Posts Tagged ‘deflation’

Are deflationists missing the elephant in the room? Or are they believing in something more sinister?

Sunday, August 1st, 2010

As you scour around the blogsphere, you will see that there are contrarians who still believe that it is impossible for the US to prevail against deflation. The most extreme of deflationists is Robert Prechter (from Elliot Wave International), who is still predicting that the Dow Jones will go all the way down to 1000. Up till March 2009, it seemed that the deflationists’ argument was correct. In the Panic of 2008, deflationary forces were so strong that asset prices were even more oversold than the infamous 1987 crash. Unfortunately for the deflationists, the subsequent rally (reflation) till May 2010 was so enduring that their argument was discredited in the eyes of many.

Our view, on the other hand, belongs to the inflationists’ camp. From what we can see, there is a big elephant in the room that deflationists miss. But as we think about the deflationists’ argument, it suddenly dawn on us that perhaps deep in the soul of the deflationists’ argument is the belief of what some may call a “conspiracy theory.” Of course, we guess not all deflationists hold (or even aware of) such a belief. But the more extreme and strident a deflationist hold on to the deflation argument, the more we suspect that they are holding on to the belief of the “conspiracy theory.” Although we do not know whether that “conspiracy theory” is true or not, it certainly helps to explain the extreme position held by some deflationists.

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If you want deflation, you would love Germany

Sunday, July 11th, 2010

From our previous article, one of our readers was very indignant at the current state of affairs. As he wrote,

During inflationary times, those who speculated made more money than those who held cash. so you could argue that those who held cash felt the "inflationary pain" but why wasn’t the government pressured politically to do something as they were when they get spooked by deflation?

Then when deflationary times come its the turn of those who held cash to benefit while those who already made their money out of speculation and over leveraging to feel the "deflationary pain", after all they did take too much risk.

I don’t think its fair or right for governments to manipulate the economy to prop up the prices of the investments of the speculators (who helped create all these bubbles in the fist place). Basically that means that they got to make a lot of money out of speculating but they didn’t take any real risk as government will step in to do "something" about the pain.

If the don’t feel the pain they will continue recklessly speculating.

Meanwhile that very same "something" the governments will do to help the speculators avoid pain will probably mean devaluation of the currency one way or another so that once again those who did not speculate and over leverage will feel the pain.

The governments actions will tend to encourage more people to speculate! I would like to see deflation happen, does anybody else feel the same way???

On the first point, why are governments more spooked by deflation than by inflation? The simple reason is that in a democracy, the mob rules. Unfortunately, the mob is heavily indebted as a whole. All we have to do is to look around and see that the culture of debt is deeply ingrained in society. For young people, not only is it fashionable to get into debt, it is very difficult not to get into debt. For example, buying your first home is enough to put you in debt for decades.

The last time governments became spooked by inflation was in 2008 when oil and food prices shot through the roof (see Who is to blame for surging food and oil prices?). If governments continue its policy of doing ?something? about deflation for a sustained period of time, we believe it will be a matter of time before prices of necessities will resume its surge again. As usual, the blame will be put on ?shortages? and ?speculators.?

But not all governments in the world are biased towards inflation. Germany is the exception here. The trauma of the hyperinflation during the Weimar times is seared into the German consciousness. As a result, they will avoid anything that hints of inflation. Unlike the English-speaking countries, politicians in Germany who stick to discipline, austerity, balanced budgets and stand against moral hazards see their popularity go up.

Coincidentally, Germany is also the most important member of the Euro zone. As a result, their attitude towards inflation is being imposed on Europe. In the recent G-20 meeting, the G-20 endorsed a halving of budget deficits by 2013 as the target.

But as George Soros wrote in a recent article,

The situation is eerily reminiscent of the 1930s. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banking system and the economy may not be strong enough to do without fiscal and monetary stimulus.

The Great Depression of the 1930s is one of deflation. In Soros? opinion, the G-20?s endorsement of government de-leveraging has increased the risk of deflation today.

So, in the coming months, we can see why the deflation argument will be gaining the upper hand.

When to start speculating again?

Thursday, July 8th, 2010

As we wrote before in Notice the change of narratives in the financial markets?, the theme for the coming months is likely to be deflation (contraction in the supply of money and credit). The symptoms of deflation will include falling asset and commodity prices and appreciation of the US dollar.

