gold will be the type of money that will tend to flow persistently out of the country as the English inflation proceeds on its way. But this means that English bank credit money will be, more and more, pyramiding on top of a dwindling gold base in the English bank vaults. As the boom proceeds, our hypothetical bank will expand its warehouse receipts issued from, say 2,500 ounces to 4,000 ounces, while its gold base dwindles to, say, 800. As this process intensifies, the banks will eventually become frightened. For the banks, after all, are obligated to redeem their liabilities in cash, and their cash is flowing out rapidly as their liabilities pile up. Hence, the banks will eventually lose their nerve, stop their credit expansion, and in order to save themselves, contract their bank loans outstanding. Often, this retreat is precipitated by bankrupting runs on the banks touched off by the public, who had also been getting increasingly nervous about the ever more shaky condition of the nation's banks.

The bank contraction reverses the economic picture; contraction and bust follow boom. The banks pull in their horns, and businesses suffer as the pressure mounts for debt repayment and contraction. The fall in the supply of bank money, in turn, leads to a general fall in English prices. As money supply and incomes fall, and English prices collapse, English goods become relatively more attractive in terms of foreign products, and the balance of payments reverses itself, with exports exceeding imports. As gold flows into the country, and as bank money contracts on top of an expanding gold base, the condition of the banks becomes much sounder. [the boom is followed by a bust which extrapolates to the financial sector size has having an inverted U-shaped effect on productivity growth. Boom initially drives up productivity and eventually contracts when the bust appears, hence the U-shape effect—my comment].

This, then, is the meaning of the depression phase of the business cycle. Note that it is a phase that comes out of, and inevitably comes out of, the preceding expansionary boom. It is the preceding inflation that makes the depression phase necessary. We can see, for example, that the depression is the process by which the market economy adjusts, throws off the excesses and distortions of the previous inflationary boom, and reestablishes a sound economic condition. The depression is the unpleasant but necessary reaction to the distortions and excesses of the previous boom. [the boom which is followed by a bust shows that “financial sector growth is found to be a drag on productivity growth”. Whatever temporary gains acquired from the boom are lost through capital consumption thus “financial booms are not, in general, growth enhancing”—my comment]

Chinese Political Neo Luddites and How Productivity Means More Employment

The clashing visions of entrepreneurs, whom in general desires to improve productivity through the marketplace (profit and loss system), and political agents, who looks at immediate needs for the purpose of staying in power, can be best illustrated by the proposed wide scale adaption of robotics in China’s economy.

From technologyreview.com

One of the defining narratives of modern China has been the migration of young workers—often girls in their late teenage years—from the countryside into sprawling cities for jobs in factories. Many found work at Foxconn, which employs nearly one million low-wage workers to hand-assemble electronic gadgets for Apple, Nintendo, Intel, Dell, Nokia, Microsoft, Samsung, and Sony.

So it was a surprise when Terry Guo, the hard-charging, 61-year-old billionaire CEO of Foxconn, said last July that the Taiwan-based manufacturing giant would add up to one million industrial robots to its assembly lines inside of three years.

The aim: to automate assembly of electronic devices just as companies in Japan, South Korea, and the United States previously automated much of the production of automobiles.

Foxconn, one of China's largest private employers, has long played an outsize role in China's labor story. It has used cheap labor to attract multinational clients but now faces international scrutiny over low pay and what some see as inhumane working conditions.

"Automation is the beginning of the end of the factory girl, and that's a good thing," says David Wolf, a Beijing-based strategic communications and IT analyst. Wolf, who has visited many Chinese factory floors, predicts an eventual labor shift similar to "the decline of seamstresses or the secretarial pool in America."

Since the announcement, Guo hasn't offered more details, keeping observers guessing about whether Foxconn's plans are real. (Through its public-relations firm, Burson-Marsteller, Foxconn declined to describe its progress.) Trade groups also haven't seen the huge orders for industrial robots that Foxconn would need, although some experts believe the company may be developing its own robots in house.

"Guo has good reasons for not waving his flag about this too much," says Wolf. Keeping quiet could give Foxconn a jump on competitors. What's more, with the Chinese economy slowing down, "it is politically inadvisable to talk too much about replacing people with robots," he says.

