Archive for April, 2008

What makes a nation wealthy?

Monday, April 14th, 2008

For many people in the West (and including China as well), rising asset values are associated with wealth. As we showed in The Bubble Economy,

Over the course of the past several years, the ?wealth? of many people in the Western English-speaking countries (mainly the US, Australia and Britain) had increased, thanks to the real estate price boom. Consequently, the economies of those countries had been growing and expanding over that period. This type of economic growth is what the IMF called the ?asset-driven growth.? One manifestation of this kind of growth is the rise of ?wealth-creation? fades, which advocate the attainment of riches through property ?investments.?

But what really makes a nation wealth? Recently, we bumped into this article, Once the World’s Great Factory, China Is the Next Great Innovator,

Everyone knows about China’s emergence as a global manufacturing power. Well, guess what: the People’s Capitalist Republic isn’t just emerging or ascending ? it’s exploding. And not only with boatloads of flatscreen TVs and great gusts of atmospheric carbon. The world’s go-to source for low-cost labor is generating mountains of capital, squads of hot new companies, and ? surprise! ? glimmers of innovation.

As we quoted Ludwig von Mises in The myth of financial asset ?investments? as savings,

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.

Thus, the very symbols of ‘wealth’ in a nation may actually hide real poverty.

New tricks required to bail out financial system

Thursday, April 10th, 2008

As we all know, last month, the Fed engineered a bailout of Bear Stearns over the weekend. It’s no secret that the Fed had to invoke an obscure law passed in the 1930s to save Bear Stearns. Some news media claimed that this law had not been invoked since the Great Depression, which is not true but is certainly attention grabbing. The truth is that, it was last used in the 1960s.

You may have recalled that we said in Recipe for hyperinflation,

Such scheme of arrangements is just a tiny fraction of ?rules? that ?govern? the vast power associated with the authority to create money. Now, imagine that those above-mentioned ?rules? are being relaxed such that the government can order the central bank to bail out everyone and every business that is financially insolvent by giving them freshly printed money. Overnight, this will solve the problem of bad debts and we will not have any credit crisis to worry about. Everyone will be happy right?


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.

Let’s review a sample of how some of these ‘rules’ had been rolled-back and relaxed:

  1. Most of the time, banks lend to and borrow from each other to cover their daily shortfall or surplus cash. But banks can also borrow directly from the Fed through the discount window. But the Fed would prefer that they do not do so by keeping the discount rate higher than the Fed Fund Rate as a disincentive. It used to be ‘humiliating’ for banks to have to go to the Fed to beg for money. But today, due to the credit crisis, staying solvent is more important than to stay ‘dignified.’ Furthermore, the Fed helped by auctioning more money (fiat money that is created from thin air) to the banks.
  2. The Fed used to only accept Treasuries as a collateral for loans. Now, it has come to the point of accepting AAA mortgage bonds (other central banks are guilty of this too). Congratulations to the Fed for getting involved into the landlord business!
  3. The Fed cannot lend to non-banks such as Bear Stearns. But last month, it had to invoke an old law to be able to lend to Bear Stearns. As this news article said, Fed Invokes Little-Used Authority to Aid Bear Stearns (Update4),

    Bernanke took advantage of little-used parts of Fed law, added in the 1930s and last utilized in the 1960s, that allow it to lend to corporations and private partnerships with a special board vote. The Fed chief probably sought to stave off a deeper blow to the financial system from a Bear Stearns collapse…

  4. The US government embarked on an economic ‘stimulus’ plan by sending newly printed money (nicely called a ‘tax rebate’) to Americans (see Watch the US government).

In the weeks and months to come, we will get to see more ‘ingenious’ plans and actions by the Fed to ‘solve’ the worsening credit crunch problem. They will try every new, weird and unprecedented tricks not found in the book to achieve that aim. As this Wall Street Journal article, Fed Weighs Its Options in Easing Credit Crunch said,

The Federal Reserve is considering contingency plans for expanding its lending power in the event its recent steps to unfreeze credit markets fail.

