Archive for January, 2008

Potential global economic black hole: credit default swaps (CDS)

Thursday, January 17th, 2008

It has been said that if you owe the bank one million dollars, you are in trouble. But if you owe the bank one hundred trillion dollars, the bank is in trouble. What happens if Tom owes you a lot of money and you are worried that he will default on his loan? Well, you can buy insurance to protect yourself against such event. Credit Default Swaps (CDS) is basically such insurance. It is a derivative in which the terms and conditions are privately negotiated between two parties. Thus, it is called an Over-The-Counter (OTC) derivative. How does it work?

Basically, you pay a periodic fee to a third-party. In return, that third-party will guarantee Tom’s loan to you in case he (Tom) defaults or partially fails to pay.

So, if all your loans are protected by CDS, you do not have to worry about bad debts right? Well, in theory, yes. But in reality, not really.

How do you know that the third-party guaranteeing your loan really has the ability to honour its contingent obligation? Since there is no
requirement for you to hold any of the third-party’s assets as collateral, its promise is as good as its credit-worthiness. So, it looks like you are back to square one again. Well, not really. This time, you’re paying money for a promise that is as good as someone else’s credit-worthiness.

Now, picture this scenario that we had described in Is this sub-prime or solvency crisis?

… much of the economic boom that we enjoy over the past several years are financed by the explosion of credit (which is debt on the opposite side of the balance sheet). There is such a colossal amount of debt created and scattered throughout the globe that it does not take a genius to see that massive amount of bad debts have to accumulate and build up in the global financial system. Eventually, all bad debts will be exposed as what they truly are.

Currently, the CDS market is valued at around $45 trillion, which is three times the GDP of the US. What happens if these waves of bad debts trigger the contingent obligations of CDS sellers to honour these mass of credit defaults? If these CDS sellers default themselves, what will happen to those who depend on CDS to remain solvent in the event of defaults?

We have a potential financial time bomb here. Note: we are not predicting that such a time bomb will explode. But this is another potential Black Swan, which Warren Buffets calls the “financial weapons of mass destruction.”

Overproduction or mis-configuration of production?

Tuesday, January 15th, 2008

Recently, the US employment data was released. With it, came the dismal news that employment growth was much less than expected. As this MarketWatch article, U.S. stocks pressured by jump in unemployment, says,

“Since 1949, the unemployment rate has never risen by this magnitude without the economy being in recession,” said John Ryding, chief U.S. economist, Bear Stearns.

Whenever we think about the unemployment rate, which is expressed as a single number, it can easily give us the picture of the employment facet of the economy as one big monolithic jobs-producing machine. With this highly abstract picture, it looks as if the economy is meant to produce a quantity of abstractly uniform ‘things,’ given a quantity of abstractly uniform ‘labourers.’ That was how it seemed to look like during the Great Depression, which Wilhelm R?pk wrote in this deeply buried 1936 classic (originally written in German), Crises & Cycles,

The paradoxical nature of the crisis is characterized by the fact that production is curtailed in every direction, and there is no work anywhere, while so far as the economic position of millions of people is concerned, we could really be doing nothing better than getting every ounce of product out of men and machinery.

When we think along this line, it is easy to think of economic downturns of just being a mismatch between the quantity of production and consumption. As Wilhelm R?pk continued,

It is an indisputable fact that a general slump, which does not permit of the scale of production reached in the boom being maintained, sets in during the crisis, and it is equally indisputable that this general slump is the result of the total demand suddenly falling behind the total supply. But let us make sure what this means and what it does not mean. Under no circumstances can it mean that the cause of the general slump is to be sought in the fact that production has outstripped consumption and that too many of all goods at once are being produced.

To explain this point further, Wilhelm R?pk came up with a metaphor:

The struggle against the scarcity of goods which we are condemned to wage for all time, and always with inadequate forces, can be compared to the struggle of the German army against the superior numbers of their opponents during the World War. Every soldier was used in that struggle, and the Germans would have been glad if they had had at their disposal more millions of men, or of tanks to replace soldiers, such as their enemies had. Nevertheless it happened, owing to difficulties of organization which could scarcely be avoided in such a huge and complicated structure as the German army, that from time to time isolated troops were kept out of action, while at other places on the front they were sorely needed. Thus a scarcity of soldiers in general was here accompanied by a superfluity of soldiers at certain isolated places. No one in possession of his senses would have concluded from this that these soldiers who were temporarily kept out of action should have been sent home as superfluous or that the ‘work’ of the army could have been ‘spread’ by lengthening the men’s leave or replacing guns by halberds and pikes.