China's leaders see employment as essential to maintaining a harmonious society. The imperative of creating jobs often trumps that of efficiency. For instance, Wang Mengshu, deputy chief engineer at China Railway Tunnel Group, says that labor-saving equipment isn't always used even when it's available. "If all the new tunnels were built with the advanced equipment, that would trim the need for the employment of about six million migrant workers," he says. "In certain fields we don't want to have fast development in China, in order to solve the national employment problem."

Political leaders are shown here as practitioners of neo-Luddism—opposed to many forms of modern technology.

They are either unaware that advances in technology leads to greater productivity and more employment or simply have been looking at their narrow interests.

Hedge fund Andy Kessler eloquently explains the causal relationship in layman’s lingo.

From the Wall Street Journal, (bold emphasis mine)

So how does productivity result in more employment?

Three ways. First, some new technology comes along that allows something never before possible. Cash from an ATM, stock trading from an airplane's aisle seat, ads next to Google search results.

The inventor or entrepreneur who uses the invention benefits from sales and wealth and hires people to produce the good or service. We don't hear about this. Instead we hear about the layoffs of bank tellers, stockbrokers and media salesmen. So productivity becomes the boogeyman for job losses. And many economic cranks would prefer that we just hire back the tellers and toll collectors.

This is a big mistake because new, cheaper technology becomes a platform for others to create or expand businesses that never before made economic sense. Adobe software killed typesetters, but allowed millions cheaply to get into the publishing business. Millions of individuals and micro-size businesses now reach a national, not just local, retail market thanks to eBay. Amazon allows thousands upon thousands of new vendors to thrive and hire.

Consider Uber, a 20-month-old start-up, whose smartphone app knows where you are and with a simple click arranges a private car pickup to take you where you want. It doesn't exist without iPhones or Androids. Taxi and limousine dispatchers lose. Customers win. We'll all be surprised by new tablet applications being dreamed up in garages and basements everywhere.

The third way productivity results in more employment is by attracting capital to satisfy new consumer demands. In a competitive economy, productivity—doing more with less—always lowers the cost of products or services: $5,000 computers become $500 tablets. Consumers get to spend the difference elsewhere in the economy, and entrepreneurs will be happy to sell them what they want or create new things they never heard of, but will want. And those with capital will be eager to fund these entrepreneurs. Win, win.

The mechanism to decide the most effective use for this capital is profits. The stock market bundles profits and is the divining rod of productivity, allocating capital in cycle after cycle toward the economy's most productive companies and best-compensated jobs. And it does so better than any elite economist or politician picking pork-barrel projects and relabeling them as "investments."

The productive use of capital is not an automatic process, of course. It is all about constant experimentation. And it is never permanent: Railroads were once tremendously productive, so were steamships and even Kodachrome. It takes work, year in and year out—update, test, tweak, kill off. Staples is under fire from Amazon and other productive online retailers. Its stock has halved since its 2010 peak and is almost at a 10-year low. So be it.

With all the iPads and Facebook and cloud-computing growth, why is unemployment still 8.2% and job creation stalled? My theory is that productivity is always happening but swims upstream against those that fight it. Unions, regulations and a bizarre tax code that locks in the status quo.

Read more of the fallacies of Luddism from must read classics of the great Frederic Bastiat from “That Which is Seen and That Which is NOT Seen” (Machinery) or from the equally distinguished Henry Hazlitt’s Economics in One Lesson (The Curse of the Machinery)

I am reminded by the recent conversation I had with the charter president of Rotary of Mandaluyong, Fred Borromeo, who at age 86 ironically is an avid fan of technology.

In his recent encounter with some local government neo-luddites who objected to his suggestion to adapt to new (farming) technology for the same reasons as Chinese politicians, Mr Borromeo told them, “the world will move along with or without you”. Indeed.

US Capital Controls: New York Fed Backs Withdrawal Limits for Money Market Funds

Step by step the US seems in a transition towards capital controls.

From Bloomberg,

The Federal Reserve Bank of New York said money-market fund investors should be prohibited from withdrawing all their assets at once as a way to make the $2.5 trillion industry “safer and more fair.”

