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Political analysis required for investment decisions

Sunday, May 20th, 2012

We haven’t been writing for quite a long while and our dear readers may wonder why. One of the reasons is because today, economic and investment outcomes are increasingly being determined by politics instead of economics. Since we are no political analyst, we have very little to say. Back in 2006, when we first started this blog, we brought our readers through with great expositions on economic theory, particularly from the Austrian School of economic thought. Back then, economic analysis was the key to foresight. Today, the environment is different?there is a rising trend of government interventions, which results in more unintended consequences, which in turn led to more interventions. As Marc Faber said, having brilliant economic and financial analysis is not enough nowadays; we also need to enlist the help of political analysts in order to anticipate the next move by politicians.

As we all know, after months of calm in the financial markets, fear and panic are returning again, thanks to political upheavals in Europe. In this video, Stratfor made a very good point regarding the solution to this problem:

So, when ANZ’s CEO reckons that a euro-zone breakup is likely, he is in effect making a political judgment, which isn’t what bank executives are supposed to do in the first place. But we live in interesting times anyway, so this is hardly unreasonable. So, what will be the economic outcome for us in Australia should that happen? We don?t know but one thing we are sure: the euro-zone breakup is the most anticipated crisis. We have been talking about Greece since February 2010 (see European politicians hammered from both sides) and had repeatedly warned that the Greek crisis was far from over. So, we are not so concerned about this. That is not to say that we aren?t concerned at all, but we are saying this to remind our readers to keep things in perspective.

What we are more concerned are the unexpected and unanticipated mishaps. That could be war, geo-political tensions, which the financial markets are currently underestimating the likelihood. We have to include the economic (or rather, political) situation in China. It is well-known that China intends to transition its economy away from investment towards consumption. That will definitely result in Chinaslowing down and paring back their demand for Australia?s commodities. But as we said before, What Black Swan can hit China?, this too is also highly anticipated. But take note, the slowdown in the Chinese economy is a political event. The real estate crash that is happening inChina right now is an act of political will by the Chinese government. A lot of Chinese property developers are in financial trouble today because they failed to anticipate the determination of the Chinese government to burst the real estate bubble. Previously, the Chinese government was weak with regards to reining in the bubble and as a result, they lacked credibility when they announced the latest bubble-fighting policies. But unfortunately for the property developers, the Chinese government was serious this time and that was the Black Swan for them.

Regarding China, the million dollar questions that we would like to know are:

  1. Will the slowdown of the Chinese economy veer outside the designs of the Chinese government (i.e. crash)?
  2. When that happens, the Chinese government will definitely intervene. The question is, will they be successful in arresting the unanticipated crash?

In Australia, we already have our hands full dealing with the stress that is currently affiliating our economy (due to the effects of Peak Debt and the planned Chinese economic slowdown). A Chinese economic crash will be the trigger that breaks the straw.

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What Black Swan can hit China?

Wednesday, January 18th, 2012

We are now in 2012 and there are plenty of talks in the mainstream media about a possible hand-landing for the Chinese economy. In today’s article, we shall not go too deep into the details. This article by Paul Krugman explains the mainstream thinking very well. Nevertheless, despite the mainstream speculation of a possible hard landing, the financial markets are still pencilling in a soft landing. This may change as more data is released to indicate otherwise.

We don’t dispute Paul Krugman’s thesis of why a hard landing is coming. In fact, as we read his articles, we find his argument familiar- in fact, they seem to come from Michael Pettis, a professor at Peking University’s Guanghua School of Management. We read his articles regularly for insights, along with Patrick Chovanec’s. Even our favourite contrarian, Marc Faber is echoing warnings that while all eyes are looking at Europe’s problems, China may surprise on the downside.