Therefore, when you read mainstream news stories about countries (e.g. China) heading towards economic crisis due to the accumulation of over-investments and over-production, you know it is an inaccurate explanation. As Wilhelm R?pk continued,

An economic crisis (that of to-day like those of the past) can therefore not be interpreted as a general over-production of all goods at once, a surpassing of the possibilities of consumption by the possibilities of production, but only as a lack of proportion between the different lines of production, in short, as a functional disturbance within the highly complicated modern exchange economy. The disparity between the goods at our disposal and our unsatisfied wants is more obvious than ever, but the wheels of the machine which delivers the goods do not fit together properly at times of crisis.

This is the key insight from the Austrian School of economic thought. Over-production or over-investment is not the problem. Rather, the trouble lies in the mis-configuration of production and mal-investments (see The first step in an economic slowdown?mal-investment in capital).

This concept is crucial in understanding the Austrian Business Cycle Theory (see What causes economic booms and busts?)

Mental pitfall: Domain Specificity

Monday, January 14th, 2008

Today, we will continue with the series on common mental pitfalls that can lead to fallacious reasoning (see Common mental pitfalls that leads you astray for a compilation of this series of articles).

The topic we will cover today is Domain Specificity. In Nassim Nicholas Taleb’s book, The Black Swan: The Impact of the Highly Improbable, he wrote,

By domain-specific, I mean that our reactions, our mode of thinking, our intuitions, depend on the context in which the matter is presented.

This is how our brain is hard-wired to operate.

An example of making a domain-specific error is,

Statisticians, it has been shown, tend to leave their brains in the classroom and engage in the most trivial inferential errors once they are let out on the streets.

That is why some people can easily solve problems in social situations but when the problems is expressed in an abstract logical format, he or she is lost. Others have the opposite problem. This explains why analogies and metaphors are very powerful in aiding understanding. This is because they are very effective at translating a story from one context to another, which enables us to process it in a more familiar framework.

Is there a way to avoid this common pitfall? We are afraid we do not really have an answer to this. But at the very least, the first step is to be aware of this common weakness.

Why is the market so easily tossed and turned by dribs and drabs of data?

Friday, January 11th, 2008

Today, we can see a lot of confusion in the market. Investors are reading the tea leaves on what Ben Bernanke will do with interest rates, economists are arguing whether the US are in recession or not, the stock market are being tossed and turned by every bits and pieces of economic data and investors are confused and nervous about what is going on. Notice one thing: the market is trying to absorb every piece of economic data (e.g. unemployment level, manufacturing index, GDP, CPI, etc.) and still yet not able to make up its mind on what is happening to the US economy. Given that many highly esteemed economists and analysts have conflicting opinions, how can investors and traders make confident decisions?

These are good questions. Why is there so much confusion?

To answer this question, we will turn to a rare, most hard to find, most buried important book, in the history of the Austrian School of economic thought: Crises & Cycles by Wilhelm R?pk. This book was originally written in German and was published in 1936. In Chapter 4 of this book, “The Causes of Crisis and Cycles,” R?pk wrote,

Among these the most important and also the most controversial question is to ascertain whether the method of deductive analysis or that of empirical description offers the better chance of bringing us nearer to a solution of the problem.

R?pk was dealing with the “methodological questions” of economics. In that book, he criticised the then current fashion of method:

It is easy to understand that, in this atmosphere of institutionalized science with its air of exactness and progressive technique, not many escape the temptation to look down upon old-fashioned ” theory,” with its small business unit of the private study, as something hopelessly behind the times and to claim for their descriptive and statistical method a wider field of application than is compatible with the logic of scientific methodology. Instead of confining themselves to the more modest but very meritorious task of collecting, arranging, and interpreting all the available facts and statistical data and of verifying the results of deductive reasoning, these men thought it possible to replace deductive reasoning entirely by their empirical and statistical method.

Methods in economics have largely been overrun by statistics. At least, this looks to be the methods of financial market economists. As R?pk said, the fault does not lie in the empirical and statistical method. Rather, the issue is the myth that deductive reasoning (qualitative analysis) can be supplanted by quantitative analysis. What is the problem with that? R?pk continues,

It was indeed an ingenious idea to apply the principle of nautical astronomy to economic forecasting, but there was one fatal flaw. For as long as we have not made a thorough investigation into the causal relationships between the time-series, the mere temporal sequence does not tell us any more than that something has happened in the past which might not happen in the future if some variables in the causal mechanism should change. But in investigating the causal relationships we are thrown back from statistical empiricism to “theory” in the deductive and analytical sense.