Money funds should set aside a portion of every investor’s balance as a “minimum balance at risk” that could only be withdrawn with a 30-day notice, the New York Fed’s staff said today in a report. The provision would reduce systemic risk and protect small investors who don’t pull out of a troubled fund quickly, according to the report.

“The delay would ensure that redeeming investors remain partially invested in the fund long enough to share in any imminent portfolio losses or costs arising from their redemptions,” the bank said today in a statement.

The idea, opposed by the funds industry, is already part of a proposal before the U.S. Securities and Exchange Commission that would force money funds to float their share value or build capital cushions and impose withdrawal restrictions, a person familiar with the plan said last month. The agency hasn’t made the proposal public and hasn’t scheduled a meeting for commissioners to vote on it.

Once again, policymakers are shown to be in desperation having to limit their visions towards attaining immediate goals, without vetting on the risks of potential unintended consequences from the reactions of the industry and of the public over the medium to long term.

The slippery slope towards capital controls eventually may imply deposit withdrawal limits ala Argentina during the 1999-2002 crisis

The biggest risks from all these would be…let me guess—capital flight and a US dollar crisis.

IMF Economist Resigns, Cites Conflict of Interests, Says: “Ashamed to Have Had Any Association with the Fund at all”

Brewing trouble at the IMF.

A renegade IMF economist recently resigned out of alleged conflict of interests. The Wall Street Journal Blog reports,

A senior International Monetary Fund economist is resigning from the Fund, writing a scathing letter to the board blaming management for suppressing staff warnings about the financial crisis and a pro-European bias that he says has exacerbated the euro-zone debt crisis.

“The failure of the fund to issue [warnings] is a failing of the first order, even if such warnings may not have been heeded,” Peter Doyle said in a letter dated June 18 and copied to senior management.

Doyle is formerly a division chief in the IMF’s European Department responsible for non-crisis countries. He currently acts as an adviser to the Fund but is expected to officially leave in the fall.

“The consequences include suffering [and risk of worse to come] for many including Greece, that the second global reserve currency is on the brink, and that the Fund for the past two years has been playing catch-up and reactive roles in the last-ditch efforts to save it,” he said in the letter.

Mr. Doyle’s shift in positions at the fund–from division chief to adviser–occurred around the same time that a new European Department chief was appointed. A senior official at the IMF said the new chief restructured the department, replacing many of its staff from outside the department earlier.

“After twenty years of service, I am ashamed to have had any association with the Fund at all,” he said in the letter. Mr. Doyle wasn’t immediately available for further comment.

IMF is funded by taxpayers from different member nations thus, like all other multilateral agencies, the IMF is a political institution subject to the advancement of the political interests of major contributors (represented through the quota-voting system).

Such distribution of power can already be seen from the appointment of executive directors. From the IMF,

Five Executive Directors are appointed by the member countries holding the five largest quotas (currently the United States, Japan, Germany, France, and the United Kingdom), and 19 are elected by the remaining member countries. Under reforms currently being finalized, all 24 Directors will be elected by the member countries, starting in 2012.

As a political institution, one really cannot expect the IMF to become apolitical and dispense their role in an objective manner, no matter the stated mission or job goals.

This also demonstrates of the web of complicity of the global cartelized tripartite political institutions of the welfare-warfare state, the privileged banking class and central banks whose interests has been promoted or upheld through all the political multilateral agencies.

And the uneven political representations in the IMF adds to the many reasons why bailouts or the redistribution of resources from poor nations (like Philippines) to the crisis stricken rich bankers and political class (whom fall under the umbrella of political interests of the major IMF fund contributors) has not only been financially unviable but immoral.

Phisix and ASEAN Equities in the Shadow of Contagion Risks

The common feature for today’s global financial marketplace has been extreme volatility

Sharp price fluctuations are seen by scalpers and short term traders as wonderful opportunities. On the other hand, such landscape for me, exhibits signs of increasing market distress. From a trading perspective, this implies for a low profit-high risk engagement.

In short, when the risk is high or when uncertainty dominates, I opt to take a defensive posture. For me, it is better to lose opportunity than to lose capital.

The Philippine and ASEAN markets have not been spared of such volatility.