Now, from all these ample warnings, we can establish the fact a Chinese economic hard landing will be the most anticipated ‘surprise’. We say it is a ‘surprise’ because 12 months ago, most mainstream pundits will scoff at the idea of China facing a hard landing. Today, they are talking about it. But you have to bear in mind that despite all these talk about it, the mainstream consensus is that whatever is happening to China’s economy today are well within the designs of the Chinese government (or rather, the Chinese Communist Party). The fact is, the Chinese government are engineering some sort of a landing for the Chinese economy. Maybe they may overdo it and err towards the territory of hard landing, giving the economy an extra dosage of tough medicine. But at the end of the day, the belief is that the government is still in control.

Of course, we are not going to argue for or against that. In fact, any self-respecting contrarian should already be preparing for a possible Chinese hard-landing the same way airline passengers prepare for mishaps by putting on seat-belts. In other words, it should be a routine manoeuvre. But what will separate the average from the excellent will be the look out for unanticipated Black Swans. For us, we are trying to evisage what kind of serious mishaps that are outside the designs of the Chinese government that can happen. We shall call that mishap a ‘crisis.’

As we mentioned before in Warning: China MAY be near an economic crisis, we mentioned that

The question was put forth to Victor Shih on what he thought may be the trigger for a financial/economic crisis in China. The usual suspects of what the trigger may be usually comes in the form of an external shock (e.g. collapse of Euro-zone, global recession) that crunch China?s export industry. Surprisingly, that wasn?t his consideration. Victor Shih offered his favourite theory (though he emphasised that it is by no means a prediction) that when it comes to the point when China?s elite begin to pull its vast wealth out of China, that will be the thing that trigger a crisis. This could happen, for instance, when the elite find that the returns on/of their investments inside China is floundering.

Already, there are some anecdotal evidence that this is already happening as this article from the Financial Times reported. On the macro level, we saw this article recently,

China?s foreign-exchange reserves dropped for the first time in more than a decade as foreign investment moderated, the trade surplus narrowed and Europe?s crisis spurred investors to sell emerging-market assets.

For now, the decline in China forex reserves are blamed on hot speculative money pulling out of China i.e. foreigners. But if it comes a day when China’s own elite are pulling out their wealth out of China en masse in sufficiently large volume, it has the potential to develop into a crisis.

How? Let’s imagine this scenario.

Let’s say the Chinese government get spooked by Europe and the collapsing real estate bubble in China. And let’s suppose the Chinese government decide to print copious amount of money and loosen the credit spigot in an attempt to re-stimulate the economy. What if this does not work? Then firstly, the liabilities of the People’s Bank of China will increase. As we wrote in Is China allowed to use its US$2.4 trillion reserve to spend its way out of any potential crisis?,

According to the chart provided by Pivot Capital?s report, only a little over 20% of China?s total currency (plus gross external debt) are ?backed? by their US dollar reserves, which isn?t spectacular compared to other emerging economies. In fact, South Africa is the winner in this aspect because their reserve coverage ratio is almost 160% i.e. it has $16 of reserves for every $10 of currency.

That aritlce was written in 2010. We believe that today, even less than 20% of China’s today currency are ‘backed’ by US dollar reserves. If China prints money even further in 2012, that percentage may go even lower. Now, combine that with capital flight out of China from China’s elite. Then China can face with two stark choices: (1) maintain the peg and have a currency crisis or (2) let the RMB depreciate further and risking a trade war with the US by pissing off Congress.

Now, we have to make clear that this is just a conjecture, not a prediction. It may not happen. Even if it will happen, it may not happen in 2012. But it is something we keep at the back of our minds. If our conjecture turns out true, this is a real Black Swan. Make sure you tell people that you read about it here!

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China is slowing down

Wednesday, March 23rd, 2011

Many things happened since we last wrote. The earthquake in Japan was the biggest news of the day. As Japan’s nuclear crisis unfolded, stock markets around the world panicked amidst screams of “nuclear meltdown.” Today, the nuclear situation in Japan seemed to be stabilising, even though the long-term radiation impacts are still unclear at this moment.

