Posts Tagged ‘savings’

How does China ‘save?’ Story of the circuitous journey of a US$

Sunday, July 19th, 2009

One of the most common expressions that we hear today is that “China has a very high savings rate.” It is said that China saves 50% of its income. But as investors, we have to be very clear what this high savings rate mean. Does it mean that Chinese families and individuals, on aggregate, save 50% of their income? Certainly, the personal savings rate in China, on aggregate, is higher than the West. On the other hand, the Chinese, especially the younger generation, are emulating the profligate and spendthrift of their Western counterparts (see Chinese increasingly overdue on credit cards)- their rising credit card debt arrears and skyrocketing mortgage debt in the major cities shows that they are learning the bad habits of the West fast.

It is fair to say that the personal savings record of the Chinese does not fully account for the 50% savings rate. So, what does this high savings rate mean?

In reality, China’s high savings rate is the result of forced savings by the government. The Chinese government ‘forced’ savings on the Chinese people by accumulating massive US$2 trillion reserves (as foreign assets, notable US Treasury bonds) on behalf of their people through the currency peg. To understand how it all works, consider how the US dollars spent by American consumers typically ends up as US Treasury bonds in the US (China recently announced changes to the rules, which will affect the steps below):

  1.  An American consumer pays US$30 for an Oral-B electric toothbrush at Wal-Mart.
  2. Most of the US$30, say US$27,  stays in America to pay for the worker’s wages, distributions costs, transport cots, Wal-Mart’s profit, Oral-B’s profits and so on. This US$27 is part of the 70% consumer spending portion of the US economy. That US$27 helps to ‘stimulate’ the US economy.
  3. The remaining US$3 ends up in a factory in southern China. The deal between Oral-B and the Chinese manufacturer is denominated in US$ (i.e. the Chinese manufacturer is paid in US$). But US$ cannot be used in China because the RMB is the currency of China. So, what happens next?
  4. The Chinese manufacturer will present the US$ to a local Chinese bank (say, the Shenzhen Development Bank). He has to show the receipts to the Shenzhen Development Bank (SDB) to prove that the US$ is earned by trade and not through speculation.
  5. The Shenzhen Development Bank (SDB) will take the US$3 in exchange for RMB.
  6. This is where China is different from the West. In Western countries, a bank in SDB’s situation can do whatever it likes with the US$- e.g. trade them for euros or yen on the foreign-exchange market, invest them directly in America, issue dollar loans and whatever they think will bring the highest return. In China, the SDB has to surrender all of its US$ to the PBOC for RMB at whatever the official exchange rate (the RMB is ultimately created from thin air by the People’s Bank of China (PBOC)- see Why is China printing so much money?).
  7. Everyday, there are thousands of transactions between the local Chinese banks and the PBOC. The pile of US$ that keep piling up in the PBOC like crazy. Please note that trade with America is not the only thing that result in US$ streaming into China. Trade between China and other countries are also settled in US$, which means even more US$ are piled up in the PBOC.
  8. The PBOC transfers the US$ to the State Administration for Foreign Investment (SAFE). SAFE must figure out what to do with the rising pile of US$ (which is currently over the US$2 trillion). Some will be parked in US stocks, bonds, euros and so on. But the great majority ends up as boring US Treasury bonds.
  9. And so, the US$ makes a round trip back to America, hopefully to be used on Chinese goods again.

From this, you can see one thing: as long as US$ keeps streaming towards China, SAFE has to keep on investing them. Most of these US$ investments will end up as US Treasury bonds because it is the only market that is big and liquid (and politically sensitive) enough to absorb those never-ending stream of US$. Therefore, no matter how much China dislikes holding its forced savings as US$ assets, it has no choice.

But lately, China had announced some changes in rules that will hopefully alter the status quo (which they detest). Keep in tune!

What should the ‘evil’ savers do?

Sunday, June 14th, 2009

In our previous article, What goes in the mind of the Rudd government as it extends FHOG?, Rebecca asked the following question:

I was wondering, can you guys make any suggestions on what potential first home owners OUGHT to be doing INSTEAD OF leaping upon the FHOG [free cash (of around $14k to $21k) that Australian government gives to first home buyers]? This reader may, uh, be personally invested in the answer to such a question 😉 but I bet a lot of others are in the same boat: people who’ve been saving saving saving only to have the cheese moved $21,000 ahead again (thanks KRudd!), and now face the possibility of having their hard-saved future deposit decimated by inflation because it’s still liquid rather than sunk into bricks and mortar?