The local benchmark fell by a measly .07% this week. But this comes after the Phisix opened strongly on Monday, lifted by the late week rally of Wall Street from the other week. Unfortunately such one day rally failed to hold ground as the following sessions essentially more than erased Monday’s gains.

Global markets have closed mixed for the week.

Almost every major equity benchmark encountered a rollercoaster week. Like the Phisix most of the early gains came under pressure during the close of the week.

In the ASEAN region, there have been signs of rotation.

This year’s ASEAN laggards, Indonesia (+6.8% year-to-date) and Malaysia (+7.33% also y-t-d) ended the week strongly as ASEAN outperformers, the Philippines (+19.2%) and Thailand (+17.9%) retrenched.

This only goes to show that the destiny of the Phisix has been tied with that of the region. So any belief that the local benchmark may perform independently will likely be disproven.

Also given the rotational dynamics, we might see some “catch up” play or the narrowing of the recent wide variance between the laggards and leaders overtime. But this doesn’t intuitively mean that such gaps will close.

But the fate of ASEAN’s markets will ultimately depend on the unfolding events in the US.

US Markets and Economy as ASEAN’s Anchor

Yes there have occasional instances where the Phisix has diverged from US or world markets[1], but overtime, the mean reversion capabilities of the markets govern.

Thus, the exemplary performance of ASEAN markets can be traced to the buoyancy of the US markets.

For as long as the US remains firm, so will likely be the fortunes of ASEAN markets and vice versa.

The US markets has so far been resilient from the Europe’s crisis, partly due to the capital flight dynamics from the Euro into the US, and similarly from the slowdown from major emerging markets as the BRICs.

Nonetheless such sustainability must be questioned considering that much of the world’s major economies (developed and emerging markets) have been in a marked downtrend.

Unlike in 2008, there hardly will be any China and other major emerging markets to rely on to do much of the weightlifting. Many emerging markets, particularly the BRICs have been bogged down by their domestic quasi-bubble problems.

In addition, the US Federal Reserve continues to employ talk therapy (signaling channel or policy communications management) instead of undertaking real actions. Media continues to broadcast the prospects of a Bernanke Put (“bad news is good news”), as Fed officials continue to signal verbal support in projecting hope for the steroid addicted markets.

And importantly political gridlock and regime uncertainty has been worsening (taxmaggedon, fiscal cliff, debt ceiling, Dodd-Frank[2], Obamacare, the forthcoming national elections and lately even the controversial LIBOR[3] issue) will likely intensify the current business, economic and financial uncertainties.

And considering that the US markets and her economy has been bolstered by sustained injections of steroids, the lack of and the perceived dearth of policy palliatives, as evidenced by the decelerating money supply growth, will likely bring to the surface and expose most of the misallocated investments, which has been camouflaged by recent monetary policies.

Such dynamics will be manifested through an economic slowdown if not a recession—but again this would really depend on how Ben Bernanke and US Federal Reserve will react or respond to increasing evidences of a slowdown.

Lately even the New York Federal Reserve swaggered about having to boost to US stock markets[4], which they say without them would have been 50% lower!!!

Proof that low interest rates have hardly worked: record low mortgage interest rates[5] have been amiss in providing sustained recovery to US property markets[6].

Yet steroid addicted financial markets continue to look forward to the FOMC’s meeting during the end of July in the hope for another round of policy opiates.

Add to these the soaring costs of agricultural commodities (chart from US global investors)[7], which have been mostly attributed to weather or drought conditions.

This, I believe, has been exacerbated by easy money policies and other interventions (e.g. agricultural subsidies, tariffs and etc…) which should extrapolate to higher food prices.

So we seem to be witnessing incipient signs of stagflation as I have long been predicting.

[As a side note, a UBS analyst recently noted that the risks of hyperinflation has been greatest for the US and UK[8]. But he sees less than 10% chance for this to occur in the near future.

Yet he believes that hyperinflation results from “unsustainable deficits” which “occurs after central banks monetize a large amount of debt”. Thus hyperinflation is a fiscal phenomenon.

I’d still say that hyperinflation is a monetary phenomenon meant to address fiscal concerns. Yes hyperinflation signifies a means to an end approach.

In dire financial straits and in desperation due to the lack of access to domestic and overseas private sector financing, governments frenetically print money to preserve on their political entitlements and power.