By the statistical method, we ascertain facts, but we cannot explain them, i.e., bring them into logical order so that we “understand” them. Only analytical theory can do that, and if there has been, in recent years, any furthering of our insight into the mechanism of crises and cycles, this has been the work of the theorists and not of the empiricists.

This is what we have today. The market is inundated with copious amount of facts and figures but receives very little insight on these numbers by mainstream economists and analysts. Without insights, the market gets tossed and turned by every minute variations of statistical information from economic reports. The end result is confusion and volatility.

That is one of the reasons why we are different from the mainstream.

Mental pitfall: Lazy Induction

Wednesday, January 9th, 2008

Today, we will continue on a series of articles on common mental mistakes that we often make. Committing mental mistakes will result in the degradation of the quality of our thinking, which for investors, can lead to serious financial losses. We will compile this series of articles in one of the Common mental pitfalls that leads you astray (in Popular Topics) for your convenient reference.

One of these common mental mistakes is Lazy Induction.

First, what is induction? According to the Encarta World Dictionary, one of the meanings of induction is the

… generalization based on observed instances, or the making of such generalizations, in the usual working method of scientists

Inductive logic is one of the valid tools of reasoning. But it produces fallacious conclusions when we apply subconscious mental shortcuts that bring us to an extreme in inductive reasoning. We will call that Lazy Induction. In the book, The Black Swan: The Impact of the Highly Improbable, Nassim Nicholas Taleb describes this flaw as

We focus on preselected segments of the seen and generalise from it to the unseen…

The trouble starts when the sample that we used for our observations is drawn from our own personal bias. Then, from the observations of the biased sample, we make generalisations based on our flawed observations. Lazy Induction allows us to prove anything that we want to be true. All we have to do is to pick a sample of observations that conforms to our bias and then generalise from there.

Here is an example of Lazy Induction:

  1. Confusing absence of evidence for evidence of absence– For example, if we find no evidence that cancer cells exists in a patient’s skin, does it mean that this is evidence that the patient is completely cancer-free?

Fortunately, it is very easy to prove the invalidity of flawed conclusion that is produced by Lazy Induction. All we have to do is to find a negative example. In the above-mentioned example, to prove that the conclusion of the patient being completely cancer-free is false, all we have to do is to find one cancer cell.

Finally, if you find any real-life examples of Lazy Induction, feel free leave a comment and share it with the rest of us.

Mainstream knows later that US is already in recession

Wednesday, January 9th, 2008

Back in July last year, in Brace yourself before the next GDP growth figures, we already foresee a recession coming in the US:

Guess what will happen then? We guess recession fears will then grip the market, causing a major sell-off or even a crash.

As you would already have heard by now, Merrill Lynch had already declared that the US is already in recession.

Long time readers of this publication should not be surprised.

The crowd understands gold not…

Tuesday, January 8th, 2008

Today, we saw this article, Flight to gold when investors lose faith in cash, from the Sydney Morning Herald (SMH):

“We think gold is … overvalued by about $US150, but that can go on for a long time,” John Reade, the precious metals chief at UBS, said. “A lot of our clients have been buying gold since the credit crunch because they think central banks will respond with aggressive monetary easing. If that becomes a mainstream view, gold will soon have four figures on it. The feeling is there is a lot of money around, and not much gold.”

This paragraph reveals a lot about the difference between mainstream views and our contrarian view. If you are a long time readers of this publication, you will notice that the words and terms that we use are different from them. For example, what the mainstream calls “monetary easing” (in the above-mentioned quote of SMH) is what we call the debasement of fiat money, which is the corollary of the Austrian School of economic thought’s definition for inflation (see Cause of inflation: Shanghai bubble case study).

For this article, we would like to question some of the mainstream thinking in that quote.

First, what is the basis of determining that gold is “overvalued by about $US150?” That magic number, “150” sounds precise, but is it accurate? Dear readers, do take care to avoid the confusion between accuracy and precision (see Confusion between precision & accuracy).