Among the options: Having the Treasury borrow more money than it needs to fund the government and leave the proceeds on deposit at the Fed; issuing debt under the Fed’s name rather than the Treasury’s; and asking Congress for immediate authority for the Fed to pay interest on commercial-bank reserves instead of waiting until a previously enacted law permits it in 2011.

As long as the Fed keeps on trying to ‘solve’ the problem, we will not rule out hyperinflation.

Can Australia’s resource boom end sooner than expected?

Wednesday, April 9th, 2008

Our long time readers will be very familiar with our frequent warnings not to take Australia’s resource boom for granted. Today, we will repeat this warning again, albeit briefly.

Back in September last year, in this news article, Post-Olympics hangover may be risky business, it said

A LEADING global manufacturing expert has warned that China could be heading for a post-Olympics hangover with the potential to disrupt the resources boom on which Australia depends.

In particular, domestic consumption in China still accounts for a relatively small 39 per cent of the economy, with the remaining 61 per cent soaked up by infrastructure investment and net exports.

“Over time, this will shift and domestic consumption is going to become a bigger and bigger piece of the economy,” Mr Gromley told BusinessDay. “But, while that transition happens, there is a risk that over-investment in infrastructure will cause a bubble effect, particularly after the Beijing Olympics.”

What Mr Gromley calls over-investment is what we call mal-investment (see our guide, What causes economic booms and busts? for the concept of mal-investments).

In January this year, we wrote about our scepticism about the Chinese de-coupling theory at Can China really ?de-couple? from a US recession?. If our theory is right, this will have grave implication for Australia’s resource boom. If this boom peters out, Australia, with such high debt levels, will fall into severe recession (if not already in recession) led by debt deflation. When that day comes, a lot of ‘rich’ people will suddenly find the value of their asset worth far less than their expectation (see Aussie household debt not as bad as it seems?).

The Problem that can throw us back into the age of horse-drawn carriages

Tuesday, April 8th, 2008

In future, if we look back at 2008, will we find that it is the year of the turning point in terms of global growth? Right now, for all intents and purposes, the US is in recession. Japan looks like it is falling back into recession again. Western Europe seems to be sluggish. But there are other bright spots, namely the BRICs (Brazil, Russia, India, China and perhaps the Middle-East and Eastern Europe) countries. (We know we are generalising here, but we are doing so for the sake of brevity because the focus of today’s article is something else). Thus, there is little wonder that although the IMF is lowering forecasts for global growth, it is still positive (i.e. their forecast does not point to a global recession).

But what is the greatest danger facing the global economy today?

Recently, we read BHP to use half of state’s electricity in the news media:

BHP Billiton will need nearly half of South Australia’s current electricity supply to power its vastly expanded Olympic Dam copper and uranium mine.

China is growing rapidly in a massive scale. Such massive growth requires massive amount of metals for building skyscrapers and infrastructure. Mining and producing all these metals requires copious amount of electricity. Copious amount of electricity requires copious amount of energy. The recent snowstorms in China shows that the entire nation has a very narrow margin of energy supply before serious disruptions occur. If China is to grow further, its current supply of energy is inadequate. China has abundant coal (it used to export coal). But today, there is not even enough for her energy needs. By now, you should be able to appreciate what is involved (in terms of energy usage) to keep China in its trajectory of growth. And we have not included India into the picture.

Maintaining the way of life in the developed Western nations requires huge amount of energy. As we said before in Smart money in alternative energy?Part 1: current energy quandary,

The most important ingredient that drives the efficiencies, comforts, automation and wonders of today?s modern way of life is energy. The trains, cars, ships and aeroplanes that transport massive quantities of people and goods over vast distances quickly require energy in the form of fuel. The heavy machines that do heavy physical work far beyond the scope of human labour require energy too. The powerful computers that process and store vast amount of data and information as well as automate mental labour requires energy in the form of electricity. The heating in winter and cooling in summer of our abode requires energy too. Take energy away and our modern way of life will very much grind to a halt and bring us back to the hard life of our ancestors. In fact, contemporary life rests on the premise of abundant and cheap energy. Therefore, whoever controls the supply and provision of energy controls power and wealth.