At the end of day, all these unwieldy or unsustainable levels of debt expansion will be defaulted upon directly through restructuring, or indirectly through inflation, where hyperinflation may arise as consequence to policy miscalculation, if not deliberately.

And this is why the risks of hyperinflation shouldn’t be discounted[9] despite today’s low interest rate environment]

Also, Spanish bonds at record highs are manifestations of persisting and growing financial and economic stress in the Eurozone and of the extreme fluidity of current conditions, which will have an impact to the US and to the world.

Markets have never really anticipated this.

As Doug Noland of the Credit Bubble Bulletin rightly observed[10],

It was not that many months ago that Spain was viewed as part of a financially stable European “core.” Indeed, Spain (5-yr) CDS ended Q1 2010 at about 100 bps. Spain commenced 2010 with government debt at a seemingly healthy 54% of GDP. Few anticipated the incredible pace of fiscal deterioration. With the federal government on the hook for the EU’s 100bn euro bank bailout package, the IMF now projects Spain will end 2012 with debt at about 90% of GDP – and poised for continued rapid growth.

Who would expect that French bonds to dramatically narrow against German bunds, where “spreads on French debt have narrowed by 16 bps in the last month and are currently at their lowest levels of 2012”[11] as French government paper morph into a ‘safe haven’ from the Euro crisis?

That’s how swift and powerful events have been moving.

To consider, people stampeding into French bonds seem to have overlooked the many sins underpinning the French sovereign paper.

As the BCA Research explains[12]

The French public sector is not in good financial health and is in worse condition than that of Italy in many respects. Italy has run large primary surpluses through much of the last two decades, while France has run large deficits. The Italian debt/GDP ratio was rather stable, while France’s has been rising sharply. In fact, France has accumulated 60% more debt than Italy since 1999, and its debt service costs are rising. More worrisome is that France’s combined private and public sector debt load is higher than that of Italy, putting the French economy in a perilous situation. The only variable where France looks better is economic growth, but even this has mostly come from larger government spending, and in turn at the cost of escalating debt.

And considering the incumbent socialist administration’s penchant for more government spending, taxes and regulations[13] which again will translate to more debt, reduction of productivity and competitiveness and potential exodus of investors, today’s safehaven may become tomorrow’s epicenter for the progressing crisis.

So we are seeing existing policy error compounded by more policy errors that only aggravates such crisis conditions, from which the sentiment of financial markets shifts violently from one end to another.

Hence, while earnings report of US publicly listed corporations may seem buoyant which has given the impetus for the bulls to provide the recent strength to the US equity markets[14], all the above compounds to signify substantial headwinds that US financial markets (equities, bonds, commodities) will be faced with.

And to add, it would be big mistake to read current market activities as tomorrow’s outcome given the huge swings happening in the financial markets around the world. That’s how unstable and mercurial current conditions are.

China’s “Good News” Ignored by the Markets

Such unpredictability has been no different for China.

This week, there has been a torrent of supposed good news that should have reanimated, if not fired up, China’s financial markets.

China’s banking system has reportedly posted a big jump in loan growth or bank lending rose by 16% to 919.8 billion yuan (US$144.3 billion) last June[15]

While news say that this signifies a positive sign from government efforts, this seems largely unclear. I am not even sure if these have been contracted by the private sector. As in the recent past, most of the so-called stimulus has been directed to the overleveraged and overindebted State Owned Enterprises (SoE)[16] which only adds to the current juncture.

The property sector likewise reported a significant surge in bank loans from April to June, up by 20% from last year to the tune of 322.6 billion yuan ($50.64 billion)[17].

Reports also say that China will ease restrictions on her shadow banking system, as well as, double up investments on railway projects[18].

This goes in contrast to previous reports where 70% of China’s railways projects recently has been suspended as a result of ballooning deficit financing, as well as last year’s deadly train crash which has brought upon safety concerns and exposed corruption at the highest levels of the ministry[19]

The confusing signals from supposed government stimulus and support, as well as, positive developments seems to have been discounted by the China’s financial markets as both the major equity market bellwether, the Shanghai Composite (SSEC-top pane), and China’s currency the Yuan (CNY/USD-bottom pane) have not demonstrated auspicious responsiveness to such developments.