Next, this little word, “overvalued” reveals a lot about the underlying logical inconsistency in mainstream thinking. When they say that gold is ‘overvalued,’ what is the unit of measurement with which they use to measure the level of over-valuation? Clearly, in this case, the US dollar is the unit of measurement. As we said before in How is inflation sabotaging our ability to measure the value of things?,

If you want to measure the length of a box, you may use the ruler to do it. The reason why a ruler can do such a job is because its length is reasonably consistent for the foreseeable future. Now, imagine that ruler is as elastic as a rubber band. Do you think it is still a useful tool to measure the length of the box? An elastic ruler is useless because you can always make up the measurement of the box to whatever you please just by stretching the ruler such that the edge of the box is aligned to any intended measurement markings in the ruler.

Now, let come back to measuring the value of oil. Since oil is priced in US dollars and if the supply of US dollars can be expanded and contracted at will by the Federal Reserve, how useful do you think it is as a calibration for measuring the value of oil?

How reliable is the Australian dollar as a unit of measurement? You may want to take a look at the monetary aggregate graph in Australia?s monetary debasement & credit expansion. What about the US dollar? Well, the US had already stopped publishing the M3 monetary aggregates, citing excuses so flimsy that we cannot even remember. With the credit crunch threatening to descend into monetary deflation, the central bankers around the world had been working the money printing press overtime (e.g. cutting interest rates, discount rates, auctioning money at below market rate, accepting lower quality paper such as mortgage-backed securities as collaterals). How can we ever rely on fiat money and credit as units of measurements? If they are unreliable as units of measurements, then how reliable are economic calculations that uses them as a ruler?

As we quoted Ludwig von Mises on our earlier article, How is inflation sabotaging our ability to measure the value of things?,

The endeavors to expand the quantity of money in circulation either in order to increase the government?s capacity to spend or in order to bring about a temporary lowering of the rate of interest disintegrate all currency matters and derange economic calculation. The first aim of monetary policy must be to prevent governments from embarking upon inflation and from creating conditions which encourage credit expansion on the part of banks.

Dear readers, don’t you see a contradiction in today’s financial system? On one hand, we all believe in the importance of the free market to determine the prices of things, from copper and toys to soya beans and oil. But why is it that when it comes the price of money, the most important lubricant of the modern economy, we let central bankers engage in price fixing? We may question the ability of Soviet central planners to set the correct price of things in the economy. But why is it that we never question the ability of central bankers to know what the right price of money should be? Meddling with the price of money set the scene for the dreaded business cycle (see What causes economic booms and busts?).

Yes, in the short term, the ‘price’ of gold may fall. In fact, we had warned our readers last year in Warning: gold price can still fall significantly that this is a possibility. But make no mistake about it: it will not be for the reason that it is ‘overvalued.’

Next, as John Reade (the precious metals chief at UBS) said, a lot of their “clients have been buying gold since the credit crunch because they think central banks will respond with aggressive monetary easing.” Again, does the mainstream understand the fundamental reason for accumulating gold? As we said before in What should be your fundamental reason for accumulating gold?,

We accumulate gold not just simply because we believe its ?price? is going up (though we think it is most likely to be so as a side effect?in case you are confused by what we mean, read on).

The root issue is trust. As we said before in Have we escaped from the dangers of inflation?,

One final word: fiat money is only as stable as the government that enforce it, and only as safe as the stringency and integrity of the central banks who create it. Gold, on the other hand, yield to neither control nor will of any government.

We favour gold because we do not trust the government to preserve the integrity of fiat money in the long run. Are we extremists for thinking that way? Well, for those who thinks we are, we would suggest that that they take a serious study of economic history. As we said before in Ancient Chinese fiat paper money,

The ancient Chinese were the first to experiment with fiat paper money. Records showed that the first paper money was used in China in around A.D. 600s. After 1455, there have been no known references to paper money. Thus, after having 500 to 800 years of paper money experience with repeated episodes of inflation and currency reforms, the ancient Chinese finally gave up using fiat money.

Every other civilisations (e.g. the Americans with the Continentals, the French with their Assignats) that uses fiat paper money end up destroying the integrity of money. Today, the US dollar (and the rest of the currencies) became fully fiat when President Nixon finally severed the last link between the US dollar and gold in 1971. Thus, excluding today’s fiat money regime, the failure rate of fiat money is 100% as recorded in the annals of human history. Will we see the demise of today’s fiat money system in our lifetime? We do not know whether we will live to see it, but we are sure the day will surely come, for we are very sure human nature has never changed and will never change. When it happens, most people will be caught with their pants down, as shown by history.