To elevate the way of life in developing nations (e.g. India, China) to a level that is on par with the developed Western world requires a greater initial upsurge of energy use. After that, to maintain that level of way of life for all these additional billions of people, the world will see a permanently much higher plateau of energy usage indefinitely. It should be clear by now the gravity of the implications of such projections.

Can the earth supply enough energy fast enough to allow the developing world to embark on such a path? The earth may have plenty of energy under the ground (i.e. coal, oil and gas), but can humanity extract them fast enough for such unceasingly growing usage? An analogy for this question would be to imagine yourself trying to breathe through a straw. Yes, there may be plenty of air around you, but if you have to breathe through a straw, there is no way you can do strenuous exercise without turning blue. There are two big-picture issues with regards to the world’s energy supply:

  1. Peak Oil. As we said before in Is oil going to be more expensive?,

    Put it simply, the Peak Oil theory states that the world?s oil production has reached the peak and is entering the stage of terminal decline. One common misunderstanding of Peak Oil is that the world is running out of oil. No, the world is not running out of oil?the world is running out of easily accessible oil.

  2. Energy production capacity Even if you do not believe in the Peak Oil theory, there is another problem. There is not enough infrastructure to extract oil and natural gas from unforgiving and inhospitable terrains (e.g. Arctic, Siberia, undersea). Oil extraction is one problem. Refining them is another infrastructure challenge.

Next, even if energy supply is not a problem, there is another headache- global warming. Burning all these oil, natural gas and coal will release colossal amount of carbon dioxide into the earth’s atmosphere. It will be a sad irony if China and India achieves the same level as the West in the way of life, only to face environmental disasters that will drag them down again.

In summary, supplying environmentally sustainable energy indefinitely at a rate fast enough is a colossal global problem that must be solved. If not, the latter generations will not live better than the current generation. That is where the best investment opportunities lie.

What lies ahead for the Australian economy in the coming years?

Sunday, April 6th, 2008

As we can see, over the past several months, there had been a lot of volatility in the global financial markets. As we said before in Why is the market so easily tossed and turned by dribs and drabs of data?, without the proper framework of sound economic theory, the outcome is that the lack of deductive reasoning and insights brought about the situation where the

… market gets tossed and turned by every minute variations of statistical information from economic reports. The end result is confusion and volatility.

Clearly, this shows that the media, pundits, investors, traders and other market participants do not know what is going on.

Today, we will present to you what we believe to be the long-term big picture. Our opinion is by no means a prediction in the forecasting sense- rather, it is just our feeling, intuition and guesses (maybe one day in the future, this opinion will be famously known as ‘insight’ or ‘foresight’?). Therefore, do NOT take our opinion as financial advice- we are not financial advisers and our conviction is that one should be ultimately responsible for one’s own investment and financial decisions.

Okay, here comes the meat…

Firstly, our belief is that the US economy is heading for a hard landing. Currently, Ben Bernanke’s forecast is that economic growth will pick up in 2009 after a possible mild recession. This is also the belief of the market, as it tentatively believes that the credit crunch is abating. We are sceptical of this view. After all, years of accumulation of bad debts, over-leverage, mal-investments and structural damage of the US economy cannot be simply brushed away with the turning of interest rate levers, money ‘printing,’ bailouts and sweet talks. As we explained 13 months ago in Marc Faber on why further correction is coming- Part 2, the liquidity contraction that started in the US is resulting in the process of global asset price deflation, especially house prices in the US. As asset prices deflate, this will bring about further bad debts, which in turn will bring about further deflation in a vicious cycle.

Next, as it especially applies to the Western developed world, the financial side of the economy has grown to be a major intertwined component of the overall economy. As we said before in Analysing recent falls in oil prices- real vs investment demand, the difference between the real and financial side of the economy is that the

.. real side [is] where you find the physical market for goods, services and labour. The financial side is where you find the flow of financial capital, assets and payments.