To help you keep things in perspective, please note one thing about Japan’s nuclear crisis: despite screams of “nuclear meltdown,” there is ZERO chance of a nuclear explosion. A nuclear reactor is NOT a nuclear bomb. Our guess is that this nuclear crisis is just a blip in the economic big picture, even though in some localised areas in Japan, it is the end of the world (e.g. some areas may not be habitable for a long time). Therefore, contrarian investors may use this opportunity to buy Japanese stocks (we know it is probably too late to do so now).

However, do not let the nuclear crisis distract you to a more important development that is already brewing for quite some time- the coming slowdown in China. This development is far more important than the Japanese nuclear crisis, which by now is no longer a crisis. Remembered we wrote in January last year at Chinese government cornered by inflation, bubbles & rich-poor gap,

By not allowing the yuan to appreciate, the Chinese government shows that at least for now, they fear unemployment and excess capacity more than inflation.

But there will be a day when they have to tackle the inflation problem. As long as the inflation problem is not solved, there will be rising prices and bubbles in the asset markets.

Today, we can say that the Chinese government are tackling the inflation problem. 2009 and 2010 was the year when they pumped in steroids into the economy. Today, they are dealing with the effects of the steroids- price inflation. China is tightening monetary conditions (e.g. rising interest rates, increasing bank reserves requirements) for quite some time already. They are serious about dealing with price inflation, at least for now. Premier Wen Jiabao had already declared that China’s target for economic growth will be lower (see China lowers growth rate target in sustainability drive), from 8% to 7%. Incidentally, the lower target of 7% is pretty close to Gary Shilling’s (a respected bear on China) definition of a ‘hard landing’ in China, which is a growth rate of 6% or less.

So, it should be extremely obvious by now that China’s economy will slow down this year. In other words, China is aiming for a soft landing.

The big question is, when the slowdown begins to bite, will China step on the accelerator again? Our belief is that there’s too much vested interests in China to keep the growth going and to prevent the bubble from bursting spectacularly. Also, the central bank in China is not independent. Thus, as we wrote in Why should central banks be independent from the government?, without an independent central bank, the bias in China is towards more inflation.

The risk for China (and by extension, Australia- see Turkeys fattened for slaughter in the Chi-tralia bubble) is that the control freaks in Beijing may stuff up and either turn the soft landing into a hard landing or losing control of inflation.

Watch this space.

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Deleveraging in the Australian economy bites

Sunday, March 6th, 2011

If you read the newspaper headlines and billboard advertisements recently, you may notice something interesting (if not, strange) happening. National Australia Bank (NAB) announced that it is ‘breaking up’ with the rest of the banks in a new campaign. That immediately provoked reactions from the other banks, including Suncorp with its “breaking up” theme in a recent billboard advertisement.

Soon, bank investors are fretting about a price war among the banks, which means the race is on to the bottom for profits. As this news article reported,

Investors are becoming nervous about the prospect of a price war breaking out between the banks, with one major brokerage labelling the attacks a ?negative sum game?.

What on earth is happening?

Only as recently as four months, politicians were aiming their gun sights on the banks for ‘lack’ of competition, when Commonwealth Bank (CBA) initiated a rise in their mortgage rates that was almost twice the rate rise of the Reserve Bank (RBA). There were talk about building a “fifth pillar” in the banking system. Today, the banks seem to be starting a price war among themselves, in a race to the bottom.

Well, the reason is dead simple. To put it simply, banks are in the business of lending money. That’s their core business. As we wrote before in The dark side of rising bank profits,

One way to make more money is to increase lending.

Banks, as publicly listed companies in the stock exchange, are always under pressure to increase their profits year after year (i.e. seek growth). Heavens forbid that their profits ever fall! All hell breaks lose if that ever happens!

But there’s one big problem for them today- the savings rate of Australians have shot up to 10%, which is the highest since the early 1990s! That means that Australians are saving more money and repaying their debts. In other words, the Australian economy is now undergoing a deleveraging process. Consequently, it is becoming harder for the banks to make more money by lending more money. A very crude (and thus, inaccurate) analogy would be to compare the banks to dogs fighting among each other for a shrinking pie. As that article reported,

The infighting is an indirect result of the sluggish credit market, with banks under pressure to find growth, the report said.

