Austrian Business Cycle at the US Federal Reserve: Unintended Consequences from Monetary Policies

A paper investigating the roots of current crisis published by former Bank of International Settlement economist William R. White now at the US Federal Reserve at Dallas comes largely with the perspective of the Austrian Business Cycle Theory (ABCT).

One may interpret that Austrian economics may have “infiltrated” the US Federal Reserve or that this could also mean the the Fed have become more open to out of the box ideas [hat tip Zero Hedge; bold emphasis mine].

Here is the abstract:

In this paper, an attempt is made to evaluate the desirability of ultra easy monetary policy by weighing up the balance of the desirable short run effects and the undesirable longer run effects – the unintended consequences. The conclusion is that there are limits to what central banks can do. One reason for believing this is that monetary stimulus, operating through traditional (“flow”) channels, might now be less effective in stimulating aggregate demand than previously. Further, cumulative (“stock”) effects provide negative feedback mechanisms that over time also weaken both supply and demand. It is also the case that ultra easy monetary policies can eventually threaten the health of financial institutions and the functioning of financial markets, threaten the “independence” of central banks, and can encourage imprudent behavior on the part of governments. None of these unintended consequences is desirable. Since monetary policy is not “a free lunch”, governments must therefore use much more vigorously the policy levers they still control to support strong, sustainable and balanced growth at the global level.

Some of my favorite segments of the study

1. Mr. White challenges the “Wealth effect” or the Financial Accelerator (I made short comments here and here) principle espoused by US Federal Reserve Chief Ben Bernanke

the argument that higher “wealth” (generated by lower rates causing rising asset prices) will lead to more consumer spending also needs serious reevaluation. While not denying the empirical robustness of this relationship in the past, the argument suffers from a serious analytical flaw. Lower interest rates cannot generate “wealth”, if an increase in wealth is appropriately defined as the capacity to have a higher future standard of living. From this perspective, higher equity prices constitute wealth only if based on higher expected productivity and higher future earnings. This could be a byproduct of lower interest rates stimulating spending, but this is simply to assume the hypothesis meant to be under test.

As for higher house prices raising future living standards, the argument ignores the higher future cost of living in a house. Rather, what higher house prices do produce is more collateral against which loans can be taken out to sustain spending. In this case, however, the loan must be repaid at the cost of future consumption. No “wealth” has in fact been created. In any event, as noted above, house prices in many countries have continued to fall despite lower policy rates. This implies that the need for “payback” can no longer be avoided by still further borrowing.

2. Mr. White amplifies the view the capital markets may have been largely influenced by central bank actions, which not only increases risk exposure by the central bank itself, but likewise signify that current policies may have gone beyond the objectives of central banks. Also, current actions by central banks may have been interfering with or influencing the fiscal dimensions of government.

Ultra easy monetary policies, whether very low policy rates or policies affecting the size and composition of their balance sheets, can also have unintended and unwelcome implications for central banks themselves. Some of these effects are more technical. First, with very low policy rates, the likelihood rises that normal intermediation spreads in private markets will fall so far that these markets will collapse. The central bank may then find itself as the “market maker of last resort”. The current interbank market might fall into this category. Moreover, a similar experience in Japan in the 1990’s indicates that restarting such private markets is not easy.

Second, deeper questions can arise about central banks operating procedures in such an environment.

Third, with central banks so active in so many markets, the danger rises that the prices in those markets will increasingly be determined by the central bank’s actions. While there are both positive and negative implications for the broader economy, as described in earlier sections, there is one clear negative for central banks. The information normally provided to central banks by market movements, information which ought to help in the conduct of monetary policy, will be increasingly absent. Finally, with policies being essentially unprecedented, wholly unexpected implications for central banks (as with others) cannot be ruled out.

Beyond these technical considerations, the actions undertaken by AME central banks pose a clear threat to their “independence” in the pursuit of price stability. First, as central banks have purchased (or accepted as collateral) assets of lower quality, they have exposed themselves to losses. If it were felt necessary to recapitalize the central bank, this would be both embarrassing and another potential source of influence of the government over the central bank’s activities. Second, the actions of central banks have palpably been motivated by concerns about financial stability. Going forward, it will no longer be possible to suggest that monetary policy can be uniquely focused on near term price stability. Third, by purchasing government paper on a large scale, central banks open themselves to the criticism that they are cooperating in the process of fiscal dominance.

3. Low interest rates may incentivize a further delay in reforms, which increases the market, credit, interest rate and political risks.

A more fundamental effect on governments, however, is that it fosters false confidence in the sustainability of their fiscal position. In the last few years, in spite of rising debt levels, the proportion of government debt service to GDP in many AME’s has actually fallen. Citing as well the example of Japan, many commentators thus contend that the need for fiscal consolidation can be resisted for a long time. Koo, Martin Wolf of the Financial Times, and others are undoubtedly right in suggesting that a debt driven private sector collapse should normally be offset by public sector stimulus. What cannot be forgotten,however, is the suddenness with which market confidence can be lost, and the fact that the Japanese situation is highly unusual in a number of ways.