The reason why deflation is gaining the upper hand is that governments are not renewing their appetite for maintaining the crutch (economic ?stimulus?) to keep the economy from sinking. In Europe, the government themselves are deleveraging (see Keep up spending- Who?s right? Europe or America?).

But as contrarian investors, we have to keep one step ahead. As deflationary forces gather steam, eventually the government will be spooked. Eventually, they will be pressured politically to do ?something? about the situation. That ?something? will ultimately boils down to turning on the monetary printing press.

For example, as this news article reported, there is an expectation that the Chinese government will do ?something? if stock prices continue its downward trajectory. In the US, RBS recently warned its clients to be prepared for a ?monster? money-printing operation from the Federal Reserve (long before RBS released this, readers of this blog already know beforehand that this will happen- see Bernankeism and hyper-inflation).

When governments do ?something? about the deflationary pain, it will be a signal to shuffle your money back into speculation.

Does gold hedge against inflation/deflation?

Tuesday, February 2nd, 2010

It is often parroted by mainstream media that gold is a hedge against inflation. Sometimes, you will hear that gold is a hedge against deflation. Also, from our previous article (Will gold mining shares hedge against deflation again since the Great Depression?), we established that even though gold stocks hedges against deflation during the Great Depression, it does not necessarily apply to today’s situation. However, one of our readers said that Marc Faber reckoned that gold and gold stock hedges against deflation.

Isn’t this very confusing? How does gold hedges against inflation and deflation?

The answer is explained clearly in our book, How to buy and invest in physical gold and silver. For those who have not read that book, we will give some hints to the answer.

First, “inflation” and “deflation” are over-generalised words. Gold is a hedge against a narrow subset of “inflation” and “deflation.” The corollary is that in certain cases of “inflation” and “deflation,” you will lose using gold as a hedge. In page 20 of How to buy and invest in physical gold and silver, we have a story of Mr Goldberg who died a miserable man because he had nothing to show for his long-term commitment to gold.

As we said in How to buy and invest in physical gold and silver, the fundamental reasons for accumulating gold as a hedge are:

  1. Lack of confidence in fiat money (to function as money)
  2. Lack of trust in the financial system

Inflation is only one of the possible symptoms of point 1. Likewise, deflation is also one of the possible symptoms of point 2. The implication is that it is possible to see these two symptoms without holding those two fundamental reasons in your heart (i.e. see some forms of price inflation/deflation and yet still trust in fiat money and the financial system). Indeed, inflation has been with most of the world in the past 20 years. Deflation has been with Japan for the past 20 years. That is why there are many people (especially those from the mainstream media) who are deriding gold and gold-bugs.

But any time you have good reasons to lack confidence in fiat money and/or trust the financial system, it will be the time you will want gold as a hedge before the symptoms show up unmistakably as inflation/deflation.

To help you understand, we will give an example. During the Great Depression, banks were collapsing en masse. If your bank fails, then your cash at bank disappears into thin air. If everyone’s cash at bank disappears, then you can be sure there will be falling prices because there will be a sudden shortage of cash- everyone will want to hoard whatever physical cash they have on hand. In such a situation, if you own lots physical gold then you need not fear. You can always go to the Federal Reserve (remember, it was still the gold standard back then) and exchange your gold for physical cash. Or in theory, you can transact in physical gold only.

Today, during the Panic of 2008, banks were dropping dead like flies. That’s also a good reason to own gold or government bonds (we imagine that you can insist that the government pays you the yields with physical cash instead of depositing them at a wobbly bank). But then someone like Kevin Rudd announced that the government is going to guarantee all cash at bank. If there’s going to be falling prices (deflation) and if the financial system is going to function, then government bonds and term deposits will be better than gold. If there’s going to be mild inflation and if everything is going to be fine and benign as in the past 20 years (e.g. no currency crisis, no collapse in the financial system), then cash at high-yield bank accounts will be better than gold too.

Remember. as we wrote in our book (How to buy and invest in physical gold and silver), gold will only do exceptionally well at the extremes.

Here is a quiz question for you: if there’s going to be a collapse in the global financial system (as Marc Faber described as “deflation could only be triggered by one event: a total collapse of the existing global credit bubble”), would you rather own physical gold or gold stocks?

Is the coming ‘crash’ in China not a real crash?

Thursday, January 14th, 2010

By now, you would have known that we have grave reservations on the quality of China’s post-GFC economic rebound. We are not alone in our reservations as there are many experts, both in the mainstream and non-mainstream media who share our view. But there are also many others who seems to hold the opposite view, including Jimmy Rogers.