Assuming stable employment (easier said than done, but run with me here), isn’t the property market almost a safe bet now just because Kevvie’s obviously bailout-happy and presumably knows he’s not going to be very popular if he lets all the first home owners he made go under, so is likely to keep on bailing?  Does the traditional advice that a person save a good deposit apply any more when the only way to save your money is to have it invested in property or some other format that’s not going to get devalued should inflation occur? What else can one do to escape being a victim in this whole mess simply through being on the poor end of the spectrum and trying to do the right thing and be responsible?

Basically, as Rebecca asked, let’s say these 3 conditions are satisfied:

  1. Assuming you have a guaranteed stable job (if we read Rebecca correctly, other people are not in this envious situation).
  2. The government will succeed in enticing people to go deeper and deeper into debt to bid up property prices higher and higher.
  3. If those who are enticed into debt default, the government will bail them out.

Wouldn’t this result in property price rising further and immune to a price crash? If that’s the case, should savers gouge themselves in debt instead because the government is committed to moral hazard?

[Note: some parts of what follows are a bit of sarcasm and humour- so, don’t take them too literally.]

Sure, it can be very cheap and easy for the government to engineer further property price inflation. The FHOG is an example of that. The government needed to fork out a relatively small outlay to result in a much larger increase in borrowing, which helps to inflate property prices even more. To see why, imagine a borrower has a $1000 deposit. At 90% LVR, he can buy a house that cost $10,000. Let’s say the government give the borrower another $1000. At the same LVR, this borrower can now pay $20,000. Thanks to the powers of leverage, a $1000 outlay from the government result in an increase of $9000 in debt.

Sure, in the event that the sh*t hit the fan for the Australian economy, the government can bail out defaulting sub-prime borrowers willy nilly and prevent a property price crash. They can print copious amount of money (until Australia runs out of paper), invoke emergency powers to prevent repossessions, confiscate the wealth of savers to bail out irresponsible defaulters, nationalise banks, and so on.

The problem is, if the sh*t hit the fan for the Australian economy AND the Australian government engage in such extreme moral hazard, Australia will become a big banana republic and the Australian dollar will have less value than toilet paper. Foreigners lend a lot of money to Australia and they will readily punish any extreme moral hazards. In that case, all Australians will lose big time, especially savers. And also, a property is not recommended in such an environment because:

  1. One cannot carve out a tiny fraction of his property in exchange for food.
  2. There are much better hedge against hyperinflation than property- gold and silver. The reason is because credit will be scarce in a hyperinflationary environment because lending money is a losers’ business. If credit is scarce, what do you think will happen to property prices in real terms?
  3. As lenders raise interest rates to match the rate of hyperinflation AND one loses his job, one is essentially stuffed (unless the government bails him out).

So, if you believe Australia is going towards that route (it may not be as extreme as the scenario that we painted, but you get the idea) and you want to protect your savings, you may want to diversify part of your savings away from Australian dollars (as well as any assets denominated in Australian dollars). Ideally, such diversification should transfer your wealth to foreign countries, where the foreign government is in a position to respond with a “stuff you” to any Australian government’s demands for information about your foreign assets. For example, you may want to consider foreign currencies (preferably in foreign banks out of reach of the Australian government), physical gold and silver (stored overseas or buried in some secret treasure island guarded by dragons), foreign assets and so on. Lastly, if the masses and government persecute the evil savers the same way the Nazis persecute the Jews, be prepared to migrate.

Please note that we are not trying to be unpatriotic here. Our point is that, if politicians resort to extreme stupidity, they can easily turn a nation into a banana republic in record time. Just ask how Robert Mugabe did it by turning the bread basket of Africa into a starving and improvished nation.