Unlike at the end of the 2012 where the SSEC hit a low but the yuan remain lofty, this time both the SSEC and the yuan have been treading downwards.

These are hardly reactions that could be reckoned as bullish.

In contrast these could be symptoms of deeper underlying malaise—a bursting bubble, punctuated by intensifying hot money outflows[20].

With scarcely any household savings to tap, most of the increases in savings are from government and corporations[21] there seems little room for bailouts without incurring risks of inflation.

So like the US, we have the same ingredients contributing to the current highly uncertain climate, ambivalent central bank (PBoC) and political stalemate which has been prompting for increasing manifestations of the unraveling of malinvestments that has been the driving force of the current slowdown.

The Asian Electronic Export Nexus

Many seem to have developed the hardened belief that domestic (or regional) markets have been made invincible by the recent events, particularly record high equities.

As I have been saying, today’s globalization has made the world much deeply interconnected through trade, capital, labor and even through the US dollar standard based banking system.

Embracing the idea of decoupling can be hazardous to one’s portfolio and detrimental to one’s emotions and ego.

In terms of trade, a slowdown in world growth will have impact negatively on Asia’s electronic exports.

As The Economist recently commented[22]

THE electronics industry accounts for two-fifths of manufacturing output in Asia, according to calculations by HSBC. So when electronics grows quickly, Asia's GDP tends to speed up too, to the tune of almost 0.2 percentage points for each full-point increase in the electronics sector. Unfortunately this correlation also applies when things slow down (see left-hand chart). And recent signs are that Asia’s electronics industry is doing just that: HSBC’s lead indicator, which gives a rough two-month preview of future production, has slowed sharply in recent months, in contrast to the latest available output figures. One bright side, given the economic woes of Europe and America, is that Asian manufacturing is no longer as closely tied to Western markets as it was. Three of the five components that comprise HSBC's lead indicator measure conditions within Asia. So when the next rebound occurs, it is likely to be home-grown.

Again while it is true that Asia has been less dependent on the West, there is no guarantee that other sectors will not be affected from slomo diffusing or spreading of the global debt crisis.

A slowdown in electronic exports incidentally constitutes about half of Philippine exports[23]

So those dreaming of immunity from a global slowdown will likely be refuted.

Bottom line: The contagion risk is real.

Unless we see aggressive collaborative actions from major central banks (which may place a temporary patch or booster to the markets), or signs of economic stabilization from developed nations or from major emerging economies (whom are experiencing market clearing liquidations from domestic bubbles), we should expect global markets to remain sharply volatile and erratic in both directions but faced with greater probabilities of “fat tail” risks.

As a final note: I don’t expect the coming State of the Nation Address by the Philippine President to have lasting effects. They are likely to be meaningless feel good political rhetoric whose goals are for his party to seize the majority in the coming congressional elections in 2013.

Bubble policies and the effects thereof will continue to be main drivers of the asset markets.

Approach the equity markets with caution.

---

[1] See Phisix: Will the Risk ON Environment be Sustainable? June 24, 2012

[2] See Infographic: Dodd Frank-enstein, July 21,2012

[3] See Barclay’s LIBOR Scandal: Self Fulfilling Turmoil July 19, 2012

[4] See Bernanke Doctrine: New York Fed Boasts of Pushing Up the US Stock Markets, July 14, 2012

[5] Wall Street Journal Blog Vital Signs: Mortgage Rates Hit Record Low July 13, 2012

[6] Wall Street Journal Blog Vital Signs: Mortgage Rates Hit Record Low July 13, 2012

[7] US Global Investors America’s Competitive Spirit, July 20, 2012

[8] BusinessInsider.com UBS: The Risk Of Hyperinflation Is Largest In The US And The UK, July 17, 2012

[9] See Taking The Hyperinflation Risk With A Grain Of Salt?