It can be argued that today, the financial side of the economy had grown beyond its original supporting role of efficiently and flexibly allocating capital for the real-side of the economy, to the point of playing one of the primary roles in the economy. In any case, both sides are interlocked hand-in-hand with each other, which means any shocks to the financial system will affect the real economy and vice versa. To illustrate this point, take the case of Australia. With the vast majority of working Australians parking their retirement savings through the superannuation system, which in turn distributes the savings into financial products (e.g. managed funds), which in turn further distribute these savings into the financial asset markets (e.g. stock market). Furthermore, even ownership of physical assets (e.g. property) requires credit, which in turn is sourced from the financial system. And when it comes to credit, developed Western economies like Australia have been gorging on them to fund anything from credit card debts, personal loans, car loans, stock investment through margin lending, store cards, etc. Therefore, you can see that any breakdown in the financial system will have serious and dire consequences on the rest of the real economy.

For Australia, it seems to be at a sweet spot. The voracious Chinese demand for commodities have been a windfall for Australia, which has vast reserves of resources to supply the Chinese economy. That, along with a highly advanced financial system helps spread the prosperity to the rest of the nation to some degree. But the dark side of this prosperity is the build up of leverage (debts) to a dangerously high level (see Aussie household debt not as bad as it seems? and Australia has no sub-prime debt? Think again!).

Now, there are dark clouds in the horizon. The global financial system had never been as interconnected as before in the history of capitalism. You can be sure that any trouble that begins in the US financial system will spread to the rest of the world. As of today, there are murmurs about the credit crunch being the most serious crisis since the Great Depression. As the financial system rot in the US economy spreads into its real side, you can be sure that Australia’s financial system will be severely affected as well. The Australian economy (along with other Western economies with advanced financial system like the US and UK economies) are highly leveraged (i.e. burdened with far too high levels of debt) both at the retail household level and at the institutional level. Already, we are hearing about bankruptcies, blow-ups and traumatic losses in the global corporate sector (e.g. Allco, MFS, Fincorp, Centro, Basis Capital, ABC Learning Centre, Tricom, Opes, Bear Stearns, UBS, Citigroup and too many more to list). The Australian household sector is feeling the debt stress (e.g. mortgage stress, housing affordability and rental crisis, soaring personal debt levels, etc). As we said before in Rising price of money through the demise of ?shadow? banking system),

Australians love their debt too much. From the large current account deficit (see Understanding the Balance of Payments), much of Australia?s debts are sourced from overseas. With the demise of the global ?shadow? banking system, the price of money in Australia has to rise too.

A highly indebted nation cannot afford to have the price of its credit rise without acute consequences. Thus, University of Western Sydney (UWS) Professor Steve Keen believes that a severe recession induced by debt deflation will arrive at Australia within 2 years.

The question is, will China save Australia from this?

For one, the rot in the global financial system may not affect the real side of the Chinese economy directly. This is because the Chinese financial system is still rather primitive compared to the advanced Wester economies. For example, there are still hundreds of millions of peasants toiling in the countryside. Those who migrated to the cities to toil under the factories are still not plugged into the developing Chinese financial system. Therefore, unlike the Western world, a bearish Chinese stock market does not necessarily forecast doom for the wider Chinese economy. As a result, the credit crunch that started in the US will have a limited impact on the real side of the Chinese economy. So far, this is good news for Australia (but Australia is not out of the woods yet).

Therefore, our opinion is that when the inevitable severe recession hits the Australian economy soon, the Australian mining (and related) sector will probably be the only bright spot in the darkness. In fact, we can argue that a recession may perhaps even be beneficial for the mining sector as much of the idle resources (caused by the recession) in the economy can be re-allocated to the mining sector (see How is Australia?s mining boom sucking resources out of the economy?).

But here comes the bad news.