What does this mean for the Australian economy?

As we explained in detail in Significant slowdown for Australia ahead?, deleveraging sucks away the aggregate demand from the economy. The first to get hit will be the retail sector that is related to discreditionary spending. The structural shift of Australian consumers from shopping in retail stores to shopping in the Internet is a symptom of deleveraging.

Given that the retail sector accounts for approximately 60% of the economy, continuation of this structural shift in consumer behaviour imply that more pain is in store for the retail sector.

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Marc Faber: correction coming

Monday, January 31st, 2011

In a recent interview (about a week ago), Marc Faber warned of a coming correction in asset prices. In this correction, he reckoned that emerging markets (e.g. China) will fall harder than the markets of the developed world (e.g. US, Europe).

As he elaborated further, for the past two years, the emerging markets and commodities were doing very well. In fact, so well that there’s talk that China’s economic/political model is superior to the model of the Western liberal democracies because it managed to dodge the GFC and thrived in the aftermath while the developed economies were going nowhere and being plagued by sovereign debt crisis.

However, Marc Faber reckoned that for the next few months, this trend can reverse for a change. The implication is that US Treasuries, US dollar may do very well, while US stocks may outperform emerging market stocks by falling less. So, the S&P500 may correct by say, 10% while Chinese stocks may correct by say, 20-30%.

For investors, it is easy to get lost in the minute details and lose sight of the forest for the trees. For one, it is clear to us that even though the massive money printing exercise of the Federal Reserve is not showing up in the US, price inflation is rearing its ugly head in the emerging economies. In other words, we believe that the US is exporting its price inflation to the emerging economies. This is because all nations are engaging in competitive devaluation of their currencies (to protect their exports in order to ‘stimulate’ their economies). However, since the US dollar is still the world’s reserve currency, the US is able to export the resulting price inflation to the emerging economies.

The price inflation had been growing for the past two years. At first, it seems benign and even seen as a badge of vindication for countries like China. And if you read our article, Turkeys fattened for slaughter in the Chi-tralia bubble, the growth and inflation is fueled by a massive credit bubble and monetary inflation. Since it is an axiom that all bubbles deflates/bursts eventually, there are speculation of when the bubble in the Chinese economy is going to burst.

Judging from the chatter in the blogsphere and mainstream news article, it seems that the spotlight is shifting towards the price inflation and asset price bubble in China. More and more articles like Crouching tiger, soaring cranes, rumbling doubts are telling us that there’re growing doubts on the Chinese economy. As we wrote 12 months ago in Chinese government cornered by inflation, bubbles & rich-poor gap,

But there will be a day when they have to tackle the inflation problem. As long as the inflation problem is not solved, there will be rising prices and bubbles in the asset markets.

Indeed, price inflation is turning into a serious problem in China. As Patrick Chovanec wrote,

China used to be cheap.? According to figures the World Bank uses to calculate Purchasing Power Parity (PPP), in 2003, a dollar?s worth of currency bought nearly five times as much in China as it did?the U.S.? A?bag of groceries,?or a hairdo, or a hotel room?that would have cost $50 in the U.S. cost only RMB?90, or roughly $11, in China.

Talk to anyone in China, though ? local or expatriate ? and they?ll tell you that, lately, things have been getting a lot more expensive.? When I went back to the U.S. a few months ago, I had the?strange sensation ? for the first time ? that a lot of things were actually cheaper there than in Beijing.

We are increasingly seeing signs that the Chinese government are taking more and more actions to attempt to control price inflation via administrative measures. But with money supply increasing 50% over the past two years, such measures are mere pin-pricks. The exploding supply of money is the root of China’s price inflation problem. And the reason why the money supply is exploding is the peg of the RMB towards the USD (see Why is China printing so much money?).