If you save, government will wage economic war on you

Tuesday, February 17th, 2009

In this economic climate of uncertainty, governments all over the world have to be seen to be doing something. The problem is, by doing ‘something,’ they are actually making the problem worse (see Are government interventions the first steps towards corruption & inefficiencies? and Supplying never-ending drugs till stagflation). In particular, they fear debt deflation because it is the more immediate threat. It is this fear that led Helicopter Ben (i.e. Ben Bernanke) to subscribe to the Zimbabwean school of economic thought (see Bernankeism and hyper-inflation) in the Keynesian belief that forcing people to spend and consume is the way to go. If printing money are the answers to the Global Financial Crisis (GFC), then Zimbabwe will be the richest and most prosperous nation in the world. Indeed, judging by the number of billionaires, in that country, it must be so! When you see Zimbabwe’s central banker praising the central banks of US and UK (see Zimbabwe?s central banker in praise of Fed), you know something is very wrong with the monetary policy of the Federal Reserve.

As we said before in “Government?s contradictory messages,”

Without the liquidation of mal-investments and restoration of the structural imbalances that is brought about by deflation, applying bigger and bigger stimulus packages will only function in similar ways to drugs- more and more for less and less effect. The reason why Keynesian reflationary pump-priming worked during the Great Depression was that it was applied after the cleansing effects of the deflation had done its work. But today, in reaction to the financial crisis, governments all over the world are doing so before the purge of fire. As a result, the much-needed economic correction that the economy had to have will not happen.

Thus, whether you are currently in debt or not, if you intend to save money, the government will be very keen to discourage you from doing so by undermining and debasing the currency in which your savings are based on. As we said in “When real interest rates is below zero, why save money in bank?

 … if we disregard the doctored statistics of the official figures, real interest rates are negative!

That is why governments all over the world are sending so many mixed messages to the effect that an average person do not know whether he/she is meant to spend or to save (see Government?s contradictory messages). A very simple way to resolve this paradox (sarcastically) is to think of it this way: save while everyone else is committing financial suicide by spending willy nilly.

What if you are a saver who simply does not wish to spend, invest, borrow or speculate? If you believe that the government will fight this war against debt deflation by marching our credit-based economy towards a Zimbabwean-style economy (see Recipe for hyperinflation), you will be forced to make very difficult choices. For such a saver, the best case scenario for your savings will be severe price deflation in an environment of zero-interest rates in a properly functioning banking system (while still employed/business earning positive cash-flow). But if you are pessimistic about this best-case scenario happening, then you will be forced to ‘speculate.’

As the government and RBA try to erode your savings by taxing them and pushing down interest rates to below price inflation (even perhaps to zero), what can you do? Good question.

Let’s take a look at the US. Currently, short-term US Treasury bonds are yielding almost nothing. At one point, their yield even became negative! In that case, what will be the difference between a nothing-yielding government bond and gold? As we said before in “Is gold an investment?“, gold is

a boring, inert metal that does not have much pragmatic use and does not pay dividends, income or interests, it is completely unfit for ?investment.?

That probably explains why we are seeing, at least for now, US Treasury bonds and gold moving upwards together. Traditionally, they move in opposite directions. Today, this inverse relationship seems to have decoupled.

Therefore, the risk/reward profile has come to the point that savers who have spare cash may want to consider transforming part of their savings from cash to gold.

P.S. Use the government’s free stimulus cash to buy gold. 😉

When real interest rates is below zero, why save money in bank?

Sunday, February 15th, 2009

In “What will happen if RBA cuts to zero?,” we described the situation whereby interest rates in many countries are moving towards zero i.e. Zero Interest Rate Policy (ZIRP). In Australia, the interest rates are currently at 3.25%. There are talk in the financial market that more cuts are on the way.

Price inflation, on the other hand, is 3.7% for the year to December 2008- that is, according to the official CPI figures. As late as October last year, the official price inflation was running at 5%. But as we wrote in “What is your personal price inflation rate?,”

Inflation is also running high in the rest of the Western world. Worse still, many of the official measurements of inflation run counter to personal experiences.

As we quoted Ludwig von Mises in How much can we trust the price indices (e.g. CPI)?,

If she [a judicious housewife] ?measures? the changes for her personal appreciation by taking the prices of only two or three commodities as a yardstick, she is no less ?scientific? and no more arbitrary than the sophisticated mathematicians in choosing their methods for the manipulation of the data of the market.