What is clearer is that exiting from a period of ultra easy monetary policy will not be easy. In this area, the Japanese experience over the last two decades is instructive. Central banks using traditional models will hesitate to raise rates because growth seems sub‐normal. Further, the recognition that higher short rates might cause longer rates to “spike”, with uncertain effects on financial stability, will also induce caution. Governments will also firmly resist higher rates, because they might well reveal that the level of government debt had indeed risen to unsustainable levels. Further, on the basis of recent experience, the entire financial community (with its formidable capacity for public communication and private lobbying) will oppose any tightening of policy as too dangerous. Their motives in this regard are questioned below.

Presumably a sharp enough increase in inflation would lead to a tightening of policy. However, by then a lot of further damage ‐ not least to the credibility of central banks – might well have been done.

The entire paper here:

Dallas Fed QE

Gary North: The Keynesian Era is Coming to a Close

Author and Professor Gary North talks about how the Keynesian political economic system via the welfare-warfare state, like Marxism, is bound for doom.

I say this to give you hope. The Keynesians seem to be dominant today. They are dominant because they have been brought into the hierarchy of political power. They serve as court prophets to the equivalent of the Babylonians, just before the Medo-Persians took the nation.

They are in charge of the major academic institutions. They are the main advisors in the federal government. They are the overwhelmingly dominant faction within the Federal Reserve System. Their only major institutional opponents are the monetarists, and the monetarists are as committed to fiat money as the Keynesians are. They hate the idea of a gold coin standard. They hate the idea of market-produced money.

There was no overwhelming outrage among staff economists at the Federal Reserve when Ben Bernanke and the Federal Open Market Committee cranked up the monetary base from $900,000,000,000 to $1.7 trillion in late 2008, and then cranked it up to $2.7 trillion by the middle of 2011. This expansion of the money supply had no foundation whatsoever in anybody's theory of economics. It was totally an ad hoc decision. It was a desperate FOMC trying to keep the system from collapsing, or least they thought it was about to collapse. The evidence for that is questionable. But, in any case, they cranked up the monetary base, and nobody in the academic community except a handful of Austrians complained that this was a complete betrayal of the monetary system and out of alignment with any theory of economics.

The Keynesians are eventually going to face what the Marxists have faced since 1991. Literally within months of the collapse of the Soviet Union, when members of the Communist Party simply folded up shop and stole the money that was inside the Communist Party coffers, any respect for Marxism disappeared within academia. Marxism became a laughingstock. Nobody except English professors, a handful of old tenured political scientists, and a tiny handful of economists in the Union of Radical Political Economists (URPE), were still willing to admit in late 1992 that they were advocates of Marxism, and that they had been in favor of Soviet economic planning. They became pariahs overnight. That was because academia, then as now, is committed to power. If you appear to have power, you will get praised by academia, but when you lose power, you will be tossed into what Trotsky called the ashcan of history.

This is going to happen to the Keynesians as surely as it happened to the Marxists. The Keynesians basically got a free ride, and have for over 60 years. Their system is illogical. It is incoherent. Students taking undergraduate courses in economics never really remember the categories. That is because they are illogical categories. They all rest on the idea that government spending can goose the economy, but they cannot explain how it is that the government gets its hands on the money to do the stimulative spending without at the same time reducing spending in the private sector. The government has to steal money to boost the economy, but this means that the money that is stolen from the private sector is removed as a source of economic growth.

The Keynesian economic system makes no sense. But, decade after decade, the Keynesians get away with utter nonsense. None of their peers will ever call them to account. They go merrily down the mixed economy road, as if that road were not leading to a day of economic destruction. They are just like Marxist economists and academics in 1960, 1970, and 1980. They are oblivious to the fact that they are going over the cliff with the debt-ridden, over-leveraged Western economy, because they are committed in the name of Keynesian theory to the fractional reserve banking system, which cannot be sustained either theoretically or practically.

The problem we are going to face at some point as a nation and in fact as a civilization is this: there is no well-developed economic theory inside the corridors of power that will explain to the administrators of a failed system what they should do after the system collapses. This was true in the Eastern bloc in 1991. There was no plan of action, no program of institutional reform. This is true in banking. This is true in politics. This is true in every aspect of the welfare-warfare state. The people at the top are going to be presiding over a complete disaster, and they will not be able to admit to themselves or anybody else that their system is what produced the disaster. So, they will not make fundamental changes. They will not restructure the system, by decentralizing power, and by drastically reducing government spending. They will be forced to decentralize by the collapsed capital markets.