For those who are looking for answers, all we can say is that China is very difficult to read. It is a country with many mirrors. When we Westerners try to interpret China through a Western lens, culture and context, we may end up misinterpreting, misunderstanding and missing the subtleties of China.

Economic data from China is something that investors should not swallow entirely without question as no one knows how accurate they are or how much of them are made up. As data flow from the bottom to the top layers of the vast Chinese bureaucracy, from the local government to the provincial government and finally to the central government, we wonder how much of the information are lost, misinterpreted, fudged, revised, falsified, misrepresented, hidden and added? Or perhaps we are too cynical?

But if you hold the view that a a big economic correction is coming to China and wants to ‘short’ the country, you have to be aware of what you are betting against. First, you are betting on deflation in China, symptoms of which include falling asset prices, rising unemployment and bankruptcies. Governments, on the other hand, would prefer to err on the side of inflation. When you have an authoritarian government that can make and change the rules, you can be sure that they will draw out the big guns to fight against deflation. For example, what if a trade war threatens to do serious harm to the Chinese economy and social stability? We wouldn’t be surprised if the Chinese government whips out nationalistic sentiments, point the finger at the nations that started the trade war and in the extreme case, start a shooting war. According to Marc Faber, he reckoned that the same would apply to the US too.

But let’s not get too carried away with expecting an almighty economic ‘crash’ in China Let’s play the devil’s advocate for now and examine the reasons why Jim Chanos (the guy who publicly wants to ‘short’ China) may be wrong.

As a whole, China is not too leveraged (unlike countries like Australia, US and UK). The people in major cities (especially Shanghai and Beijing) are highly leveraged and share many similarities with highly indebted Australians and Americans. For example, the housing bubble in Shanghai is much bubblier than the one in Australia. Credit card habits of the city young adults are just as bad as their Western counterparts. Since the financial system in China are still very much primitive compared to countries like Australia, US and UK (the financial sector in those countries are probably too big), the debt disease have yet to reach everyone in China, especially the hundreds of millions of rural peasants.

At the same time, the rich-poor gap in China is much wider than in Australia. For example, there are still hundreds of millions of poor peasants living in under-developed or undeveloped rural areas. Large swathes of China have yet to develop and catch up with the affluence of the coastal cities. A deflationary crash will affect the highly indebted city folks much more than the rural peasants. Since the fruits of China’s economic boom have largely bypassed the latter, they will hardly miss the loss of wealth due to an economic correction because they have not gained much in the first place. Whether boom or bust, these people will still go about their business everyday.

Deflation, in fact, will benefit those on the poor side of the rich-poor divide. The economic boom has a very detrimental effect on them as the price inflationary effects actually made them poorer (we heard stories of migrant workers in Shanghai who are too poor to even buy food). Deflation re-distributes wealth to these people. Currently, the Chinese government is in the process of developing the poorer regions in China. That, plus deflation may re-distribute economic resources and activities to those areas. For example, those same migrants workers who are too poor to buy food in Shanghai may want to return to their home villages because of better opportunities (from government development) and better standards of living (food are probably cheaper and affordable there).

If this theory is correct, it means that a ‘crash’ in China should not be interpreted in the same way as a crash in Australia, Japan or the US. In the Western world (including Japan), an economic crash means that the standard of living for everyone in general will decline. For China, because of its relatively wider rich-poor gap, it may just be a wealth re-distribution exercise in which some will be better off and some will be worse off. On paper, a Chinese ‘crash’ is bad in terms of GDP growth and demand for resources. But socially, it may not be such a bad thing as it may be China back into a more sustainable growth path.

That could be the reason why people like Jimmy Rogers are still optimistic on China. Investors like him are probably not investing their capital on the frothy affluent cities. Instead, he is probably investing in sectors of the Chinese economy that will still be humming along and going about their business even when the ‘crash’ hits the economy. Unfortunately for many investors, the ‘China’ that their investments are in will probably not survive the ‘crash.’

Does rising house prices imply a housing shortage?

Thursday, August 27th, 2009

There is a common argument that Australia has a housing shortage because prices are rising. The flawed reasoning goes like this: “Under the ‘irrefutable’ law of demand and supply, if prices rise, it must be due to demand outstripping supply i.e. shortage situation.”

