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Difference between ‘assets’ and real assets

Monday, June 30th, 2008

From our previous article, How do we prepare for a possible economic crisis?, one of our readers asked:

A lot of us, simply do not have free floating (saved) money to worry about. What we have, instead, are huge debts that are closely tied to the so-called, and as yet unrealised, ?equity? we are supposed to have in the assets that we borrowed against.

…

But for the rest, all I see is a sea of debt with an island in the hazy distance that is supposed to be my ?equity? in assets held hostage by banks as security. So, to simplify it to the bare bones, the first question for many is, not whether one should buy gold or silver, but whether one should liquidate assets in which one supposedly has some equity.

Before we continue, we must stress again that we are not providing financial advice of any sorts in this web publication. All views expressed are merely our own personal opinions. With this disclaimer, we can now proceed to what we think…

This question from our reader requires a long and thoughtful answer. Therefore, we will answer it over the course of a few articles.

First, we must be sure of the meaning of “asset.” This word is often misused and misunderstood, leading people to make the wrong investment decisions. We will use Rich Dad, Poor Dad‘s definition- an asset is something that puts money into your pocket regularly.

That definition may sound too simple, but many people do not really understand this concept, thinking that an ‘asset’ is something that can go up in price. That is why there are property speculators ‘investing’ in houses that are far overvalued and getting caught out in a property price bubble when the business cycle turns. In essence, the property price bubble is a Ponzi scheme that collapses when the economy runs out of money through a credit contraction brought about by the credit crisis or rising interest rates. If you read the newspapers today, you will find ‘investors’ bemoaning the horrible superannuation returns of the past financial year because the stock prices were ‘performing’ very badly. Fund managers are judged according to how prices of ‘assets’ under management ‘performs.’ As we said before in Harmful effects of inflation,

The surging asset prices (e.g. stocks, bonds, properties, commodities and yes, even artwork!) of the past several years are not signs of a strong economy. Rather, they are symptoms of inflation, brought about by speculation.

Without a proper understanding of what an asset is, many people mistook rising prices for wealth and could not see them for what they truly are- inflation. If an asset is something that can go up in price, then in this time of commodity price inflation, a sack of rice (or a bottle of vegetable oil, or a can of petrol, etc) is also an asset! In fact, there are plenty of ‘assets’ in Zimbabwe today, with the prices of stuffs going up exponentially.

If we return to the fundamental definition of an asset being something that puts money into your pocket periodically, then we put ourselves in the right frame of mind in evaluating the value of assets. Next article, we will talk about the value of assets.

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Posted in Investor Education, Value Investing | 4 Comments »

How do we prepare for a possible economic crisis?

Sunday, June 29th, 2008

We will continue with some of our readers’ questions from our previous article, What is a crack-up boom?:

David:
My comment/question is how do you plan, as a family, for an event that is this big and catastrophic and that could happen any day over the next 10 years, or take place ?slowly? over months or years (or really is happening already at some rate)? Buying gold it seems is a good investment strategy, but not a complete preparation by any means.

Temjin:
Is another great depression an inevitable event that will occur sometime in the near future? Can it be AVOIDED or at least, the effect minimised with any sort of human intervention? My main concern would be that I am still in the early stage of my career and have not yet accumulate sufficient wealth to withstand any significant recession/depression.

Alex:
Personally, I think it would be great (if you have the time) to see an article explaining why it’s unlikely; and perhaps explaining how – given the stark possibilities we’ve been shown – it will be possible for the US (and the rest of the world) to NOT enter an inflationary or deflationary recession.

To be honest, we do not really have all the answers to these questions. This is because what we are experiencing today is unprecedented in the history of humanity. Therefore, history can only be a limited guide to what is to come. As we said before in Epic, unprecedented inflation (remember, that was written 12 months ago, when the bear market had not yet arrived),

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

Since 1971 (when President Nixon severed the final link between gold and the US dollar), this is the first time in the history of human civilisation that the entire world is using freely fluctuating and pure fiat money (see What should be your fundamental reason for accumulating gold? for the meaning of what fiat money is).