When the Soviet Union collapsed, academics in the West could not explain why. They could not explain what inherently forced the complete collapse of the Soviet economy, nor could they explain why nobody in their camp had seen it coming. Judy Shelton did, but very late: in 1989. Nobody else had seen it coming, because the non-Austrian academic world rejected Mises's theory of socialist economic calculation. Everything in their system was against acknowledging the truth of Mises's criticisms, because he was equally critical about central banking, Keynesian economics, and the welfare state. They could not accept his criticism of Communism precisely because he used the same arguments against them.

The West could not take advantage of the collapse of the Soviet Union, precisely because it had gone Keynesian rather than Austrian. The West was as compromised with Keynesian mixed economic planning, both in theory and in practice, as the Soviets had been compromised with Marx. So, there was great praise of the West's welfare state and democracy as the victorious system, when there should have been praise of Austrian economics. There was no realization that the West's fiat money economy is heading down the same bumpy road that led to the collapse of the Soviet Union.

It was not a victory for the West, except insofar as Reagan had expanded spending on the military, and the Soviets stupidly attempted to match this expenditure. That finally "broke the bank" in the Soviet Union. The country was so poverty-stricken that it did not have the capital reserves efficient to match the United States. When its surrogate client state, Iraq, was completely defeated in the 1991 Iraq war, the self-confidence inside the Soviet military simply collapsed. This had followed the devastating psychological defeat of the retreat of the Soviet Union out of Afghanistan in 1989. Those two defeats, coupled with the domestic economic bankruptcy of the country, led to the breakup of the Soviet Union.

The present value of the unfunded liabilities of the American welfare state, totaling over $200 trillion today, shows where this nation's Keynesian government is headed: to default. It is also trapped in the quagmire of Afghanistan. The government will pull out at some point in this decade. This will not have the same psychological effect that it did on the Soviet Union, because we are not a total military state. But it will still be a defeat, and the stupidity of the whole operation would be visible to everybody. The only politician who will get any benefit out of this is Ron Paul. He was wise enough to oppose the entire operation in 2001, and he was the only national figure who did. There were others who voted against it, but nobody got the publicity that he did. Nobody else had a system of foreign-policy which justified staying out. His opposition was not a pragmatic issue; it was philosophical.

The welfare-warfare state, Keynesian economics, and the Council on Foreign Relations are going to suffer major defeats when the economic system finally goes down. The system will go down. It is not clear what will pull the trigger, but it is obvious that the banking system is fragile, and the only thing capable of bailing it out is fiat money. The system is sapping the productivity of the nation, because the Federal Reserve's purchases of debt are siphoning productivity and capital out of the private sector and into those sectors subsidized by the federal government.

Read the rest here.

Quote of the Day: Keynesian Policies as Root of Inflationism

What is happening instead is that workers are getting higher money wages, which are lower real wages because the value of the monetary unit is constantly being diluted. We are going into progressive inflation. Savers are being liquidated. Their property is being confiscated. New savers are scared away. Politicians are constantly afraid, and rightly so, of doing things that are unpopular. They endorse popular spending measures but they shun the resulting costs, and to stay popular they have resorted to inflation. This is the so-called Keynesian policy. It is set forth in Keynes' book, The General Theory of Employment, Interest and Money. The key sentence is: "A movement by employers to revise money-wage bargains downward will be more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices."

This was the policy endorsed by Keynes. It is the policy of most governments in the Western world today. Keynes knew, as every economist does, that the only way that you can employ more people is to lower the wage rate. But ever since World War I this had become politically more difficult in Great Britain. Powerful British labor unions, with the help of the Fabian Socialists, had built up public pressures which opposed any lowering of any money wages. British politicians of all parties were afraid to resist this popular union policy. So in 1931, when the number of unemployed became unbearable, the politicians in office preferred to lower wages by devaluing the British pound. The workers kept their puffed-up pound wages, but their pounds bought less.

In 1936, Keynes gave this political policy academic sanction in the book and sentence just quoted. Since then, most Western nations have adopted this "full employment" policy. In essence, when unemployment is considered too high, wages are lowered by lowering the value of the monetary unit. This is done by increasing the quantity of the monetary units. This will be the subject of the next lectures. We will then discuss money and the government handling of this monetary problem. We have gotten into a situation of ever-rising wages and prices, with more and more workers paid less than they would earn in a free market. It is very difficult to get out of such a situation. The real answer, of course, is economic education.

Neither union leaders nor union workers are stupid people. Keynes and the British politicians were able to fool the employees in England when they first tried this scheme in 1931. They changed all the index numbers, making it difficult to document the price rises reflecting the lower purchasing power of the pound. But now every union has a statistician. They may call him an economist, but he can see from the official cost of living indices that prices are going up. And when they go up, the unions demand still higher wages. This system of Keynes' has just about reached the end of the road. You can no longer fool the workers by lowering the value of the monetary unit. They are on to what is happening and they are not going to take it much longer. The only final answer to this problem is more economic education, showing that the only way to keep raising wages permanently is to increase production, and the way to do this is to encourage savings. For it is only increased savings that can provide workers with more and better education and more and better tools, with which they can produce and buy more and better products that they want most.