This flawed reasoning has its roots in the mainstream Neo-Classical school of economic thought. Under this school, the market is assumed to be in equilibrium. As we wrote in Soft landing hope built on faulty framework assumptions

But this is a very erroneous assumption built into the framework of mainstream neo-classical economic thinking. Does the economy always have to return to equilibrium the way an elastic band spring back into its previous relaxed state? Can there be other forces that can pull the economy further and further out of equilibrium until a breakdown occurs?

In Neo-Classical reasoning, equilibrium is when the supply curve meets the demand curve. If prices go up, and the market has to be in equilibrium as assumed, then it has to imply that the supply curve had shifted left and/or demand curve had shifted right. Subsequently, prices had to rise to ease the demand-supply imbalance. With rising prices, many of these housing ‘experts’ then go hunting for reasons (that suits their vested interest) to explain the ‘shortages.’

In the real world, the market need not necessarily be in equilibrium. In fact, it can go out of equilibrium and remain so for an extended period of time, independent of the housing shortage/surplus situation. In Australia’s housing market, we have identified two major factors:

Price rise expectation
The first factor is price inflation expectation. As we quoted Ludwig von Mises in What is a crack-up boom?

He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief: accordingly he restricts his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding.

This observation is true for generic commodities that can be purchased with cash alone- in contrast, houses are almost always purchased with debt. The belief that prices will always go up forever and ever can create its own artificial demand. The insidious thing with this belief is that it is a self-fulfilling prophecy- belief leads to increased ‘demand,’ which in turn leads to higher prices, which reinforced the belief, which in turn leads to increased ‘demand’ and so on and so forth. When this happens, higher prices lead to even higher ‘demand.’ Such artificial demand can act as a sink-hole for whatever quantity of supply until money runs out in the financial system (which is not possible under today’s a fiat credit system). The Dutch Tulip Mania (which burst in 1637) is an example of the power of belief. Indeed, there must a ‘shortage’ of tulips at that time, according to Neo-Classical supply-demand ‘fundamentals.’

This is the same dynamic working in hyperinflation, where everything (not just houses) rises in prices. It was just last year that there’s talk of food shortages (see Who is to blame for surging food and oil prices?). Today, we hardly hear of food ‘shortages’ after deflationary Panic of 2008.

Availability of credit
As we all know, almost everyone borrow money to buy houses. Very few buy them with cash. What if banks decide to withdraw all credit in the economy? Obviously, people’s purchasing power of houses will fall as they can only rely on their cash savings to buy houses. Consequently, the ‘demand’ for housing will collapse immediately. As we said before in Another faulty analysis: BIS Shrapnel on house prices,

Where is the housing ‘demand’ going to come from as credit becomes more expensive? The only way for most people to buy a property is to borrow money. If credit becomes more expensive (i.e. harder to borrow money), obviously the ‘demand’ for properties will fall as well.

Conversely, when there’s more and more easy credit are available, more and more borrowed money can be used to bid up house prices. This can go on until the debt servicing burden becomes too big to bear.

How the two factors interact with each other
People’s expectation that prices will rise (abetted by belief that there’s a housing ‘shortage’) will lead to higher prices. Unlike the Dutch Tulip Mania of the 17th century, today’s financial system can spew out more and more credit continuously (see Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model). This means that self-reinforcing artificial demand can be fuelled by more and more credit, which helps prices to rise.

Then, through the principle of imputed valuation, increase in house prices at the margins will result in every other house to be re-valued upwards. As we said before in Spectre of deflation,

One thing many people fail to understand is that values of financial assets can vanish as easily as they are created in the first place. It is a fallacy to believe that just because money has to move somewhere from one asset class to another, the overall valuation in the financial system cannot contract. The very fact that all the money in the world cannot buy up all capitalisation is proof of that fact. This leads us to the next question: how do financial assets derive their value?

As we mentioned in The Bubble Economy, we have to understand the principle of imputed valuation. Suppose you have a house which you bought for $100,000. What happens if one day, your neighbour decide to sell his house (which is similar to yours) for $120,000? When that happens, your house would have to be re-valued upwards to $120,000 even though you had done absolutely nothing. The same goes for stocks. All it needs for a stock to increase in value is for a pair of buyer and seller to transact at a higher price. As long as the other shareholders do absolutely nothing, that higher price will be imputed into the values of the rest of the stocks. Thus, when asset values rise, all it takes is a handful of them to trade at higher prices in order for the rest to be re-valued upwards. If assets can ?increase? in value that way, it can ‘decrease’ in value that way too.