Talking to some people from the US, we learnt that despite having an official falling inflation rate (based on CPI), people feel that things are still very expensive.

In other words, if we disregard the doctored statistics of the official figures, real interest rates are negative!

In Australia, interests from savings are taxed. This means that after tax, putting money in the bank is a losing proposition. If excessive debt is the cause of the global financial crisis (GFC), then this means that the solution is to slim down, cut down on debt and start saving. But if savers are punished with negative real interest rates, then the very poison (that caused the crisis in the first place) is used as the medicine. If a doctor do this, then he/she will be charged with criminal negligence. Yet, with interest rates in Australia projecting to fall further, the econocrats are doing this!

For foreigners, the solution is very simple- just pull your capital out of Australia. After all, who on earth will want to lend money below the rate of price inflation? If the government is really concerned about the foreign banks pulling out of Australia (and further tightening the local credit market), then wouldn’t falling interest rates worsen the situation? It has come to the point that even our local banks are murmuring about further cutting their lending rates to match RBA’s projected rate cuts. If the banks are politically pressured to cut their mortgage rate, then they will have to: (1) draw blood from elsewhere- see Canberra is destroying jobs or (2) ration capital.

For the hard-working Aussie savers, what are their options? We will look more into it in the next article. Keep in tune!

Jamming on brakes and accelerator simultaneously

Sunday, February 8th, 2009

A few years ago, we were chatting with our friends on the topic of personal finance and investments. Back then, it was a global financial bull market in which the savings (made compulsory by law in the form of superannuation) of millions of Australians were ploughed into ‘assets.’ Our friend’s attitude is that she will leave it all to the ‘experts’ and ‘professionals’ to invest her savings and would not want to bother herself with it. The prevailing thinking was that, as we described in The myth of financial asset ?investments? as savings (in February 2007),

… there are some who argued that if we include financial asset ?investments? such as home equity, pension and managed investment funds, stocks and so on, the savings rate is actually positive.

As we elucidated in that article, we had strong reservations on this fallacious idea. In essence, many people’s savings were (and still are) thrown into chasing prices of intangible financial assets, which hardly result in real capital formation. By chasing and bidding prices upwards, it gave rise to the illusion that ‘wealth’ had increased when in actual fact, there were no corresponding accumulation in capital goods (see The myth of financial asset ?investments? as savings to understand the meaning of capital goods). The global financial crisis (GFC) is a correction to this grand illusion.

Think about it: Why is it that after the years of ‘prosperity’ (economic boom) the state of infrastructure is so poor and neglected that governments today have to spend billions in nation building to ‘stimulate’ the economy? After all these years of boom in ‘asset’ prices, wealth and prosperity, is that what our nation (including the US, UK and Australia) has to show for?

Where had all the money gone to?

Once you understand the Austrian Business Cycle Theory (see What causes economic booms and busts?), you will be able to see that limited resources in the economy are being mal-invested into wasteful and unproductive use. So, this bust is the period when mal-investments are in the process of liquidation (e.g. deflation in asset prices). Very unfortunately, governments are hell-bent in preventing this liquidation process and at the same time, trying to redirect resources into urgently needed area via central planning.

The governments’ actions are akin to jamming on the brakes and accelerator simultaneously. No prize for guessing what will happen to the car.

Fading glory of the financial services and ‘wealth’ management industry

Sunday, November 2nd, 2008

October has just passed and it will go down in history as one of the worst months in stock market history. Even many veteran traders have not seen anything that bad before. As Marc Faber said in a recent Lateline interview (on 13 October 2008),

As of last week, world stock markets became oversold. Statistically probably the most oversold condition in the last 50 years or so.

One good gauge of fear in the stock market is the Volatility Index (VIX) indicator. As you can see from the chart below, the VIX spiked to its record high level (since 1990) at above 80 in October.

VIX indicator since 1990

Consequently, such intense level of fear had provoked the government into making up policies as they go and then tweaking away the side effects as an after-thought. For example, when the government gave unlimited guarantee to bank deposits, fearful money began to defect away from investment funds into banks. As these funds reacted by freezing redemptions from investors, prompting a crisis on their investment business. Some of these investment managers then pleaded with the government to guarantee their investment funds. We could sense the underlying sarcasm of the government officials as they replied by ‘taunting’ these investment funds to become banks if they want to fall under the protective umbrella of the government.