(bold emphasis added)

This is from the must read transcribed lecture by economist Percy L. Greaves, Jr. (1906–1984) at the Mises.org.

Signs of China’s Hard Landing: Profits of Industrial Firms Fall

China’s economic deterioration seems to be broadening and worsening and may be indicative of a hard landing…

From Bloomberg,

Chinese industrial companies’ profits fell for a fourth month in July, a government report showed today, adding to evidence the nation’s economic slowdown is deepening.

Income dropped 5.4 percent last month from a year earlier to 366.8 billion yuan ($57.7 billion), the National Bureau of Statistics said in a statement on its website today. That compares with a 1.7 percent decline in June and a 5.3 percent drop in May.

Today’s data add pressure on the government to step up policy easing to reverse a slowdown that may extend into a seventh quarter. On an inspection of Guangdong province from Aug. 24 to 25, Premier Wen Jiabao said difficulties in stabilizing the expansion are “still relatively large” and called for measures to promote export growth to help meet the country’s annual economic targets, the Xinhua News Agency reported.

Another Bloomberg article says bad news is good news, as Premier Wen’s call for more stimulus means the end to China’s economic woes.

Most Asian stocks rose, recovering from declines last week, on speculation policy makers in Asia and the U.S. will take more steps to support economic growth. Oil gained for the first time in three days as a storm shut output in the U.S. and soybeans reached a record..

China’s Premier Wen Jiabao urged extra measures to support exports as evidence mounts that the nation’s slowdown is deepening. U.S. Federal Reserve Chairman Ben S. Bernanke said policy makers can take additional steps to boost the economy before they meet on Aug. 30 in Jackson Hole,Wyoming. About 24 percent of U.S. oil production and 8.2 percent of natural gas output from the Gulf of Mexico has been shut because of Tropical Storm Isaac.

People are really being made to believe in the magic of political snake oil elixirs.

Unfortunately, investors in China’s stock market do not seem to buy such balderdash.

(Table from Bloomberg)

As of these writing China’s stock market has bleeding profusely.

Singapore’s Gradualist Descent to the Welfare State

This is sad news. Using demographic conditions, Singaporean politicians are considering to embrace more welfare policies.

From Bloomberg,

Singapore will need to raise taxes in the next two decades as the government boosts social spending to support an aging population, Prime Minister Lee Hsien Loong said as he proposed measures to boost the country’s birth rate.

The prime minister pledged to ensure sufficient affordable housing for citizens, invest in pre-school education and add nursing homes for the elderly. He urged Singaporeans to build a more compassionate society, reject anti-foreigner sentiment and have more babies, saying the nation needs to re-invent itself as the economy faces slower growth after years of rapid expansion.

“As our social spending increases significantly, sooner or later, our taxes must go up,” Lee said late yesterday in his annual televised National Day Rally address, which ran for more than two hours. “Not immediately, but if we are talking about 20 years, certainly within that 20 years, whoever is the government will at some point have to raise taxes because the spending will have to be done.”

The government has sought to address public concern that Singapore’s economic progress has left its poorest citizens vulnerable to rising living costs while an influx of foreigners increased competition for jobs, education and housing. After the ruling party last year suffered its smallest electoral win since independence in 1965, Lee tightened rules on hiring overseas workers and boosted aid for the poor

This just goes to show that politicians everywhere and of all stripes are cut from the same cloth. They use up all kinds of populist excuses to justify the expansion of political power over society which benefits them more than their constituents.

(chart from Tradingeconomics.com)

The reality is that rising costs of living has been a result of Singapore’s negative real rate regime and hardly from foreign workers.

This easy money regime has fueled a property bubble… (chart from Department of Statistics Singapore)

…through a build up of unsustainable private debt (Chart from UTW.blogspot.com)

Crises emanating from busting bubbles have been frequently used to justify social controls. The Emmanuel Rahm famous quote during the peak of the 2008 crisis resonates

You never want a serious crisis to go to waste…Things that we had postponed for too long, that were long-term, are now immediate and must be dealt with. This crisis provides the opportunity for us to do things that you could not do before.

Once the ball gets rolling for the feedback loop of tax increase-government welfare spending then Singapore eventually ends up with the same plagues that has brought about the current string of crises, particularly loss of economic freedom, reduced competitiveness and productivity, lower standard of living, a culture of dependency and irresponsibility and of less charity and unsustainable debt conditions. The outcome from politically instituted parasitical relationship would not merely be a financial or economic crisis but social upheavals as well.