Unfortunately for the Chinese people, there are too many vested interests (e.g. corrupt officials, provincial governments, big businesses with links to government) in China who wants to keep the credit and asset price bubble going. Since asset price bubbles and price inflation are the symptoms of a common course (monetary inflation), the bias of the Chinese government (and for most governments in the world for that matter) is towards more inflation. Once the root cause of the price inflation is tackled, the asset price bubble will deflate/burst as well. With that, the massive wealth of many vested interests will deflate/disappear as well. Since we doubt those vested interests want that to happen, the price inflation problem will continue to rage in China.

Now, here comes a crucial point. As long as the masses in China believe that the government is working towards ‘solving’ the inflation problem, there are still hope. Indeed, a friend in China told us that her country (i.e. government) is “working its brains” to solve the inflation problem. Unfortunately, this is something that has yet to be dawned on her. As Patrick Chovanec wrote,

I find it incredibly ironic that the two hot populist issues among Chinese citizens these days are the high price of housing and U.S. pressure for a stronger RMB.? People are hot under the collar about both issues, but they never draw stop to think that China?s position on currency (maintaining a weak RMB) might be fueling inflation in the form of?rising housing and other living costs.? ?Of course, I don?t expect average citizens to draw the connection, but economists should.

However, the truth is this: the vested interests who control the government are NOT serious about solving the price inflation problem. The danger is that once the masses realise this, hyperinflation begins. As we quoted Ludwig von Mises in What is a crack-up boom?,

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ?real? goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.

So, as it becomes increasingly clear that the current trends in China is unsustainable, investors should watch the reaction of the Chinese government.

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Queensland flood good for economy, says lousy economists

Sunday, January 9th, 2011

A couple of days ago, we saw this article reported in the mainstream news media: A meagre upside, admittedly, but Queensland rebuild will boost GDP.

Oh dear!

Is the mainstream news media so gulliable and stupid that they can’t recognise the opinions of fools dressed up as ‘respectable’ economists? If the Queensland flood will ultimately benefit Australia by? boosting the GDP, why don’t we all do this: evacuate say, Sydney and bomb the hell out of it and surely, the rebuilding of Sydney will boost Australia’s GDP big time and bring great prosperity?

To understand why these economists are fools, consider this essay by Frederic Bastiat in 1850,

In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause – it is seen. The others unfold in succession – they are not seen: it is well for us, if they are foreseen. Between a good and a bad economist this constitutes the whole difference – the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, – at the risk of a small present evil.

What did those fools fail to see?

You see, the rebuilding of Queensland after the flood will consume money and resources from the Australian economy. Tradesmen have to come in to repair broken homes, engineers have to rebuild destroyed infrastructure, household durable goods have to be imported and so on. Those fools can only see that this will boost Australia’s GDP. But what they fail to see is that as a result, these same money and resources cannot be used on other sectors of the economy. The result is a net loss to the Australian economy.

For example, suppose a bridge is destroyed by the flood. Engineers have to come in to rebuild that bridge. Now, consider the case that there’s no flood. These same engineers could be deployed to build a new bridge instead. So, with the flood, we have only one bridge. Without the flood, we have two bridges.

In Australia’s case, we all know that the mining industry grappling with the shortage of skills to build mining infrastructure in order to dig more metals to sell more to China. The last thing they want is for those skills to be redirected to the rebuilding of Queensland. Elsewhere, the Federal government’s nation building projects would most likely have to be postponed to make way for the rebuilding of Queensland.

It is true that more engineers and workers will have to work harder in the coming months to repair and rebuild. That in itself may boost the final GDP number. But it is a fallacy to think that a boosted GDP number implies greater prosperity for Australia. In reality, a boosted GDP number means that the economy has to work ‘harder’ to repair, replace and rebuild what was lost. That makes Australia less prosperous despite the boosted number.

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Dumb politicians trying to push interest rates down

Thursday, December 2nd, 2010

In Australia, banks are very unpopular. They are seen by the public as greedy blood-suckers who are out there to rip the people off with fees and oppress them with debt repayments. Thus, when the Big 4 oligopolistic banks raised mortgage rates by up to twice the increase in rates by the Reserve Bank, there was an outcry by the heavily indebted majority.