As John Reade said in the quote above, “If that becomes a mainstream view, gold will soon have four figures on it.” We would like to add this: by the time that view becomes mainstream, it will be too late- the loss of confidence in fiat monetary system will already have happened by then, along with many upheavals and disruptions in the financial system. You will want to own some gold before such a day.

Meanwhile, it still looks to us that the mainstream still does not understand gold and its long history. For example, some are still calling gold a commodity (see Is gold a commodity?). For you, you may want to read our short introductory premiere on gold at Why should you invest in gold?. Meanwhile, we will be doing what we said before in Recipe for hyperinflation:

Therefore, watch what the US government is doing with the monetary ?rules? in its attempt to fight deflation [see Spectre of deflation].

Actions speak louder than words.

Updated Recommended Books section

Saturday, January 5th, 2008

We have added a new book in the Recommended Books page’s Trend Following section.

Australia’s monetary debasement & credit expansion

Saturday, January 5th, 2008

Today, we will show you a graph of the latest released figures of Australia’s monetary supply growth:

Australia?s Monetary Aggregate & Money Multiplier
Click above for the full-size image

This graph shows the growth of standard (base money) and fiduciary (credit) money from July 1959 to October 2007 (see Are we heading for a deflationary type of recession? for an explanation on what standard and fiduciary money is). That graph also shows the standard-fiduciary money ratio over that time period (i.e. the multiplier effect of standard money into fiduciary money).

From the graph, we can see that Australia’s M3 money supply (one measure of fiduciary money) grew 20.75% from October 2006 (A$ 777.7 bn) to October 2007 (A$ 939.1 bn)! At the same time, you can see that the standard money multiplier effect (see 363 tons of US dollars to Iraq?how much money will eventually be multiplied into the economy? for an explanation of the money multiplier effect) has been increasing steadily to a record high- in October 2007, the reserve ratio is at record low of 4.1%. If you use the broad money (another broader measure of fiduciary money), the ratio is even lower (i.e. higher multiplier effect)- 3.8%!

What does this 3.8% mean? It means that, overall, every $3.80 of physical cash in the economy gets lent and re-lent, over and over again until it becomes $100 of credit (broad money). This means that every dollar of debt default in Australia can result in the ‘disappearance’ of up to $24.40 of fiduciary money (see How money & credit can shrink (i.e. deflation)?) in the economy [insert on 06/01/2007: assuming that this 3.8% is to be maintained].

You can easily imagine what the effect on the economy will be when that happens.

Example of precisely inaccurate information

Friday, January 4th, 2008

Carrying on from yesterday’s article, we will give an example of highly precise numbers that may not necessarily be highly accurate as well. As we said yesterday in Confusion between precision & accuracy,

In another example, are the precise CPI figures that are being released monthly very useful? Given that we distrust price indices, we do not see the point of attaching too much significance into the minute details of only one month?s reading. It is the job of the professional economists and analysts to be highly precise in their measurement of numbers. Whether these numbers are accurate or not is completely another matter.

If you notice, the growth in the general price levels (price index, e.g. CPI) is usually expressed as a percentage figure that is precise up to one decimal point. We can argue that this is an example of a highly precise number. But are these figures accurate? As we explained in How much can we trust the price indices (e.g. CPI)?,

But this idea of price index is flawed and is easily subject to manipulations.

Now, if the mainstream economics? definition of inflation is flawed, then the whole idea of the price index is flawed too. Therefore, no matter how much ?enhancement? that statisticians and economists can think of to improve the ?accuracy? of the price index, it is an exercise of futility.

Therefore, beware of price indices! It is not as ?scientific? as you think!

The price index is a very important number. It is used to derive real GDP growth from the nominal GDP growth. From the growth (or contraction) of real GDP, we can then define when an economy is technically out of (or in) recession.

Now, if the price index is a logically invalid number (let alone accurate), then how accurate will real GDP growth figures be for capturing the growth of output of an economy? If this figure is inaccurate, then how accurate will it be for defining when an economy is technically in recession? In that case, how useful will it be to be so precise in defining the exact point for which the economy is in technical recession?

Today, there is a lot of talk in the financial markets about the probability of the US entering a recession. But really, what is the point of drawing a line in the sand to mark out whether the US is in recession or not? Here, we are more concerned about being vaguely right (accurate) on where we are in the business cycle then to be precise on which side of the recession line we are in. As investors, being accurate is far more important then being precise.