Therefore, we must impress upon you that we do not know what the future holds and hence, are not making any predictions. Understanding what is to come lies outside the realm of economics and finance, into the realm of psychology, politics, sociology and so on. The latter group are outside our circle of competence. As such, this topic is full of Black Swans. As we said before in Failure to understand Black Swan leads to fallacious thinking,

For this reason, that is why we delve more on the big picture and economic history and get mired less on minute statistics and detailed numbers. In technically philosophical terms, it means we are taking on a meta-view i.e. we are taking on a view of our view. At times, this means we have to expand our circle of understanding and venture outside of finance, investing and economics into fields such as psychology, politics and history. The broader our circle of wisdom and experience (that includes borrowed experience from a study of history), the less vulnerable we will be to being caught out like that turkey.

Thus, your guesses of the future are as good as our guesses. Here are some of our thoughts…

A lot will depend on the level of law and order if/when the epic economic crisis happens. In the United States during the Great Depression, there was still a functioning government, with law and order still functioning. We can think of modern examples of countries that are not so lucky: Rwanda, Yugoslavia, Somali, Congo, and so on. If anarchy reigns, we doubt money in any form would be useful- guns, food and survival equipment may be better bets. On the other extreme, we can imagine a potential demagogue secretly practising his incendiary orations in some back rooms today, to be used tomorrow to seize absolute power and authority- a case if ‘too much’ law and order.
As David said, buying gold may be a good idea. But gold ownership was outlawed in the United States during the Great Depression. Currently, Vietnam is banning gold imports (see Vietnam Suspends Gold Imports) as price inflation surges to 25%. This is another example of Black Swans. For our United States reader, this is one thing to bear in mind.

Can an economic catastrophe be avoided, or at least be minimised?

Firstly, the coming ‘catastrophe’ may not happen in a way that we expect, in a manner that we may recognise today as a conventional ‘catastrophe.’ Would life under the coming ‘catastrophe’ be some form of hellish tribulation or just a very difficult disruption of the life, as we know it? The answer may depend on the context of which country/currency/region you live in. The Middle-East is the place we would like to avoid. Australia, the “lucky country” may be a safer place. There is a possibility that we may have to revert back to a much simpler lifestyle (e.g. cycling to work, planting our own vegetable gardens, no television at night, etc). Maybe the financial markets as we know it, will be completely different and much simpler under an overhauled system (e.g. a gold standard)? Some may welcome this while others may fear it. For those who live in the third-world countries, it may not be any difference.

Who knows, perhaps another Paul Volcker may take on the helms of the Federal Reserve? As we said before in Peering into the soul of Ben Bernanke,

In a way, Paul Volcker, the chairman of the Fed in the 1980s, is the anti-thesis of Ben Bernanke. He was credited with ending the US?s stagflation crisis in the 1970s by crushing the economy into the worst recession since the Great Depression. To do this, he had to raise interest rates to unbelievably high levels, to the point that in 1981, interest rates charged by banks exceeded 20 percent (Note to Australian readers: the Labor was often blamed for the super high interest rates of the 1980s. Now you know where such high interest rates come from- such high interest rates was a global phenomenon). Paul Volcker crushed severe inflation by crushing the growth of money supply.

If such a person heads the Federal Reserve today, you may want to consider selling your gold straight-away. On the other hand, with the United States mired in so much more debt than in the early 1980s, can such a harsh medicine work without killing the patient?

Can an inflationary/deflationary recession be avoided?

Well, how do we see ‘avoidance?’ Back in 2001, the United States briefly dipped into a very shallow recession before the economy bounced back into growth. But did it really avoid a recession? Or was it merely postponed? Back in November 2006, as we said before in How will asset-driven ?growth? eventually harm the economy?,

In 2001, when the US economy was faced with a threat of recession, the Federal Reserve embarked on an expansionary monetary policy (aka ?printing money?) in an attempt to prevent it from happening. We believe this policy does not prevent a recession?it merely postpones it, in which the upcoming one will be more severe instead.

So, if the world manages to ‘avoid’ another severe recession, will that be setting itself for an even larger one down the track?

With such a colossal amount of debt owed today, the consumption of the present generation will consign the future generation to slavery paying off what was owed by their parents. If Peak Oil is true, how can the future generations have the capacity to do so? Who knows, perhaps a new technological breakthrough is about to happen, bringing us to a new paradigm shift? This looks to be the only way for both inflation and deflation to be ‘avoided.’

Are young people more vulnerable to an economic crisis?