The global financial market had never been subjected to so much fear for a very long time. The sheer terror of a global financial meltdown had provoked knee-jerk reactions from governments, regulators, central banks, investors, traders and the humble savers. Beneath the raging waters of fear, panic, reactions and counter-reactions, the many decisions made on the spur of the moment by governments, regulators, and central banks will be judged by history to be turning points. These decisions will have many long-term side effects that are not immediately apparent. At this point in time, although there are signs that the panic is starting to melt away and calm gradually returning to the market, the lingering smell of mass ‘wealth’ destruction will still remain for a considerable period of time.

As we mull through the long-term ramifications, our thoughts are drawn to the future of the investment and financial service industry. The first effect we can think of is the loss of trust and confidence on the idea of ‘wealth’ management. Much of the panic selling in October was contributed by investors redeeming their money from managed funds and stuffing them towards the proverbial cash under the mattress (i.e. treasury bonds, guaranteed bank deposits and even gold). The number one priority was not return on their money. Rather, it was return of their money.

Our stand is that the trust and confidence on the idea of ‘wealth’ management through ‘investments’ in financial assets was a misplaced one. The whole idea of ‘investments’ was based on a massive bubble. As we said before at Have we escaped from the dangers of inflation? in February 2007,

Today, the global spigot of liquidity (see Liquidity?Global Markets Face `Severe Correction,? Faber Says on the concept of ?liquidity?) is wide open, spewing out huge amounts of money and money substitutes into the financial system.

With all these flood of fiat money inundating the global financial system, we look at all these skyrocketing financial asset prices with a yawn. Price bubbles of all sorts are found everywhere in the world?from Chinese stocks, junk bonds to private equity booms. Back here in Australia, it looks to us that nowadays, everyone is ?playing? the stock market, many using leverages like CFDs and margin lending. We hear stories of novices ?investors? opening a trading account to ?learn? how to trade. The logic is simple: central banks around the world are hard at work ?printing? money. These monies first go to the financial system, creating price bubbles. The bubbles then attract speculators, gamblers and punters into the asset markets the way bees get attracted to honey. Soon, word get round to the masses and they want a slice of the action too.

Over the years, central bankers are creating copious amount of money and credit out of thin air. The masses then take on the delusion that these fiat money are real wealth. As we asked before in The myth of financial asset ?investments? as savings,

Can the printing of money, which spawns the growth of an industry to shuffle it, cause a nation to be richer in the long run?

There were so much money and credit conjured from thin air that an entire industry (i.e. financial service and investment industry) has to be bloated beyond its fundamental use in order to shuffle them. As we said before in Connecting monetary inflation with speculation,

Thus, by further inflating the supply of money and credit in the financial system at such a time, there comes a situation whereby there are excess liquidity without adequate avenues for appropriate investments.

Thus, the global credit crisis is a return back to reality as the masses wake up their idea that all these ‘wealth’ are illusionary. As we quoted Ludwig von Mises at The myth of financial asset ?investments? as savings, real wealth is based on real capital formation. Shuffling money and competitive chasing after assets with fiat money do not make a nation any richer.

Alas, there are still many who still do not get it, even when the threat of a Great Depression II is gathering at the gates of the global economy. For example, in Australia, the Opposition Leader, Malcom Turnbull still speak of the ‘savings’ trapped in investment funds due to the Australian government’s unintended side-effect bank deposit guarantee. The fact that he is using the concepts of savings and investments interchangeably to refer to the same thing shows that he has no idea about what he is talking about.

Dear readers, to be a successful investor, you have to understand the difference between savings and investments. We urge you to read The myth of financial asset ?investments? as savings. The entire superannuation and wealth management industry is based on the myth that investments (especially ‘investments’ in financial assets) are savings. Consequently, the build-up of mal-investments that such a myth introduced brought about the financial crisis that we have today. Real investment brought about real capital formation, which is the cornerstone of real wealth in the future.