As Cato’s Doug Bandow write,

The history of the welfare state is the history of public enterprise pushing out private organization. The impact was largely unintentional, but natural and inevitable. Higher taxes left individuals with less money to give; government’s assumption of responsibility for providing welfare shriveled the perceived duty of individuals to respond to their neighbors’ needs; and the availability of public programs gave recipients an alternative to private assistance, one which did not challenge recipients to reform their destructive behavior

The sad truth is that people never really learn.

Phisix: The Correction Cycle is in Motion

The correction phase of the Phisix has become more evident.

Reversion to the Mean: Convergent Market Breadth and Technical Picture

Technical actions and domestic market internals seem to self-reinforce the ongoing cyclical dynamic.

First of all, a technical indicator suggests of a bearish pattern called the head-and-shoulders[1] where a breach of the 5,125 support could mean a test of the major support level at the 4,800 (or from a technical perspective the Phisix may even fall to 4,700).

While I am not a fan of technical charting, I do use it in the understanding that there are many practitioners of these. This implies that critical break points may lead to self-fulfilling momentum swings, albeit the impact could be on a short-term basis. Technical targets often miss.

Anyway, the principle of charting feeds on the pattern seeking behavior or cognitive biases inherent in people than from the more important scientific understanding of human action.

Second, developments in the market internals seem to chime with current chart dynamics.

When the impeachment trial of former Chief Justice of the Supreme Court concluded last May, I laid down my suspicions over the probable political interventions to prop up the Phisix. That’s because during certain periods last June, the Phisix strikingly defied major developments abroad. Amidst hemorrhaging global markets, the Phisix had a huge intraday swing from big losses to substantial gains.

I wrote[2],

The point is ‘interventions’ will eventually be smoothed out or neutralized by the underlying forces which drives the financial markets.

Such interventions had hardly been a one-time event. A deluge of popular self-congratulations over the supposed political accomplishment and mainstream media halleluiahs rationalized the accompanying euphoria in the Phisix.

Nearly a quarter after, circumstantial evidence appear to validate my hunches

The bullish market breadth as measured by the advance-decline spread peaked last January. This has not been surpassed by the recent rally, which ironically brought the local benchmark to a milestone all-time high.

This only means that the June-July rally had been mostly “concentrated” to major heavy cap issues that had large influence in the fluctuations of the local benchmark.

When the market is broadly sanguine, people are willing to take on more risk, thus, the tendency has been to accelerate trading activities.

That supposedly boisterous (politically based) bullish outlook has not matched with the July record setting high of the Phisix.

The same divergence has been exhibited in the number of daily trades (averaged weekly).

In other words, the record breaking rally last June-July has not improved the risk appetite of the median investor as aggressive trading apparently topped out last March.

Again when the market is generally confident, the increase in trading activities will similarly be manifested on the number of issues traded.

Has there been broad market bullishness here?

Nope. Media and popular blarney was not evident in real action.

The same story can be seen. Another divergence emerged, the total number of issues traded daily (averaged weekly) reveals that bullish market sentiment crested on March. The July landmark of the Phisix has not been reinforced by broad market gains.

From the picture based on the market breadth, the record Phisix in the face of divergences meant that correction became imminent. This is what we are encountering today. It simply shows of the forces of “reversion to the mean[3]” at work where artificial price levels supposedly revert to the average.

Oh, to add, the bear market in the Mining sector, which for me, signified as the proverbial shot across the bow for the imminent correction of the Phisix has partly been confirmed.

Then I wrote[4],

I lean on condition (B) or where the bear market of the mining sector will likely percolate into the general market, due to growing risks of contagion

For the holiday abbreviated week (which will be extended for the coming week), only the service sector has posted positive returns. All other sectors including the Phisix fell.

And in looking at the price actions of the different industries, this year’s biggest gainers; the property (violet), banking and finance (black candle) and holding (teal), including the Commercial Industrial sector (blue) have all exhibited signs of rolling over.

After a major selloff, the mining index (light orange) seems to be probing for a bottom.

Again, it is only the service sector (red), which has been this year’s second laggard after the mines, that has showed some signs of resiliency. But my guess is that the current correction cycle will be broad based.

The abovementioned divergences are in fact signs of distribution—where gains over the market have been narrowing. Again technical actions (chart patterns and broad sector activities) seem to reinforce this cycle. In short, previous divergences appear to be converging through a retrenchment phase.

The interventionists, whoever they maybe, managed to push up the Phisix by less than 5% in two months. Now and in the coming sessions, whatever gains they have accrued will likely be eroded if not entirely expunged.

As I have repeatedly been pointing out, the impact of financial market interventions tend to be short term.

Yet the clear lesson that can be gleaned from the above is that People’s action speaks louder than verbal “feel-good” but senseless utterance.

In the theory of human action this is called demonstrated or selected preference.

Central bankers have Rigged the Capital Markets

Of course, I keep emphasizing that the interim gyrations will depend on external developments, particularly from the US.