We believe that having a large nest egg is no guarantee as much as having a minuscule one. When inflation strikes, the purchasing power of any nest eggs will be severely eroded very quickly in no time. For example, say you had accumulated 1 million Zimbabwe dollars for your retirement. But today, that nest egg is worthless through hyperinflation, unless you have a foresight to convert that to foreign currencies or gold BEFORE it happens. Our point is, to protect yourself against hyperinflation, it is not how much you accumulated that makes the difference. It is what you hedge it with that means the difference between the poorhouse and a much better life. With deflation, no matter what amount of nest egg you have is useless if your counter-parties (e.g. bank, superannuation fund) default on their liabilities to you. See Should you hold gold or cash in times of deflation? for more details on this.

For young people, you have one advantage that the old folks does not have- the energy and drive to learn new skills and embark on useful enterprises/projects that may be far more useful and relevant in a tougher and different economic scenario. In that sense, retired people are far more vulnerable than young people.

What are your thoughts on how to prepare for an economic crisis? Share them at this forum!

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Posted in Looking Forward | 22 Comments »

Can lower interest rates re-inflate the property price bubble?

Thursday, June 26th, 2008

Recently, those people at BIS Shrapnel are busy spreading misinformation in the mainstream media again (see this mainstream news article: House prices set to climb despite rates). Their first ‘analysis’ regarding house prices was first released in March this year. This month, their ‘analysis’ was again reported in the mainstream media. We had already criticised their flawed ‘analysis’ earlier in Another faulty analysis: BIS Shrapnel on house prices and would not repeat them again in this article.

But we would like to add one more point with regards to one of their flawed assumptions. When you read the mainstream news media, you will notice that one of their assumptions is that when the RBA eventually cut interest rates (insert: Mr Angie Zigomanis, the report author, said that “As credit conditions recover over the course of 2009…”), it will lead to the further re-inflation of property bubble. Judging from this flawed assumption of theirs, we wondered whether they are really that ignorant about economics.

To understand the flaw in their assumption, we have to first understand the RBA’s latest decision to hold interest rates in June. Currently, the RBA is still keeping an eye on price inflation. As BIS Shrapnel themselves acknowledged, the RBA is likely to raise interest rates again this year to combat price inflation. But the reason why the RBA kept interest rates on hold this month was that they expected the Australian economy to slow down in the coming months. In other words, the RBA is expecting the economy to slow down so that inflation will be kept at bay, which will reduce the necessity to raise interest rates.

When the economy slows down, what happens? You will see rising unemployment, falling profits, declining consumer confidence and so on. Given the astronomical levels of debt Australians owe, en economic slowdown will increase the debt servicing burden, which in turn (1) increases the likelihood of bad debts and thereby, (2) decreases the quality of the loans in the banking system. Effect (1) increases the likelihood of debt deflation (see Aussie household debt not as bad as it seems? for more detailed explanation). Effect (2) will lead to the contraction in the supply of money and credit (or at least a slowdown in its expansion) in the economy (see How money & credit can shrink (i.e. deflation)? for more detailed explanation).

As we said before in Australian property good investment? Part 3?prospects of capital appreciation (written more than a year ago),

Traditionally, it is the rising income levels that drive property prices upwards over the years. Naturally, as people?s general income level increases, the prices paid for property will increase as well. Recently, we have another phenomena that drive property prices upwards?the sudden availability of easy credit and low interest rates, which are manifestations of monetary inflation (?printing? of money). The result is a short-term property price bubble…

So, given that Australian house price inflation are driven mainly by credit (NOT income), shrinking supply of credit will at least put a brake on further price inflation. In fact, we can argue that for every same percentage increase in asset prices, the amount of credit required increases exponentially. Thus, we do not even need a shrinking amount of credit to induce asset price deflation- a slowdown in credit increase is enough to do that job. In Australia’s case, credit is the oxygen for the property market. Without it, no matter how much excess ‘demand’ for housing is out there, there will not be enough people who can afford them.

As we can see from this Bloomberg article, Australian House Prices Fall Most in Five Years on Higher Rates,

Australian house prices fell in the first quarter by the most in five years after the central bank raised interest rates at the fastest pace in more than a decade.

The median price for houses fell to A$458,488 ($439,644) in the March quarter, down 2.7 percent from the previous three months, the Real Estate Institute of Australia and Mortgage Choice Ltd. said. Apartments also fell 2.7 percent to A$355,297.