What is more worrying is that assets of such imputed values are used as collaterals for further borrowing, which becomes the borrower’s liability.

When the values of the houses sold at the margins are imputed to the rest of the houses, it result in higher valued collateral for more granting of even more credit. More credit adds another round of self-reinforcing feedback loop.

Pre-requisites for a substantial house price fall in Australia
All we need for house price to fall substantially in Australia is (1) a reversal of house price rise expectation and/or (2) tighter credit and/or critical mass of debt servicing failure (which can be caused by rising unemployment- see RBA committing logical errors regarding Australian household finance). When that happens, the self-reinforcing feedback loop for higher prices will become a self-reinforcing feedback loop for lower prices.

Look at UK…
There are many ‘experts’ who argued that house prices are falling in the US due to ‘over-supply’ and that Australia’s housing ‘shortage’ will prevent a house price fall. These experts conveniently failed to look at the UK. Just do a Google search on “housing shortage” site:uk and you will find many reports of a housing ‘shortage’ in the UK too.

We all know what happened to the UK housing market.

Why is the modern economy so dependent on ever-lasting growth?

Tuesday, August 11th, 2009

Have you ever wonder why economists and policy makers are so obsessed with economic growth? Why is it such an acute problem if the economy is not in a treadmill of growth (i.e. ever-lasting increase in the quantity of goods and services produced)? What is so bad with zero economic growth (i.e. an economy that takes it free and easy)?

As one of our readers wrote in our previous article,

This is all to say that the [modern capitalist] system is much more fragile than anyone would have guessed and that the cult of markets and efficiency have left the world with a system that is less and less resilient. The crisis that has begun over the last couple years begins to bear that out. In fact we’ve become dependent on efficiency and without it the system may just fail under it own weight. Time will tell but the process has begun.

Why?

We believe the root of the problem lies in the monetary system. Today, we have a monetary system that is at its heart a system of credit. That is, the ‘money’ that flows around the system is loaned out of existence. To understand what this means, read on…

Originally, mankind started with commodity money. Money was a physically tangible thing. In the 15th century, Spain found gold in the New World. As gold was money back then, Spain found a lot of money and became ‘rich’ as a result. Today, most of our money has become virtual, intangible and in the form of electronic information. The overwhelming values of transactions are made in the form of electronic fund transfers instead of exchange in physical paper cash.

Now, think of your cash at bank- it is an asset to you and a liability of the bank. Say, when you make a non-cash purchase (either with cheque, credit card, bank transfer, etc), that transaction ultimately becomes a transfer of liability from one entity to another. This text-book idea implies that assets have to exist first before it can be loaned out as someone’s else’s liability.

The real world does not conform to this text-book idea: liabilities are created by banks first (in the form of loans) before the assets exist (we recommend you read Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model if you need a deeper understanding). After the liabilities are created out of thin air, the bank then go hunting for the assets by borrowing from another entity (e.g. central bank, depositors, another bank, investors, etc). Ultimately, either directly or indirectly, that asset (currency) originates from the central bank.

The central bank is the only institution that can create assets (currency) out of thin air to be loaned out as liabilities. Imagine you are a central bank- all you need to do is to declare $100 into existence, lend it to the banking system and then have the power to demand that the money (which you created out of thin air) to be paid back to you at an interest rate that you decide.

The observant reader will then be asking this question: “If the entire economy pays back all the currency that was borrowed into existence, but still owes the interest, where does it get the currency to pay the interest?” The answer is startling simple: more currency has to be borrowed into existence to pay back the original interest!

Now, you can see that total debt in the economy will grow exponentially (compounded interest) continuously and can never be repaid fully. That means the economy has to grow continuously in order to generate the income to pay back the continuously growing debt. Since the physical world has a finite quantity of resources, the quantity of goods and services produced in the economy cannot always grow fast enough to match the continuously growing debt. Therefore, the only way to keep the system running is to add in price inflation (growth in the nominal value of the goods and services produced) so that the nominal value of the continuously growing debt can be repaid. That’s why, as our reader observed, the “cult of markets and efficiency” in the modern capitalistic economy is there by necessity to keep the economy growing continuously.