[10] Noland Doug Risk On, Risk Off And The Spanish/Chinese Tug Of War, Credit Bubble Bulletin PrudentBearcom July 20, 2012

[11] Bespoke Investment Group EU Sovereign Spreads, July 20, 2012

[12] BCA Research, Watching France, July 10, 2012

[13] See Quote of Day: The Last Hurrah of Socialist Welfare States May 8, 2012

[14] See US Stocks Markets: Earnings Trump Economic Data, Leading Economic Indicators Fall, July 20, 2012

[15] Channelnewsasia.com China bank loans rise in June, July 12, 2012

[16] See China’s New Loans Unexpectedly Surged in May June 12, 2012

[17] Reuters.com China Q2 property loans rebound with sales, July 19, 2012

[18] See Will China Ease Banking Curbs? Has the Railway Stimulus been Launched?, July 17 2012

[19] Payne Amy Morning Bell: Transportation Secretary Wants Us to Be Like Communist China, Heritage Network, July 9, 2012

[20] Zero Hedge, Forget China's Goal-Seeked GDP Tonight; This Is The Chart That Keeps The PBOC Up At Night, July 12, 2012

[21] See Contagion Risk: Watch for China’s Catastrophic Deleveraging, July 16, 2012

[22] Graphic Details Chips are down, The Economist July 18, 2012

[23] RGE Analyst Blog Philippines: Reconciling Short-Circuiting Electronic Exports, Economonitor, February 17, 2012

Misrepresenting Frédéric Bastiat and the Black Swan Theory

Populist financial analyst John Mauldin seem to have misrepresented Frédéric Bastiat in his latest outlook.

Mr. Mauldin writes of Frédéric Bastiat,

He was a strong proponent of limited government and free trade, but he also advocated that subsidies (read, stimulus?) should be available for those in need, "... for urgent cases, the State should set aside some resources to assist certain unfortunate people, to help them adjust to changing conditions."

Really?

Here is the complete quotation from the great Frédéric Bastiat in Justice and fraternity, in Journal des Économistes, 15 June 1848, page 313 (Wikipedia.org) [quoted from Bastiat.org, bold emphasis mine, italics as per Mr. Mauldin’s quote]

When a great number of families, all of whom, whether in isolation or in association, need to work in order to live, to prosper, and to better themselves, pool some of their forces, what can they demand of this common force save the protection of all persons, all products of labor, all property, all rights, all interests? Is this anything else than universal justice? Evidently, the right of each is limited by the absolutely similar right of all the others. The law, then, can do no more than recognize this limit and see that it is respected. If it were to permit a few to infringe this limit, this would be to the detriment of others. The law would be unjust. It would be still more so if, instead of tolerating this encroachment, it ordered it.

Suppose property is involved, for example. The principle is that what each has produced by his labor belongs to him, the more so as this labor has been comparatively more or less skillful, continuous, successful, and, consequently, more or less productive. What if two workers wish to unite their forces, to share the common product according to mutually agreed-upon terms, or to exchange their products between them, or if one should make a loan or a gift to the other? What has this to do with the law? Nothing, it seems to me, if the law has only to require the fulfillment of contracts and to prevent or punish misrepresentation, violence, and fraud.

Does this mean that it forbids acts of self-sacrifice and generosity? Who could have such an idea? But will it go so far as to order them? This is precisely the point that divides economists from socialists. If the socialists mean that under extraordinary circumstances, for urgent cases, the state should set aside some resources to assist certain unfortunate people, to help them adjust to changing conditions, we will, of course, agree. This is done now; we desire that it be done better. There is, however, a point on this road that must not be passed; it is the point where governmental foresight would step in to replace individual foresight and thus destroy it. It is quite evident that organized charity would, in this case, do much more permanent harm than temporary good.

Bastiat was for subsidies (stimulus)? Go figure.

This is a nice example of doublespeak or the language that deliberately distorts or reverses the meaning of the words or statement—usually employed in politics. Yes just pick out an excerpt from which to stress one’s bias, even if these had been taken out of context.

Oh by the way, Mr. John Mauldin may have also misread the Black Swan Theory

He writes,

A Black Swan is a random event, something that takes us all by surprise. Economic Black Swans are actually quite rare. 9/11 and the aftermath was a true Black Swan.