The statistics at RBA shows that credit growth in Australia is starting to slow due to interest rates rise. And at the same time, we see property price deflation in the first quarter of 2008.

Therefore, a slowing economy is NOT good for house price.

But what if the economy slows down too much for the RBA’s liking? In that case, given the high levels of debt of Australians, if the economy slows down too much, the Australian economy can tip into a dangerous downward deflationary spiral. That was what happened to Japan during the 1990s. Today, the Japanese are still trying to recover from that deflation. When that happens, the RBA will be cutting interest rates just like Ben Bernanke did recently. In short, while the RBA is looking at inflation, it will not cut interest rates unless deflation becomes a serious threat. By the time deflation becomes a serious threat, will cutting interest rates re-ignite the property price bubble?

Again, we doubt so. As we said before in What makes monetary policy ?loose? or ?tight??,

A common misperception is to assume that any rise in interest rates automatically implies a monetary tightening (and conversely for a fall in interest rates).

Underneath BIS Shrapnel’s assumption lies the erroneous misconception that the cutting of interest rates automatically result in a loose monetary policy (i.e. increase in the quantity of money and credit in the economy). If deflation gets serious enough, the cutting of interests will still result in a ‘tight’ monetary policy. Japan was an excellent case in point. Another excellent case in point is the United States today. Despite Ben Bernanke cutting interest rates desperately, did it re-inflate the property bubble over there (see this news magazine article, US Home Prices Tumble in April)?

In short, BIS Shrapnel has no credibility.

P.S. Temjin & David: We will continue to answer your questions (in What is a crack-up boom?) in the coming articles.

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Posted in Economics/Finance, Looking Forward, Property | 16 Comments »

Is property a good hedge against hyperinflation?

Wednesday, June 25th, 2008

Today, we will answer another of our readers? question from our earlier article, What is a crack-up boom?,

A question on property: If the masses inflation expectations get high enough, and they rush to buy assets at any cost, would this make property prices soar even higher? Or…would this be curbed by interest rates or lack of credit availability? See I would think the prices would soar as housing is the ‘asset of masses’ – a fairly simple and needed asset that most people can understand.

Another question on property: If the central banks do not put up rates to force a recession or at least reduce inflationary pressures, wouldn’t the banks just do it themselves anyway? In Australia the RBA has been increasing rates, yet the banks have also been increasing rates at times when the RBA has not. It seems to me that banks would take lending rates into their own hands, in hyperinflationary crisis, even if the RBA did not?

Reading between the lines of this reader’s question, we re-phrase it as such: is property a good hedge against hyperinflation? No doubt, in times of hyperinflation, property prices can soar, along with prices of ‘stuffs’ in general. But does that necessarily make property a good hedge against hyperinflation?

Before continuing, we have to get some definitions right. First, when we talk about hyperinflation here, we do not mean the high inflation of the 1970s. Hyperinflation is far worse than that. Weimar Germany in the 1920s and Zimbabwe today is the hyperinflation that we mean in this article. Both of them began as low inflation, developed into high inflation before finally ending up as hyperinflation.

Does property fulfil the purpose of preserving your purchasing power in times of hyperinflation?

First, a good hyperinflation hedge has to be liquid so that it can be readily exchanged for money or bartered. With property, even though its imputed value may soar with hyperinflation, it is not a liquid asset (see Spectre of deflation for an explanation of what “imputed” value is). To liquidate property, one will have to go through a lengthy legal process. As we quoted Ludwig Von Mises in What is a crack-up boom?, in the final stage of a crack up boom,

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.

It is much faster to swap your money against general ‘stuffs’ than with property.

Next, a good hyperinflation hedge has to be easily divisible. Suppose you want to purchase a sack of potatoes for your daily meal. There is no way you can sell 1/30000th portion of your property to pay for that sack of potatoes. Thus, though owning a property may preserve your net worth’s purchasing power theoretically, it is of no use if you cannot use it to acquire goods for your daily needs.