For the past decade, total private debt is growing at a speed far in excess of GDP growth (i.e. growth in income). For a while, it seemed sustainable because asset prices (most notably, house prices) were rising fast enough to keep the financial system solvent (i.e. able to pay back the continuously growing compounding debt in nominal terms). As you can see by now, if asset prices stops rising in the context of adequate economic growth, the game is over. That game-over situation is what we all know as the Global Financial Crisis (GFC).

The GFC trigger the economic phenomenon called deflation. Once the debtors (e.g. banks, households, businesses) become insolvent, they can cause their creditors to become insolvent, who in turn threaten the creditors’ creditors with insolvency. This systemic debt defaults will now reverse the debt growth, which means the currencies that are loaned into existence will be written off into non-existence, which means money supply will shrink, which in turn will cause vast tracts of the economy to shave off its productive capacity (e.g. unemployment, idle factories, excess capacity).

If the economy is not expected to grow sufficiently and the government wants to keep the wheel running, what would they do? The only course of action is run the money printing press (i.e. create currencies out of thin air, pump them into the system for free). The risk is that without a properly growing economy, they risk igniting another asset price bubble. An asset price bubble may seem to ‘work’ because they can keep the system solvent for a while, until the bubble burst and restart the deflation nightmare again. The government will then have to start the monetary printing press again while the economy shaves its productive capacity the second time. If this process is repeated umpteen times, it will come to a point whereby the only thing to keep the system running is rising asset prices and not economic growth. When that happens, it is hyperinflation.

The current asset price rebound around the world is the stage where rising asset prices are keeping the debt wheel running. We don’t know how long that gig will keep running.

Is the GFC over? And what about the recession?

Sunday, August 2nd, 2009

In our previous article, we wrote about the coming looming disaster that will eclipse the Global Financial Crisis (GFC). This prompted one of our readers to ask,

Editor, you believe that the GFC is over?

What about the recession?

We realise that there’s plenty of room for misunderstanding regarding our stand on the GFC. So, we are writing this article in the hope that all misunderstandings will be clarified and also provide a road map to help you understand the big picture.

First, we believe that 2007 will be the year of peak prosperity in the real economy. The decade leading to 2007 was indeed a time of euphoria for many. It is a time of low price inflation, thanks to the massive ramp up of China’s industrial productive capacity, flooding the world with cheaper and cheaper Chinese made products. It is also a time of low interest rates (thanks to Alan Greenspan) and cheap credit (thanks to the advances in ‘innovation’ from Wall Street). Consequently, through the current account deficit of the US, the world was flooded with liquidity to send a high tide of ever-rising asset prices. As we wrote back in June 2007 at Epic, unprecedented inflation,

Today, the world is experiencing an unparalleled inflation of asset prices. This is the first time ever that the world is experiencing asset price inflation in all asset classes (e.g. property, bonds, commodities, stocks and even art!) and in all major nations (e.g. US, China, Japan, Australia, UK, Russia, etc). We will repeat this point again: never before had such a universal scale of asset price inflation ever happened in the entire history of humanity! Today, even artwork is also in a ?bull? market (if you consider artwork as an asset class)!

All these confluence of factors made the world go merry in drunken excesses. But unbeknown to most except the contrarians, the rot was already setting in (see our guide, What causes economic booms and busts?).

Then, as we all know, the GFC struck. Our long-time readers are certainly not caught by that- they’ve been warned as early as January 2007 at Spectre of deflation. The panic culminated in the Panic of 2008 (which ended with a final low in March 2009).

Currently, emboldened by the ‘green shoots’ of recovery, there is another powerful rally in stocks and commodity prices all over the world. Optimism returned, speculations returned and confidence turned up again.

So, is the GFC over?

It depends on what you mean by GFC and which part of the world.

If by “GFC” you mean another panic in scale and intensity as the Panic of 2008, then we believe it is ‘over’ (notice the quotation marks). Statically, the Panic of 2008 resulted in a more oversold condition than the 1987 and 1929 crash. That is, the selling pressure was worse than 1929 and 1987. Therefore, based on statistical probability, another panic that is worse than the Panic of 2008 is unlikely to return for quite a while yet.

Does that mean stock prices will never revisit the March 2009 lows? That depends on how successful the Keynesian reflation attempts (government stimulus, printing of money, bailouts, etc). If deflationary pressures gains the upper hand against governments’ reflationary efforts, then stocks can still drift lower to below the March 2009 low in say, a couple of years time. In such a scenario, this current “green shoots” rally will certainly meet with a major correction- currently, prices are at extremely overbought territory. After that major correction, then can be a counter-rally, than correction than counter-counter-rally (i.e. a saw tooth movement) until the ultimate low. If March 2009 turns out to be the ultimate low, we may end up with indecisive whipsaw movement for quite a while. The stock market may end up hyperinflating if governments are too ‘successful’ (see Can we have a booming stock market with economic calamity?).