Firstly, in a hard landing of the US economy, the real side of their economy will be crunched as well. Our theory is that this may lead to a more than proportionate contraction in the investment activities that dominates the Chinese economy, which will trigger a hard landing in the Chinese economy. Even if this theory turns out unfounded, there is another worry- the Chinese economy may not have enough resources supplied to it fast enough to maintain the trajectory of its economic growth. When that happens, the risk is that the trajectory may be shot down, resulting in the forced liquidation of all these mal-investments. The outcome is a big Chinese bust. Our article, Can China really ?de-couple? from a US recession? has the full explanation of our theory. When that happens, the last leg supporting the Australian economy will be kicked off. This is the worst-case scenario for the global economy (and by extension, Australia). Our feeling is that the coming Chinese bust may come with a time-lag after the US hard landing. If our theory about the more than proportionate contraction in Chinese investment holds true, then the time-lag may be shorter.

But yet again, this may not be all bad news in the longer run. If China’s rise is a secular event (see Example of a secular trend- commodities and the upcoming rise of a potential superpower) of the 21st century, then Australia can still climb out of this worst-case scenario.

Please note that we are not making any predictions here. Our vision is very far out into the future. Generally, the further one ventures into the future, the more likely unforeseen Black Swans will sneak in to turn one’s vision into fantasy. But as the old adage says, prepare for the worst but hope for the best.

IMF: Risk of property price correction in Australia ‘high’

Friday, April 4th, 2008

Today, we saw this article in the Australian Financial Review: Property correction risk in Australia ‘high’:

The risk of a correction in Australian house prices is high by international standards, the International Monetary Fund says.

The IMF, which says Australian property is among the most overvalued in the developed world, has warned that about 25% of the increase in house prices between 1997 and 2007 cannot be explained by fundamental economic factors such as population growth and income, The Australian Financial Review reports today.

If you want to see the IMF report for yourself, go to the April 2008’s IMF World Economic Outlook report here. This finding is found in page 11 of the report’s Chapter 3 PDF.

Support mortgage lenders to keep borrowers in indentured servitude?

Thursday, April 3rd, 2008

Last week, there was an article in the mainstream news media, Call to support mortgage lenders,

THE global credit crunch is destroying competition in the home-lending market, leading to the threat of permanently higher mortgage rates.

The warning comes from two leading economists, who are calling on the Rudd Government to establish a scheme similar to those operating in the US and Canada, under which it would use its AAA credit rating to bolster the funds available for home lending, helping to keep small operators in business.

So, these ‘leading’ economists are asking the government to get into the landlord business? By reviving the shadow banking system that way (see Rising price of money through the demise of ?shadow? banking system), they hope to re-introduce ‘competition’ into the mortgage industry to lower mortgage rates.

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?

Mortgage rates have to rise for a good reason. Money had been too cheap for too long, and this is the primary reason why there are so many bad debts in the global financial system as far too many gorged on debt that they cannot really repay. Rising mortgage rates is just a reversion to what should have been long time ago. Supporting mortgage lenders will not solve the problems of scarcity in the real world- it will merely lead more people into indentured servitude.

Get paid to borrow gold and silver?

Wednesday, April 2nd, 2008

For the vast majority of us, gold is a lump of metal that does nothing. As we said before in Is gold an investment?,

… since 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.?

But for a certain class of gold owners, they DO earn interests on gold. Right now, instead of receiving interest for lending out gold, they are paying people to borrow gold. Who are these gold owners?

They are the central banks. The ‘interest rates’ on gold is the gold lease rates. Typically, central banks lend out gold through bullion banks, which then pass them on to the market. Eventually, the gold has to be repaid with ‘interest’ paid with more gold. Sometimes gold producers pre-sell their gold by borrowing them from central banks first and then repaying those borrowed gold (with interests, of course) later through their own production.

Right now, at this point of writing, the gold lease rate for 1 month is -0.0483%. This negative lease rate has been going on since last week. For silver, the lease rate for 1 month and 2 month is -0.04% and -0.0379% respectively.  This is a very curious phenomenon. In other words, central banks are paying for others (e.g. bullion banks, gold miners,  hedge funds, etc) to borrow gold to sell to the market. In other words, central banks are paying for others to ‘short’ gold.

That could be the reason why gold prices had been falling recently.