Next, purchasing property as a hedge introduces a major risk to the buyer. This risk is often ignored by ‘experts.’ Nowadays, almost everyone purchase property through debt. That is where the risk lies. As we explained before in Does inflation (deflation) benefits the borrower (lender)?,

Debt servicing burden = (Debt payment rate – Growth in wage) + Price inflation rate

In a hyperinflation, prices of ‘stuffs’ rise very rapidly. In fact, they can even rise by the hour (exponential rise). However, wage rate may rise much slower than the general price levels. That was what happened in Germany in the 1920s. Real wages fell, reducing the workers’ quality of life even though there was hardly any unemployment.

At the same time, you can expect bankers to raise borrowing rates very quickly to protect their profits. To understand why, imagine you are a banker in Zimbabwe. If you are to lend money to home loan borrowers, what is the interest rates you should charge? In a crack up boom, prices are rising by the hour. By the time the official statistics for the CPI inflation rate is released, the information will be outdated because prices are increasing exponentially. If you do not charge high enough interest, your profits will be consumed by hyperinflation very quickly. But without any stability in the value of fiat money, there is no telling what level of interests is sufficient. Therefore, for bankers, it is either they charge extremely high cost of borrowing (which is very punishing for borrowers) or they exit this business altogether (which makes credit scarce).

Therefore, for those who purchase property on credit in the belief that it can serve as a hyperinflationary hedge, this can be a decision of regret as they get crushed by the debt servicing burden. The only way out is to sell the property. But if the liquidity of property dries up during a crack up boom, then this only escape route is being cut off.

Finally, with property already highly over-valued due to the prior boom in credit binge, we have doubts that property can even maintain its real value. If the crack up boom is of the stagflationary flavour (i.e. rising prices AND rising unemployment), there are reasons to believe that holding property may even result in losing wealth in real terms. In the United Sates, they are now experiencing falling property prices AND rising price inflation. For those who are thinking of gearing into property to hedge against inflation, the current situation in the US should serve as a warning.

Posted in Property | 22 Comments »

Can there be an alternative reserve currency?

Tuesday, June 24th, 2008

Today, we will answer another of our readers’ question from our earlier article, What is a crack-up boom?,

Pete

So in a crack-up boom, will this be different to the times of Germany? There are so many fiat currencies out there, whats to stop Australia for instance adopting the Euro? (I bet there are many reasons). What about if people get sick of $USD, and start trading in Chinese Yuan instead? Or Reals? Is that possible? Due to our global trade system, that was not as highly developed in the time of Germany?s troubles, would that not alter the possible outcome when the crack-up ?conditions are met??

Sergey Stadnik

It the new hyperinflation hits the world, starting with US. What?s going to become such an anchor: gold, oil, Chinese Yuan?

For those who are new to this publication, the context of these two questions lies in the US dollar being the world’s reserve currency. Please note that as always the case, we are not making any predictions about the future. Instead, we are exploring the possibilities with a view to understand what are the economic signs to watch out for.

First, how will today’s crack up boom different “to the times of Germany” in the 1920s? Well, if a crack up boom is confined to only one currency, then it is only that currency’s country that get affected. For example, Zimbabwe is ravaged by hyperinflation today. There is no major economic effect on the rest of the world because of it. But the US dollar is a different- it is the world’s reserve currency. An inflating reserve currency will have an effect on to the rest of the world- see How does the US export inflation?. As we can all read from the mainstream media, inflation has become a global phenomenon, with the sky-rocketing oil prices blamed on the ‘weak’ US dollar (see Can ?weak US dollar? be partially blamed for rising oil prices?).

Now, let us suppose that the US will fall into a crack-up boom (i.e. hyperinflation). As we said before in What if the US fall into hyperinflation? (and we encourage you to read this article for the context), when that happens,

… a disorderly flight from the US dollar is a Black Swan event that will result in a mad scramble to find a reliable alternative. It will be a time of volatility and uncertainty. No prize for guessing that gold will be the primary beneficiary when that happens.

Will the Euro become the reserve currency? Or the Chinese yuan? There are a few problems with that:

Firstly, all these currencies are fiat money (in fact, all currencies today are fiat money). As we said before in What should be your fundamental reason for accumulating gold?, money is fiat if it

… enjoys legal tender status through the authority of the government instead of through the choice of the free market. This means that fiat money is not backed by anything physically tangible?it derives its value from an elusive intangible called ?confidence.? Simply put, fiat money is backed by nothing!

For this reason, we can liken choosing a reserve currency to a beauty contest that chooses the least ugly woman as the winner- all choices are bad choice and we have to choose the least bad choice.