Even as the current domestic environment operates on bubble policies, the extent of misallocations of capital has not yet reached cataclysmic bubble proportions.

We are more prone to the risks of contagion.

Except for a few standouts, most of the major markets traded lower this week.

Except for blazing hot Thailand, for the rest of the ASEAN giants, the Phisix (PCOMP-red) along with Indonesian (JCI green) and Malaysian (FBMKLCI orange) bellwethers also seem to be topping out.

That should be natural considering the he unfolding developments in China which for me remains as a big concern.

The ballooning number of unsold goods[5], hot money outflows and worsening manufacturing activities[6] among many other economic indicators seem to be worsening and exhibiting signs of a “hard landing”.

A China hard landing or a recession which will likely involve a debt or financial crisis, which will most likely affect commodity exporters and the Asian supply chain network.

Moreover, the slew of negative economic developments has also been manifested in Friday’s breakdown of the Shanghai Index. This should be taken seriously.

China’s major bellwether has so far been in a slow motion decline. Where fear is the most powerful of human emotion[7], slomo can transform into panic in snap of a finger.

For the US and Europe, markets remained transfixed on the central bank actions with special attention over this weekend’s Jackson Hole meeting[8].

Friday’s substantial rally in US stock markets which mitigated the week’s losses, the first loss in 6 weeks, shows of deepening expectations of central banking rescue. From a Bloomberg article[9]:

U.S. stocks rose, paring the first weekly decline in almost two months for the Standard & Poor’s 500 Index, as Federal Reserve Chairman Ben S. Bernanke said he saw “scope for further action,” increasing speculation the central bank will act to boost economic growth.

Again this has been no different in Europe, where financial markets seem to seek for an escape mechanism for their real world problems with the narcotic effects from central bank policies. From another Bloomberg article[10]:

European stocks were little changed, with the Stoxx Europe 600 Index posting its first weekly drop since June, as German Chancellor Angela Merkel said Greece must stick to its commitments to stay in the euro area, and a news report said the European Central Bank is considering setting yield band targets.

Stock markets have been transformed into a game of anticipation on the prospective actions of central banks. It’s a game tilted towards politically connected insiders where the central bankers have effectively rigged the capital markets.

Audit the Fed and President Obama’s Re-election

US equities, for me, seem to have greater downside risk, considering developments abroad prompted for by dilly dallying central bankers and of seeming interminable political wrangling. That’s my bias based on my past analysis[11] [12].

However, given the effective politicization of financial markets, it would be a mistake to discount that US stocks may be manipulated to advance President Obama’s re-election goals[13].

The performance of the stock market have been said to have some influence on or connections to the outcome of US Presidential elections.

According to FoxNews[14],

Of the 28 presidential elections since 1900, an improvement in the S&P 500 prior to an election preceded an incumbent victory 80% of the time, or 16 of 20 of times. The S&P 500’s direction during that period carried an accuracy rate of 82%, according to S&P Capital IQ data.

“Either we have a tremendous situation of being fooled by randomness or we have an interesting stock market phenomenon,” said Sam Stovall, chief equity strategist at S&P Capital IQ.

Of the three out of the four times the incumbent lost following an S&P 500 upswing, outside factors such as third-party candidates were involved, like when Teddy Roosevelt created his own conservative political party ahead of the 1912 election, taking away votes from incumbent William Howard Taft and ultimately leading to the election of Democrat Woodrow Wilson.

When the market fell ahead of a presidential election, the incumbent was overthrown 88% of the time. The only time this predictor failed was in 1956, when Adalai Stevenson failed to overthrow incumbent President Dwight Eisenhower, which could have been a reflection of macro political pressures such as the Suez Canal crisis or Soviet headaches.

This may be coincidence. But advancing stock markets, perhaps, could be interpreted by the public as “progress” even when gains are manipulated or boosted artificially by bank credit expansion.

Besides, policymakers see stock markets as barometer for the animal spirits or market confidence. In the past, US Federal Reserve Chairman Ben Bernanke as an academic professor wrote that

History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.

This is what I call as the Bernanke dogma. As proof that such dogma has been used as a major tool in today’s policymaking, recently the New York Federal Reserve even boasted of having successfully pushed up US Stock Markets[15].

The Bank of England recently admitted that their Quantitative Easing policies boosted asset prices of mostly the rich[16].

The Bernanke doctrine incorporates not only saving the stock market but of the other financial markets as well, through what he calls as financial accelerator

In a 2007 speech, Chairman Bernanke expounded on what he sees as the importance of keeping financial assets afloat[17]

financial conditions may affect shorter-term economic conditions as well as the longer-term health of the economy. Notably, some evidence supports the view that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator." Moreover, a fairly large literature has argued that changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission

The above underscores the academic justifications of central bank interventions. Also one cannot ignore that policy interventions can be timed to attain political goals.