This barely represents the definition of the theory

According to the book description of Nassim Taleb’s Black Swan: The Impact of Highly Improbable [bold emphasis mine]

A black swan is a highly improbable event with three principal characteristics: It is unpredictable; it carries a massive impact; and, after the fact, we concoct an explanation that makes it appear less random, and more predictable, than it was…

Why do we not acknowledge the phenomenon of black swans until after they occur? Part of the answer, according to Taleb, is that humans are hardwired to learn specifics when they should be focused on generalities. We concentrate on things we already know and time and time again fail to take into consideration what we don’t know. We are, therefore, unable to truly estimate opportunities, too vulnerable to the impulse to simplify, narrate, and categorize, and not open enough to rewarding those who can imagine the “impossible.”

For years, Taleb has studied how we fool ourselves into thinking we know more than we actually do. We restrict our thinking to the irrelevant and inconsequential, while large events continue to surprise us and shape our world.

Black swans appear to be random when they are products of OUR failure to "take into consideration what we don’t know”. In short, the knowledge problem

For instance, 9/11 was considered a black swan for the victims, but not for the terrorists.

Mr. Taleb alludes to the Turkey problem as model for the Black Swan theory: For the turkey—after months of fattening who suddenly have been put into the dinner table for Thanksgiving—would be a (surprise) black swan, but not for the butcher.

This applies to the financial markets as well.

Graphic: Made Everywhere, Even the Apparel Industry has been Globalized

“Made in China” has been a politically colored phrase not only in the US (US Olympic Uniform controversy), but also in the Philippines –the other day while on a cab, I heard a similar balderdash coming from a local radio announcer, who in ranting against China over territorial disputes included such false claims.

In reality, even the apparel or clothing industry has been about globalization, particularly the supply chain network. (hat tip Scott Lincicome)

To add, the apparel industry’s value added comes from design and post production facilities (marketing and distribution), an article from the Businessweek/Bloomberg.com points this out,

Garment manufacturing is a low-cost commodity business. Most of the value in the apparel industry comes from design, technology, sales, marketing, and distribution—not manufacturing. The successful players in apparel, such as Ralph Lauren and Nike, figured this out long ago.

Because the economics are bad, most U.S. apparel manufacturing operations folded decades ago. Only 97,000 Americans still have jobs in apparel production, according to the U.S. Department of Labor, and most of them are making highly specialized products like DuPont Kevlar uniforms that cannot be made elsewhere.

But just because America doesn’t manufacture apparel anymore doesn’t mean we can’t lead the industry. In fact, the world’s largest apparel companies are almost all U.S.-based, including Nike, VF, PVH, and Ralph Lauren, to name a few. These companies have grown a combined 146 percent during the past 10 years, adding more than $27 billion in revenue. Nike has created more than 15,000 new jobs in the U.S. during this time, Ralph Lauren almost 10,000. And unlike the low-paying production jobs next to sewing machines, these are well-paying jobs in marketing, accounting, design, and management.

These companies are winning globally by out-designing, out-innovating, and out-marketing the competition. Nike, for example, is unveiling a new TurboSpeed running suit at the London Olympic Games that it claims can reduce 100-meter sprint times by .023 seconds. Nike’s gear will be used by teams from many countries, including Russia, China, and of course, the U.S.

What Nike and Ralph Lauren don’t do is make their own products, in the U.S. or elsewhere—and this has become their competitive advantage.

Both companies source products from hundreds of independent manufacturers in more than 30 countries (less than 3 percent coming from the U.S.). The flexibility allows them to be cost-competitive globally. It also allows their design teams to focus on creating the most exciting new products possible without having to worry whether they can be made on a legacy production line.

Remember Fruit of the Loom? Brown Shoe Co.? Cannon Mills? Levi Strauss? In 1970 these were the largest U.S. apparel and fabric companies. They all owned their own U.S. manufacturing plants. They all struggled to innovate and grow, and they either went bankrupt or were bypassed by more nimble competitors who had no factories. If only they had outsourced …

Not only is outsourcing good for business, but the future of the American economy is dependent upon it.

So let’s stop whining about a few “Made in China” tags and start cheering for all of the great athletic performances made possible by superior U.S. innovation.

So when you hear someone rail about “Made in China” you can be assured that the person regurgitating such absurdities have either been ignorant of the real developments or have been deliberately employing deception as part of political propaganda to invoke nationalist (us against them) sentiment.