As a result, politicians have to be seen to be doing ‘something’ to rein in the ‘greedy’ bankers. They have to engage in populism by coming up with policies to improve ‘competition’ in the banking sector in order to put downward ‘pressure’ on interest rates. But as we wrote two years ago in Support mortgage lenders to keep borrowers in indentured servitude?,

These economists do not understand the concept of competition. In the real economy, competition means utilising scarce resources in a more efficient way to produce more, create new products or make better products. But for the mortgage industry where the product is credit, how can the idea of ?competition? be applied when the product (money and credit) can be created limitlessly out of thin air by the government (central bank) and financial system?

If higher interest rates are that evil, why bother with difficult policies to put downward ‘pressure’ on interest rates? Why not legislate interest rates to zero? As we wrote in Why does the central bank (RBA) need to punish the Australian economy with rising interest rates?,

Think about this: if raising interest rates is ?bad? and cutting interest rates is ?good,? then why don?t the RBA set interest rates to zero, thereby putting the economy into a path of eternal boom (plus runaway inflation)? For those who think this is a good idea, then this article will set to let you understand why this is a bad idea.

Politicians are toying with the idea of introducing a fifth pillar to the banking system (in addition to the current Big 4) to increase ‘competition.’ But the fact that they are thinking about this shows that they are either dumb or extremely short-sighted. For example, as this article reported,

CREATING a ”fifth pillar” of banking through building societies and credit unions would require small players to almost triple their lending levels within four years, analysts say, raising questions over its impact on financial stability.

…

Australia’s housing debt is already equal to 82 per cent of gross domestic product, one of the highest proportions in the world. He said competition and financial stability had an ”inverse relationship,” a point demonstrated in recent years.

”There was no shortage of mortgage competition in the US and [Britain] between 2000 and 2007,” Mr Mott wrote.

Oh dear! Do we need to teach our politicians how to spell “SUB-PRIME?”

Furthermore, our Reserve Bank (RBA) had already explicitly said that they take into consideration the banks’ interest rates when they set their monetary policy. So, it follows that any downward pressure on mortgage rates will mean that the RBA has to increase interest rates even more.

If the idea of fifth pillar is not harmful enough, both side of politics are considering an even more insidious idea in to put downward ‘pressure’ on mortgage rates- they are considering allowing banks to issue covered bonds to make credit cheaper and more available.

Just what are covered bonds? Take a read at this news article,

Historically, regulators have banned banks from issuing [covered bonds] as they are at odds with legal requirements that depositors rank first in claiming bank assets if a bank fails – a cornerstone of the Australian banking system.

In other words, covered bond investors have a higher claim to the bank’s asset than depositors! Someone wrote of this idea as

The reason covered bonds are cheaper to issue is because they are stealing from the security enjoyed by depositors under existing banking laws. No complicated financial structuring… just straight-up queue jumping.

If the ban on covered bonds are lifted in Australia, how secure will depositors be when the government guarantee on deposits expires next year?

Now, with dumb politicians coming up with dumber and dumber populist policies, Australian investors should now be planning exit strategies for their risky cash at bank!

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How the Consumer Price Index (CPI) could indicate false inflation?

Tuesday, August 10th, 2010

The Consumer Price Index (CPI) is one of the price indices used by the RBA to calculate the inflation figures felt by ordinary Australians. In fact, some of our pensions, wages and other payments are indexed to match the CPI.

However, sometimes the CPI really doesn?t seem to reflect the actual increase in the cost of living. According to this article, price inflation is close to 3.1%, however experts say that the increase in the cost of living feels closer to 5-6%:

There’s a disconnect between the high frequency items, which people regard as driving their cost of living and the broader measure of inflation, which includes less frequent purchases

We potentially have a scenario whereby cost of living is actually higher that is reflected in the CPI. However, the RBA will attempt to ‘manage’ inflation at the CPI rate (see Why central bankers are obsessed with inflation not breaching a certain band?), which means that they may mismanage their response to inflation.