As far as we can see, the bull market (in real terms) on financial assets is over. What comes next is either deflation or stagflation. The implication is that peak glory (2001-2007) of the financial service and wealth management industry will be history.

Will RBA’s cutting of interest rates help?

Sunday, October 26th, 2008

Recently, Associate Professor Steve Keen made the prediction that interest rates in Australia will be cut to zero by 2010. As this news article reported,

University of Western Sydney associate professor of economics and finance Steve Keen is radically bullish on interest rates, predicting a 2% cash rate by the end of 2009, dropping to 0% in 2010.

Dr Keen said the RBA would become more concerned about high household debt levels than inflation, as deep rate cuts in 2009 failed to stimulate the economy.

”The debt bubble is bursting and when it bursts, people stop spending and borrowing,” he said.

Investors should realise is this: if interest rates is ever cut to zero (i.e. Zero-Interest-Rate-Policy or ZIRP), it will not be good news for the economy. It will reflect the complete failure and impotence of monetary policy in regulating the ‘temperature’ of the economy. In other words, to arrive at ZIRP, it means that the economy is in a very serious trouble.

Japan fell into ZIRP in the 1990s. As we all know, the malaise in the Japanese economy lasted 16 to 17 years before a glimmer of hope was seen at around 2003. Today, due to the global credit crisis, they are falling back into the recessionary hole. With interest rates at 0.5%, they have no more room to cut further.

One thing that is different about the Japanese economy from the Australian/UK/US economies is that Japan had a relatively high savings rate. During their lost decade of the 1990s, the Japanese drew on their savings and retreated to their economic bunkers as their economy and asset prices contracted year after year.

In contrast, Australia/US/UK today have no savings and are heavily indebted.

If the RBA cut interest rates further, it will be in reaction and anticipation to Australians closing their wallets, cutting up their credit cards and shunning debt. As we explained before in Will Australia?s own pump-priming work?, all we need is for Australians to stop borrowing in order to induce a deflationary force of $250 billion. This deflationary force alone will wreck havoc to many Australian businesses, which in turn will wreck havoc to the employment market. Once mass unemployment appears, a lot of prime debt will become sub-prime debt. When debt becomes sub-prime, cutting interest rates to zero will not help.

Dangling pornography in front of a dead man will not induce him to open his dead eyes. Likewise, the RBA dangling free credit to banks (i.e. ZIRP) will no longer induce banks to lend because of the pervasive fear of bad debts. To understand this, we highly recommend that you read What makes monetary policy ?loose? or ?tight??.

Currently, Australians are voluntarily shunning debt (as shown by the rapidly decelerating rate of credit growth) as banks are still willing to lend money (although lending standards are tightening). When this voluntary action crosses over to involuntary, it will be the day when the deterioration will accelerate.

Where are we in the business cycle?

Friday, February 9th, 2007

Yesterday, in our article, The real story behind the phenomena of booms and busts, we asked this question. Today, we will look at the indications of where we may possibly be in the business cycle in Australia (which is applicable to the US as well).First we look at the November 2006 Statement of Monetary Policy from Reserve Bank of Australia (RBA):

What does seem clear, however, from several sources of information, is that the economy is operating with very limited spare capacity.

Clearly, as in the metaphor we gave in What cause booms and busts? Introduction to the Austrian Business Cycle Theory, the bus is running low on fuel i.e. the economy is reaching its limit of productive capacity. This is also the same situation that the United States is facing right now. Further down the statement:

Demand in some sectors has been especially strong over a number of years, reflecting the growth of the domestic and international economies. If firms cannot bring new factories or mines immediately on line when capacity constraints become binding, they may decide to hire more labour to work their existing production processes more intensively. This would lead to strong employment growth, but also a fall in the growth rate of average labour productivity because only relatively modest additional output can be produced by hiring more labour without additional capital.

To cope with the strong demand, businesses are forced to increase output. Unfortunately, the effectiveness of the existing capital stocks in the economy is reaching its limit and the only way to increase production further is to employ more labour and pressure the existing employed workers to produce more. As the statement says, without complementary capital, these extra labours are constrained in its effectiveness in increasing output.