Also considering that President Obama’s opponent, Mitt Romney, has piggybacked on Ron Paul initiative to have the US Federal Reserve audited[18], which thereby diminishes the political power of Ben Bernanke, we cannot rule out that Mr. Bernanke will use the banking system and the Fed’s monetary tools to ensure Obama’s re-election.

So far, in terms of growth of monetary aggregate, M2 has been on a decline but has now reached at a nominal record high.

The chart of the S&P shows of two contrasting patterns: a bullish rounded bottom (lower green arc) and a seeming double top (two upper green arcs).

So US markets and the economy seem both mixed to neutral for now.

Commodity Rally and the Risk of Stagflation

Current environment has not been about consumer price inflation or deflation. Focusing on these manifests of confused perception of what has been happening.

Instead the current environment has been about deflating bubbles and of the monetary inflation responses from central banks. The articles quoted above are clear manifestations of such dynamics.

Consumer price inflation signifies as one of the symptoms of monetary inflation. Yet bubble cycles can occur with or without excessive consumer price inflations.

As the great dean of the Austrian school of economics, Murray N. Rothbard wrote[19],

if new money is created via bank loans to business, as much of it is, the money inevitably distorts the pattern of productive investments. The fundamental insight of the "Austrian," or Misesian, theory of the business cycle is that monetary inflation via loans to business causes over-investment in capital goods, especially in such areas as construction, long-term investments, machine tools, and industrial commodities. On the other hand, there is a relative underinvestment in consumer goods industries. And since stock prices and real-estate prices are titles to capital goods, there tends as well to be an excessive boom in the stock and real-estate markets. It is not necessary for consumer prices to go up, and therefore to register as price inflation.

The bubble dynamics of Thailand in the 90s demonstrates that booms may not necessarily be accompanied by strong surges in consumer price inflation. When the Asian crisis emerged as exhibited by the collapse of the SET[20], Thailand’s CPI fell close to zero[21]. No CPI inflation or deflation here. But a bubble occurred.

A significant development over the past two weeks has been the resurgence of gold.

The price of gold has made a critical breakout from the one year consolidation phase which came along with significant upside moves from the broader commodity sphere.

The recent rally by gold has been backed by the major bellwether the CRB, the industrial metals ($GYX) and energy ($GJX), as well as, the frontrunning agriculture ($GKX) indices. The latter has been catalysed by the US drought and worsened by the distortions from the policies aimed at the promotion of ethanol and biofuel energy.

As Cumberland Advisor’s Bill Witherell points out[22],

The US is projected to divert about 40% of its corn crop into ethanol, and about 60% of Europe's rapeseed crop goes to the production of biodiesel. Brazilian ethanol production consumes half of their sugarcane crop.

I would suspect that these belated moves by commodities have been prompted by the same expectations that have driven the recent stock market rally.

But instead of the constant toggling from risk ON to risk OFF environment, this may seem more of a rotational process or of the relative impact of monetary inflation to the economy. Oh yes, this seems hardly been about fear….yet.

It is yet unclear if the recent gains by commodities will be sustained. These will heavily depend on the actions of policymakers of the developed world and of China.

A recovery of commodity prices should eventually put a floor on the Philippine mining sector.

We should remember that the commodity bull run over the last decade, has largely been a function of insurance against monetary disorder, asset diversification and a position on emerging market development.

Yet current rally may be more about the insurance aspect as China’s economy seems to be stagnating.

It is also unclear if a sustained recovery in commodities will accompany a RISK ON environment for emerging markets and Philippines.

High commodity prices are likely to influence emerging markets consumer price inflation more. Food makes up a large segment of consumption basket for emerging Asia including the Philippines. This would prompt for their respective central banks to reluctantly tighten. Monetary tightening will put pressure on the stock market.

Stagflation, thus, also represents both a contagion and internal (political and market) risk for the Philippines and for emerging Asia[23].

Yet the divergence in policy rates between emerging markets and developed economies may induce more commodity inflation which eventually could be transmitted to developed economies.

Under this environment, positions on resource companies would be more ideal than to hold cash.

And should a stagflationary environment escalate around the world, do expect more pressures on the debt laden developed nations to default as the cost of interest payments on current liabilities soar. And any inflationist response from central banks, to drive down rates, would likely backfire and even worsen the situation.

I might add that if the US economy faces imminent risks of recession, it is likely that the US Federal Reserve will engage in more balance sheet expansion to bailout by reflating the system, this may fire up consumer inflation.

In the US, signs of consumer price inflation have begun to emerge from a combination of reasons. Peter Luger Steak house[24] expects to increase prices of their products based on higher commodity prices. Papa John’s Pizza will raise prices due to compliance on Obamacare[25], so has Chipotle Mexican Grill Inc., McDonald's Corp. and Buffalo Wild Wings[26]

Maintain a Defensive Posture

For now, do expect the Phisix to playout the normal and ‘healthy’ correction phase unless external events deteriorate more than expected.