Secondly, each of these currencies have their own unique problems.

Thirdly, if an alternative reserve currency is to emerge, it will involve unhealthy economic conflict and competition among the nations (similar to the years prior to the Second World War). A good way to illustrate this instability is to use the reality TV show, Big Brother, as an analogy. In that show, all house mates vie, plot, back-stab and struggle among each other in order to win the one and only top prize. In the same way, the country having the world’s reserve currency will be in a very commanding position. We can be sure that if China vies for this position, there will surely be opposition.

All these problems leave only one candidate to function as the world’s reserve currency- gold. The world used gold under the classical gold standard (there is a brief history of money in Why should you invest in gold?) and it arguably worked very well until the interruption of the First World War. But it will require the global economic situation to deteriorate to the point of extreme pain for the idea of reverting to the gold standard to be entertained. So, don’t hold your breath on that. But if it does happen (who knows?), we can imagine it happening the way we described in What is the future of silver?.

Lastly, can oil function as money? As we said before in Properties of good money, oil does not fulfil the necessary properties to function as money.

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Posted in Economics/Finance, Gold | 14 Comments »

What should the RBA do?

Monday, June 23rd, 2008

Yesterday, our article What is a crack-up boom?, resulted in many interesting responses and questions from our readers. Each of these questions requires very long and thoughtful response. Therefore, we will slowly answer each question chronologically one at a time. If we have not answered all your questions today, please be assured that we will do so in the days to come. The answers come in a first-come-first serve basis.

Today’s article will answer this question:

Do you think that the RBA is doing the right thing then? It has raised interest rates, although it has also bailed out financial institutions.

Let’s start off with what we would do if we were the RBA (and the Federal Reserve). Not only would we raise interest rates, we would have done so very early to prick the emerging asset price bubble right at the start. So, why didn’t the RBA do that? As Ian Macfarlane, the former head of the RBA, said here,

Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify an emerging bubble, it may still be extremely difficult for a central bank to act against it, for two reasons.

First, monetary policy is a very blunt instrument. When interest rates are raised to address an asset price boom in one sector, for example, house prices, the whole economy is affected. If confidence is especially high in the booming sector, it may at first not be much affected by the higher interest rates, but the rest of the economy may be.

Second, there is a bigger issue which concerns the mandate that central banks have been given. There is now widespread acceptance that central banks have been delegated the task of preventing a resurgence of inflation, but nowhere to my knowledge have they been delegated the task of preventing large rises in asset prices which many people would view as rises in the keeping of his wealth. Thus if they were to take on this additional role, they would face a formidable task in convincing the public of the need.

The last sentence is where the problem lies. The masses have not given the RBA the mandate to spoil the asset price inflation party. Although, Ian Macfarlane acknowledged that asset price bubbles can be very dangerous for the economy, his hands were tied. Elsewhere, Coalition opposition politicians were toeing the populist line by demanding that Glen Stevens (the current head of the RBA) be grilled more frequently in order to pressure him against hiking interest rates.

The next question is: should the RBA raise interest rates aggressively now? University of Western Sydney Professor Steve Keen reckoned that it is too late to do so now. His reasoning is because at this point in time, deflation is the greater danger and that inflation, though also an evil, should be left alone for now. We believe his view is that when debt deflation takes hold, it will drag consumer price inflation along with it. Is he right? Well, we are right now experiencing asset price deflation plus commodity price inflation. If the RBA leave inflation alone, our fear is that the seeds of the crack up boom can eventually grow up to become a hyperinflation dragon.

Next, should the RBA bail out financial institutions? So far, they have not officially bail out one yet in the same way the Federal Reserve had bailed out Bear Stearns. But it has certainly absorbed some of the bad debt assets and provided more liquidity. Our view is best summed up by what Jimmy Rogers said in Jimmy Rogers: ?Abolish the Fed?,

If xyz needs to go bankrupt, let them go bankrupt. I promise you, that will send a very straight signal and you will have a lot of self-regulation when these guys start to go bankrupt.

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Posted in Economics/Finance | 12 Comments »

What is a crack-up boom?

Sunday, June 22nd, 2008

In our previous article, Are we past the first stage of a crack-up boom?, we explained that much of the ‘prosperity’ that the Western world (more specifically, the English-speaking nations) experienced over the past several years was an illusion of monetary inflation (see our guide, What is inflation and deflation? to understand the true nature of inflation). As we are entering the second stage of the crack up boom, we must, as investors, learn how to read the economic signs.