Recently, we read in this news report, Consumer confidence ‘lowest since 2003’, ?dragging sentiment down in the half was a sharp 14 point fall in the quality of life rating to 25.5 points… But (they are) finding it more difficult to achieve due to the demand for longer working hours and more intense competition in the job market.? Anecdotally, many of us are feeling the increasing strain of work. Though Australia may be experiencing the lowest unemployment rate, it comes with a cost at our quality of life. Worse still, according to our personal experience, we can feel that price inflation is more pronounced lately.

With the economy struggling to increase output and the money supply still growing, we can expect price inflation to still remain a threat. But price inflation has been quite benign during the past few years. Why is it so? As in the United States, price inflation has been ?controlled? by importing of goods from China. As we said in The Bubble Economy, the rise of the Chinese economy?s productive capacity has a disinflationary effect on prices worldwide. But such low inflation can only be achieved at the cost of incurring a ballooning trade deficit?our imports exceeding our exports. But make no mistake about it: we cannot always rely on the Chinese to save us from price inflation by blowing out our current account deficit even further. So, the greatest danger to Australia?s economy right now is price inflation. As we said in The real story behind the phenomena of booms and busts, if interest rates persistently remain out of sync from the natural rate of interest for too long, we can run into the danger of hyperinflation.

How can we restore the economy back to equilibrium and ensure that it remains in a firm footing for the future?

The first thing that has to happen is to increase our national savings. As we said in The myth of financial asset ?investments? as savings, we need to restore and rebuild our stock of capital goods to ensure our future prosperity. Already, the quality of our education, health, telecommunication and transport infrastructures are in decline and they are in need of repair and upgrade. This means that the only way we are going to achieve that is to reduce our current consumptions and cut down our debt. When that happens, the economy will slow down and many businesses and investments will fail as a result. Since most of the Australian (and the US as well) is made up of consumer spending, in which much of it is funded by debt, we can see that this remedy will be painful. If the consumers do not slow down and get their act together, we can expect the RBA to impose a restraint by raising interest rates.

Thus, we believe that Australia (and the US as well) is at the top of the business cycle. For investors, we have to bear in mind that we are now probably at the cyclical top. If we assume that the current trend of companies? profit growth will extend indefinitely into the future, we will be in for a nasty surprise.

The real story behind the phenomena of booms and busts

Thursday, February 8th, 2007

Today, we will explain how the business cycle of booms and bust comes about. If you have not already read What cause booms and busts? Introduction to the Austrian Business Cycle Theory followed by What cause booms and busts? Explanation of Austrian Business Cycle Theory metaphor, please do so because what comes next will not make sense without the background understanding of these two articles.

First, we revisit the thought-provoking question that we first asked in What cause booms and busts? Introduction to the Austrian Business Cycle Theory: How can the central bank know the ?right? price of money when it decides the level of interest rates? The truth is, it does not and the outcome is less than ideal as it sets interest rates at levels other than ones the free market would have chosen.

Let us suppose that interest rates are decided by market forces. How would it be decided? As expected, the fundamental economic law of supply and demand determines the level of interest rates. As consumers seek to defer their consumption to the future, they increase their savings rate. This increase in the supply of money from savings pushes down the interest rates. Conversely, as consumers seek to increase their current consumption at the expense of the future, they decrease their savings rate, which decrease the supply of money for savings, which in turn pushes up interest rates. On the side of the entrepreneurs, their demand of capital, which is supplied from the consumers’ savings, will lead to an equilibrium level where supply equals demand. This equilibrium level is the natural rate of interests.

Now, what happens if the central bank interferes with market forces and set the interest rates below the natural rate? The outcome would be that the demand for capital (from entrepreneurs) will exceed the supply of capital (from consumers). The only way to bridge this gap would be to increase the supply of money (that is, ‘printing’ of money). When that happens, through the fractional reserve banking system, the amount of credit in the financial system will be increased multi-fold. Consumers will spend more than they would have if the interest rates had been higher. Entrepreneurs would invest more than they would have if the interest rates had been higher. The outcome would be ‘greater’ economic activity.