There will be interim sporadic rebounds but unless we see improvements on both domestic actions and external conditions, we should remain defensive.

Playing defensive means patient positioning. Current events should extrapolate to a buyer’s market.

In the interim, we need to monitor the conditions in China, as well as, watch over feedback loop between the responses of the G-7 policymakers (as well as China) and of the market’s impact on them.

This only means that events remain highly fluid and susceptible to sharp volatilities.

Also, if the commodity rebound will be sustained, then the beacon of an impending bottom of mining sector should be in the horizon.

---

[1] StockCharts.com Head and Shoulders Top (Reversal) - ChartSchool

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

[3] Investopedia.com Mean Reversion

[4] See Philippine Mining Index: Will The Divergences Last? August 13, 2012

[5] see China’s Mounting Glut of Unsold Goods, August 24, 2012

[6] see China’s Manufacturing Slump Deepens August 23, 2012

[7] see Why Not to Pay Heed to the Prophets of Ecological Apocalypse August 21, 2012

[8] US Federal Reserve What's Next

[9] Bloomberg.com U.S. Stocks Rise As Fed Sees ‘Scope For Further Action’ August 25, 2012

[10] Bloomberg.com European Stocks Little Changed; Stoxx 600 Falls On Week August 24, 2012

[11] See Phisix: Managing Through Volatile Times August 6, 2012

[12] See Phisix and ASEAN Equities in the Shadow of Contagion Risks July 22, 2012

[13] See Has US Federal Reserve Policies Been Engineered for President Obama’s Re-election?

[14] Foxnews.com Betting on a Romney Win? Check the S&P 500 First August 2, 2012

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

[16] See Bank of England Study: QE Benefited the Elites August 24, 2012

[17] Bernanke Ben The Financial Accelerator and the Credit Channel Federalreserve.gov June 15, 2007

[18] Businessweek Romney Calls for Fed Audit as Party Mulls Platform Plank, August 20, 2012

[19] Rothbard Murray N. Money Inflation And Price Inflation Chapter 77 Making Economic Sense Mises.org

[20] Chartsrus.com Thailand SET

[21] IndexMundi.com Thailand Inflation rate (consumer prices)

[22] Witherell Bill Food Prices and International Equity Markets August 18, 2012 Cumber.com

[23] See Will Soaring Agricultural Commodity Prices Bring about Stagflation to Asia? August 2, 2012

[24] Bloomberg.com Peter Luger Steak Prices May Soar as Drought Culls Herds August 21, 2012

[25] Politico.com Papa John's: 'Obamacare' will raise pizza prices August 7, 2012

[26] MoneyMorning.com Rising U.S. Food Prices are About to Eat Away at Your Savings, July 31, 2012

Quote of the Day: Democracy is a Delusion that the Majority is Master of Itself

participatory democracy became fashionable in the 19th century. The main reason was probably because it is easier to squeeze and bamboozle a citizen than it is a subject. The real genius of modern democracy is that it makes the citizen feel that the government and its workings are somehow the product of his own aspirations. If he wants more money for his retirement, he presumes he can get is — provided only that enough fellow citizens share his desire. If he wants to go to war, that too is up to him and his fellow voters. If he wants to spend more money on space exploration or ban people from saying prayers in bars, the majority — of which he feels he should be part — can do that too.

There is hardly anything he and his fellow lumpenvoters cannot do — just so long as they are of one mind on the subject. That is why you so often hear people say, ‘If we could only get together on this…” They believe solidarity is the key to success. Whatever the majority wants, it gets.

Even kings had bits in their mouths and a hand on the reins. According to the “divine right of kings” doctrine, a king was a servant of God. A king was subject as well as monarch. God himself had given them the post; they could not refuse it. Nor could they refuse to carry out the job on the terms that they believed God had prescribed. God could pull on the reins whenever He wanted.

Often, monarchs were ridden by those who claimed to represent God. In the famous example from the 11th century, Pope Gregory VII got into a dispute with Henry IV, the Holy Roman Emperor. Henry was excommunicated. How much harm Gregory’s excommunication would do him, Henry might not have known. But he didn’t want to find out. He dressed as a penitent and waited three days outside the Pope’s refuge at Canossa. Then he was admitted and forgiven.

The democratic majority, on the other hand, recognizes no authority — temporal, constitutional nor religious — that can stand in its way. And thus it deludes itself to thinking that it is the master of itself, its own government and its own fate.

“The government is all of us,” said Hillary Clinton.

This from Bill Bonner, founder and president of the Agora Publishing, in one of his latest articles published at the Agora’s Daily Reckoning website.

In reality, participatory democracy is the manipulation of the delusional majority to serve the interests of the political minority.