The RBA?s response does not immediately hurt everyday Australians as much as it could. Increasing rates by small increments to fight 3% price inflation is not as bad as the increments required to fight 6% price inflation, especially if you?re heavily in debt. So let?s reverse that idea ? what about if cost of living increase is less than the CPI indicates? Suppose cost of living is increasing at a rate of 3% and the CPI was running at 6%. The RBA is vigorously increasing interest rates, whilst inflation is well ?under control?.

And this scenario could happen. The CPI is prone to overstatement of single items. The most recent CPI values for the year to June are heavily weighed down by a nearly 20% drop in Computers/Audio and a 6% drop in men?s clothes (single female technophobes must be doing it tough). A 50% rise in the cost of cigarettes could easily tip the CPI into high territory, whilst the non-smokers of Australia enjoy a lower level of inflation. Therefore, the RBA has to use other statistical hacks like “trimmed mean” and “weighted median” to smooth away the effects of once-off, seasonal or volatile price changes to arrive at an ‘underlying’ price index.

Yet, statistical hacks, regardless of how sophisticated the math is underneath them, are still not good enough. As we quoted Ludwig Von Mises in How much can we trust the price indices (e.g. CPI)?,

The pretentious solemnity which statisticians and statistical bureaus display in computing indexes of purchasing power and cost of living is out of place. These index numbers are at best rather crude and inaccurate illustrations of changes which have occurred. In periods of slow alterations in the relation between the supply of and the demand for money they do not convey any information at all. In periods of inflation and consequently of sharp price changes they provide a rough image of events which every individual experiences in his daily life. A judicious housewife knows much more about price changes as far as they affect her own household than the statistical averages can tell. She has little use for computations disregarding changes both in quality and in the amount of goods which she is able or permitted to buy at the prices entering into the computation. If she ?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.

At the root of the problem with any price indices is that, as Mises said,

All methods suggested for a measurement of the changes in the monetary unit?s purchasing power are more or less unwittingly founded on the illusory image of an eternal and immutable being who determines by the application of an immutable standard the quantity of satisfaction which a unit of money conveys to him.

Basically, price indices, regardless of the level of sophistication, are not as ‘scientific’ as it seems. Central banks, however, have no choice but to rely on them to target price inflation with their monetary policy.

So, how much is the increase in your cost of living reflected by the CPI figures? Vote below!



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Interview with Marc Faber (inflationist) and Michael Shedlock (deflationist)

Wednesday, August 4th, 2010

A few months ago, we found this interview with Marc Faber and Michael Shedlock (aka “Mish”). Faber once said in an interview that he was “100% sure” that the US will fall into hyperinflation. Mish, on the other hand, is a very staunch deflationist (see Are deflationists missing the elephant in the room? Or are they believing in something more sinister?).

What if you put the two together in an interview? Will they clash? Surprisingly not, as you can see…

In particular, pay attention to what Mish said in the final moments of this video.

The takeaway lesson is this: the unfolding train wreck will be something the world has never seen before (as one of our reader, DavidL said). Whatever ‘flation it is, it would not follow the script of the past.

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Posted in Economics/Finance, Looking Forward | 3 Comments »

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.

To understand our view, we must first understand the crux of the deflationists’ argument. Professor Steve Keen had the best explanation for? the deflationist argument:

Note Bernanke’s assumption (highlighted above) in his argument that printing money would always ultimately cause inflation: “under a fiat money system“. The point made by endogenous money theorists is that we don’t live in a fiat-money system, but in a credit-money system which has had a relatively small and subservient fiat money system tacked onto it.

The implication of this paragraph is that Bernanke does not understand how the credit-money system works and hence, does not know how to engineer inflation. Elsewhere, Steve Keen wrote that,

The only way that Bernanke’s “printing press example” would work to cause inflation in our current debt-laden would be if simply Zimbabwean levels of money were printed?so that fiat money could substantially repay outstanding debt and effectively supplant credit-based money.