But there is one problem with this state of affairs?there are finite amount of resources for the economy to work on in order to keep up the rate of production with the increased investment and consumer demands. Thus, for a time, the economy can be stressed to increase its rate of production, but ultimately, it will meet its limit. At this point in time, the boom part of the business cycle is coming to a halt. This is what is happening to Australia right now as the Reserve Bank increasingly uses the phrase “capacity constraint” to describe the economic situation.

If the interest rates are still kept artificially below the natural rate, the outcome will be price inflation as the artificially induced demand far outstrips the economy’s capacity to produce. If left unchecked, the result will be hyperinflation. Thus, the central bank will have to raise interest rates to curb the excess demand. Consumers will cut their consumption as their debt becomes more expensive. Entrepreneurs will slow down their rate of investments, which means that employees will be laid off, projects cancelled, and cost being cut. At this point, we have come to the bust part of the business cycle.

Thus, the adjustment of interest rates by the central bank does not ?smooth out? the peaks and troughs of the business cycle. Instead, such interference of the interest rates is the cause of the business cycle.

Now, where are we in the business cycle?

The myth of financial asset ?investments? as savings

Friday, February 2nd, 2007

Today, the savings rate of the United States has never been lower since the Great Depression. This is a very serious concern that should never be underestimated. However, there are some who argued that if we include financial asset ?investments? such as home equity, pension and managed investment funds, stocks and so on, the savings rate is actually positive.

Here, we wish to dispel this myth.

First, we would need to understand what the true nature of savings is. In Chapter 15, Section 2 (Capital Goods and Capital) of Ludwig von Mises?s book, Human Action: A Treatise on Economics:

At the outset of every step forward on the road to a more plentiful existence is saving?the provisionment of products that makes it possible to prolong the average period of time elapsing between the beginning of the production process and its turning out of a product ready for use and consumption. The products accumulated for this purpose are either intermediary stages in the technological process, i.e. tools and half-finished products, or goods ready for consumption that make it possible for man to substitute, without suffering want during the waiting period, a more time-absorbing process for another absorbing a shorter time. These goods are called capital goods. Thus, saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material conditions of man; they are the foundation of human civilization.

Goods that directly relieve a need or want are called consumer goods. Capital goods, on the other hand, are goods that help in the production of consumer goods?they increase the future productive capacity of the economy. As we all know, the economy has a finite quantity of resources. It has to choose between producing consumer goods for current consumption or capital goods which will help in producing future consumer goods. Furthermore, capital goods depreciate over time?resources are required to maintain them. The extent in which the people in the economy choose to produce (and maintain) capital goods over consumer goods constitutes the savings rate of the economy.

For example, let?s say we save $100 in the bank. The bank then lends out $90 to an entrepreneur who uses it to set up a business enterprise that will produce goods that consumers want down the track. In this case, the $100 that we save is a sacrifice on our current consumption. Part of that $100 of ours is then put in good use to add value to the economy in the future. In return for my sacrifice, we are paid interest.

In another example, let?s say a company decides to raise money in the stock market to fund its expansion plans. We invested $100 in that company?s IPO. That company then uses our $100 to build a new manufacturing plant that will produce consumer goods in the future. In this case, that $100 that we invest is considered savings since it involves us sacrificing current consumption worth $100. In return for our sacrifice, we are paid dividends from the company?s future earnings.

Now, based on this understanding on savings, can our home equity be considered savings? We have ‘equity’ in our homes if its current value exceeds the amount we owed. But the problem with such ‘equity’ is that it depends on the home’s current value, which is merely a paper value based on the principle of imputed valuation (see Spectre of deflation for the concept of imputed valuation). As we said before in The Bubble Economy, since the phenomena of inflating home values is mainly due to the increase in money supply (colloquially known as ?printing money?), they cannot be considered as savings as they do not have any resulting influence in the increase of capital goods in the economy. In the same way, if we buy and sell existing stocks (as opposed to newly issued ones in an IPO) in the stock market, are we in any way contributing to the accumulation of capital goods in the economy?

As the financial side of the economy (see Analysing recent falls in oil prices?real vs investment demand on the concept of the real and financial side of the economy) becomes increasingly influential in the economy, we wonder how much this side contributes to the amassing of capital goods, which is the foundation of building the future wealth of the nation? Can the printing of money, which spawns the growth of an industry to shuffle it, cause a nation to be richer in the long run?