So far, we are focusing on the financial markets. The real economy, on the other hand, will continue to grind down slowly, thanks to never-ending government stimulus (see Are governments mad with ?stimulating?? and Preserving jobs at all costs leads to economic stagnation). It is unlikely to fall off the cliff in the same manner as during the Panic of 2008. We remembered someone saying that had the real economy continue to deteriorate that way (i.e. fell off a cliff), the world will return to the stone-age in a few decades time. As the real economy grinds down, we expect price inflation on the street will continue to make life more difficult.

Now, can you see that asset prices in the financial markets and the real economy are walking on two different independent tracks? This observation has yet to be noticed by the mainstream. Many investors still think that rising asset prices imply a recovering economy and falling asset prices imply a deteriorating economy. As we have taken great pains to point out to our readers, asset prices and conditions in the real economy can go in opposite direction (as they are doing right now) for an extended period of time. We are more certain of what will happen to the real economy than what will happen to asset prices.

So, what follows next? We will continue this story in the next article. Keep in tune!

When will the next bull market for commodities arrive?

Tuesday, May 12th, 2009

Following from what we wrote at Does the major Chinese economic slowdown signify the end of the commodities boom?, what is our view on the long-term prices of commodities? To understand our view, you will have to follow our explanations below…

No doubt, the global financial markets have experienced a serious bout of price deflation for financial assets and commodities (except US Treasury bonds), especially in the second half of 2008. So far, government stimulus, bailouts, rescues and money printing are minuscule compared to the overwhelming tide of de-leveraging. It has been said that a value of US$33 trillion was wiped out from the global financial markets. So far, government interventions had only forked out at around a few trillions of dollars at most. These numbers are not meant to be accurate, so please do not quote us on that. The point is, compared to the amount of ‘wealth’ lost in the financial asset markets, government injections of money so far are just a small fraction of what was lost. If you include the coming de-leveraging by consumers in the real-economy, then the outlook for the economy and asset prices is even bleaker. Having said that, if governments continue to inject even more money unceasingly, it’s only a matter of time reflation will occur. Indeed, the current rally in commodities and stock prices shows that reflation is working for now.

So, while asset (and commodity) prices are deflating at such unprecedented speed, what will happen to real physical investments in the real economy? Such volatility in prices will make it very difficult for businesses to engage in long-term real capital investments. Using the mining executive as an example in Real economy suffers while financial markets stuff around with prices,

For example, place yourself in the position of a mining company executive today. Commodity prices are falling precipitously over the past few months as the global economy is staring into a possible depression. At the same time, you know that China and India is still going to demand lots of commodities in the very long run in the coming decades. Besides knowing these two basic facts, there will still be great uncertainty in prices as the forces of deflation and inflation battles each other for supremacy, regardless of which forces will eventually win. Will we even be using US dollars to calibrate prices in the future? Who knows? In such an indeterminate environment, it is clear that many more mining projects will have to be shelved. Some have to be abandoned. You may be scratching your head, wondering whether to push forward your project plans.

As we have already seen in various news reports, mining companies are already losing mining, closing down their mines, laying off staffs, cutting production and so on. These will result in lower productive capacity in the long-term. Since the mining business is very capital intensive, it is not easy to ramp up production at a flick of the switch.

Now, let’s turn our eyes at China. As we explained before in Does the major Chinese economic slowdown signify the end of the commodities boom?, a major economic correction for China does not spell the end of Chinese economic growth. Eventually, they will recover and consume resources hungrily again (see Example of a secular trend- commodities and the upcoming rise of a potential superpower).

The question is, when will China recover? Will it happen within our life-time? Some reckon it’s a matter of waiting a couple of years. Others are more sceptical. But let’s assume that a Chinese recovery will happen in a few years time. At the same time, with the long-term productive capacity of mining companies severely impaired by the effects of the credit crunch, what will happen to commodity prices?

Please note that this does NOT mean that commodity prices will surge soon. Rather, this credit crisis is setting the stage for a new commodity bull market from a very low base. The question is, are the current prices near the low base? Or is there more deflation in prices to come?

Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber’s view

Thursday, May 7th, 2009

In our previous article, “Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model”, we promised to explain Marc Faber’s view on why inflation (rather than deflation) will be outcome in the years to come. As he wrote in his most recent Gloom, Boom, Doom market commentary,

Now, from the numerous emails I get I have the impression that most investors are leaning toward the view that ?deflation? will be the problem in the future and not ?inflation.? An ?expert? [Editor’s note: For the sake of peace, let us all assume he was not referring to Professor Steve Keen] even opined that whereas it was possible under a pure paper money system (large quantity of banknotes in circulation) to create high inflation rates, this was not possible under an electronic banking system.

First, let’s take a look at Professor Steve Keen’s view that the destruction of credit (IOUs) will overwhelm any money printing by the government. As Steve Keen said in “The Roving Cavaliers of Credit”,

To make a serious dent in debt levels, and thus enable the increase in base money to affect the aggregate money stock and hence cause inflation, Bernanke would need to not merely double M0, but to increase it by a factor of, say, 25 from pre-intervention levels.

Our view is that while massive deflation of credit will occur, it will not happen overnight. Instead, while the deflationary pressures will continue, it can be slowed down via unconventional monetary policies (see “Bernankeism and hyper-inflation”), gigantic fiscal policies, bailouts and even government fraud. The result will be a long drawn out affair, akin to a grinding trench warfare and a war of attrition on the real economy as credit contraction (IOU destruction) collide head on with money printing, massive government spending, stimulus and bailouts. In fact, this is what is happening right now in the US as optimism for “green shoots” of economic recovery fuels a rally from the depths of the panic of 2008. To make this saga even more confusing, despite the credit destruction in the second half of 2008, prices on the street have yet to make a meaningful decline. Simply speaking, money ‘printing’ will be spread out over a number of years until deflationary pressure subsides. Thus, Bernanke is not going to increase M0 by 25 times in a flash- he is going to do so over an extended period of time until it is no longer deemed necessary.

Next, credit contraction will not go on forever. As Professor Steve Keen commented before, he expects deflation to end eventually and inflation to return after say, a few (or several or dozen or whatever) years.

Now, we will talk about Marc Faber’s argument. Consider what’s happening as the Global Financial Crisis (GFC) unfolds:

  1. Economy contracts
  2. Interest rates are cut
  3. Fiscal policy is stepped up to assist failed monetary policy (see “What makes monetary policy ?loose? or ?tight??”). Then as Marc Faber said,

    But for the fiscal stimulus to even have a small chance of succeeding at reviving economic activity it has to be larger than the private sector credit contraction.

    With that, he had a chart to show that “US Private Sector Credit Contraction Is Offset by Public Sector Credit Expansion!”

  4. Government spending going up when tax receipts declines.
  5. Upward pressure on interest rates (see “How are governments driving up fixed mortgage rates?”)
  6. Governments forced to monetise debt (i.e. print money, which is already happening in the US, UK and Japan) in an attempt to force long-term interest rates down. See “Why are nothing-yielding US Treasuries so popular?”.

That’s where the crux of Marc Faber’s argument,

And here lies the crux of the problem most deflationists do not understand. By keeping short term rates artificially low and by monetizing the growing fiscal deficits a central bank digs its own grave in terms of its ability to pursue tight monetary policies when such policies become necessary.

If the US Fed failed to tighten monetary policies after the US economy began to recover in November 2001, what are the chances of tight monetary policies in the future (which would significantly increase in the short run the cost of servicing the government?s debt) when both the US government and the Fed will be loaded with toxic assets and burdened by all kinds of other liabilities? The chances of the US government implementing tight monetary policies in the next few years are exactly zero.

But my point is simply this: Once a government embarks on highly expansionary fiscal policies which entail government expenditures vastly exceeding revenues (leading to enormous budget deficits and soaring government debt) and simultaneous monetization (?printing money?), the reversal of these inflationary policies becomes for all practical purposes impossible. Inflation and higher interest rates follow. At this point the reader should clearly understand that any upward pressure on interest rates brought about by the market participants will actually force a central bank that embarked on monetization to monetize even more [Editor’s note: This is the time when money supply will increase exponentially!]. The other point to remember is that the longer an economy does not respond to such ?inflationary? fiscal and monetary policies, the larger the ?doses? will become.

So, by implication, any global recovery from the Global Financial Crisis (deflation) will bring forth another crisis (inflation)!