Based on the deflationists’? credit-money model of the economy, the forces propelling the credit destruction will be so strong that Bernanke will not print money fast enough to cause inflation.

So, where is the elephant in the room?

First, remember that the credit-money model of the economy is just a representation of the real, living and breathing economy- it is not the real thing. The biggest mistake any investor can make is to believe that the model is as good as the real thing and believe whatever the results produced by the model. In other words, a model is just an abstract of reality i.e. a subset of reality.

In the real world, there are many events and happenings that can never be captured by the model. By definition, these events and happenings are Black Swans to the model. As we wrote in our report, How To Foolproof Yourself Against Salesmen & Media Bias,

In the same way, many financial market analysts and economists are highly skilled in creating artificial lab-created models of the real world. These models are highly predictable, with the ?rules? well-defined.

What if the ‘rules’ get broken by real world events? Obviously, the model breaks down. As we wrote in Recipe for hyperinflation,

The main point is, once those ?rules? are rolled-back to give the government more power and authority with regards to their monopoly on money, the slippery road towards the ultimate loss of confidence in the integrity of money begins.

…

One thing we have to be clear. Assuming that the ?rules? are strictly adhered to, there will only be one outcome for the current credit crisis: deflation.

Currently, the Federal Reserve alone, with the powers they have on hand, cannot easily create inflation. What if the Federal Reserve, in conjunction with the government, changes the ‘rules’ and act on the changes?

Think about it: the Federal Reserve have more powers today than in 2007. Today, it can buy toxic assets from the banks as collateral, which is something that was against the ‘rules’ prior to the GFC.

Mind you, these breaking of ‘rules’ are just the beginning. Bernanke and his staff had written lots of papers and gave lots of speeches on the crazy ideas they have in mind to fight deflation. These crazy ideas are in the public record. As you can see in Bernankeism and hyper-inflation, some of these crazy ideas are already implemented in response to the GFC. However, there are many more that are yet to be implemented.

But remember this very important point: Many of these ideas are currently illegal. This is where the confluence between economics, politics and law come together. The deflationists have excellent models on the credit-based economy. But law and politics are outside the scope of their models. That is, their models cannot see what’s happening in the legal and political arena. Unfortunately for them, events from these arenas will be the ones breaking their credit-money models. That can only be achieved by overturning some of the existing laws.

Michael Shedlock? (aka “Mish”), who is one of the most strident deflationists insists that it is not in the interest of the powers to be to break the credit-based system. It seems that he sees the Federal Reserve System as some kind of powerful privately owned cartel that wants to preserve the status quo. Hyperinflation will screw up the wealth and power of such a cartel because in such a scenario, credit can no longer play any role in the economy (which is what Steve Keen calls a “fiat-money” system as opposed to the current “credit-money” system). On the other hand, between deflation and some forms of inflation, they would prefer the latter.

Please note that we are now venturing into unknown Black Swan territory. What follows is murky, dark and just our guesses…

For such a cartel to have its way of preserving the status quo, it has to be powerful enough to even subject the US government to the rules of credit. That is, if the US government monetise its debt (by selling its bonds to the Federal Reserve), it is accountable to the cartel (whatever it is). We could be wrong, but we guess this must be what Mish believes? in- a cartel of extremely powerful and secretive bankers is controlling America via control of the credit-based monetary system. In fact, we remembered that in one of his blog articles, he mentioned that contrary to popular belief, the Federal Reserve is a privately owned institution. Contrasts that with what the Federal Reserve describe itself as a “quasi-public” institution.

If this is what Mish believes in, than it makes sense to take the deflationary view. This is because only a cartel that is more powerful than the US government can have the power to prevent the confluence of law and politics from breaking the ‘rules,’ causing hyperinflation and breaking the credit-based system.

Of course, a hyper-deflation scenario? will do the cartel no good too because that scenario implies a total breakdown of the financial system.

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Posted in Economics/Finance, Looking Forward, Market Observations | 9 Comments »

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