So, for today’s article, we will turn to Chapter 9 of Human Action: A Treatise on Economics by Ludwig Von Mises. First, we will begin with a self-evident axioms and then work our way up to the more complex economic phenomena:

The deliberations of the individuals which determine their conduct with regard to money are based on their knowledge concerning the prices of the immediate past. If they lacked this knowledge, they would not be in a position to decide what the appropriate height of their cash holdings should be and how much they should spend for the acquisition of various goods. A medium of exchange without a past is unthinkable.

Clearly, some people may say this is laughingly obvious. But this is just the beginning of the economic method from the non-mainstream Austrian School of economic thought. Next, having established this self-evident axiom, we move on to the next axiom:

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

If you hear the boring and meaningless talk of central bankers, this will be what they call “inflation expectation.” Central bankers are desperate to control “inflation expectation” of the masses. Obviously, if the masses expect price inflation, then they will reduce their cash balance and buy more things to pre-empt it. There is an old-fashioned word for this: hoarding. Hoarding often exacerbate the economic rot (see Connecting monetary inflation with speculation).

As we can all observe, the ‘boom’ of the past several years was possible because of the low price inflation expectation that was made possible by the rise of Chinese manufacturing. As Ludwig Von Mises continued,

As long as such speculative anticipations are limited to some commodities, they do not bring about a general tendency toward changes in cash holding.

As long as speculative anticipations are limited to property (see The Bubble Economy) and stocks (e.g. the booming record highs on the ASX 200 just before November last year), the masses are generally comfortable. In fact, we argue that this make the masses (e.g. individuals with their property ‘investments’ and businesses with the ridiculous amount of borrowing) more reckless with regards to their cash holdings. The sub-prime crisis and the credit crunch is a fine example of the consequence of the widespread underpricing of risks in the global financial system.

The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services, as has been shown, at different dates and to a different extent.

This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation

As we said before, at this first stage, the masses were fooled into thinking that the asset price inflation was ‘prosperity’ and they failed to understand that the underlying cause was actually monetary inflation. During that time, prices have not yet fully adjusted according to the increase in the supply of money and credit.

There are still people in the country [world] who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services.

Today, the masses are slowly getting more aware of this price revolution. It may not be that clear for the fortunate few in Australia, but for the millions of poor starving Asians, Mexicans and Indians, this price revolution screamingly obvious.

These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.

We are at the crucial point whereby the masses are gradually losing hope that prices will one day stabilise and fall. In other words, using central bankers’ talk, inflation expectations are in danger of getting entrenched. This is the greatest fear of Ben Bernanke and all his other accomplices in the other central banks. The last stage of inflation occurs when:

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.

As we can hear very often in the media, high oil prices are blamed on speculators and the rising demand of China and India. There are fundamental supply and demand factors for the rise in oil prices. But oil price speculation is a sign that some among the masses are waking up to the fact that inflation is still an ongoing policy. Since oil (and we can say commodities in general) is a major root input cost for much of the activities that are going on in the global economy, it will soon result in consumer price inflation. Sustained consumer price inflation will be a very clear signal to the rest of the masses that inflation is a deliberate policy. When that happens, the die is cast. As Ludwig Von Mises wrote,

It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last.

What is the only way to avert hyperinflation? Very unfortunately, the only way is to abandon inflation as a policy (i.e. raise interest rates aggressively), which will be devastating to the credit market and worsen the credit crunch. The outcome will be severe deflation. When that happens, the word “depression” will appear in the media continuously. Do you think the masses will opt for a painful cleansing voluntarily? As we said before in A painful cleansing or pain avoidance at all cost?,

Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles? heel of democracy. The mob will scream at the Fed to bail them out by ?printing? money (i.e. pump liquidity into the economy in the form of cutting interest rates). Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible.

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Are we past the first stage of a crack-up boom?

Thursday, June 19th, 2008

Around 15 months ago (when we first wrote Have we escaped from the dangers of inflation?), there are many people who believed that the world was in an unprecedented boom and prosperity. Indeed, many economists called this the “asset-driven growth.” The truth is that, this boom was nothing more than inflation in disguise (see Myth of asset-driven growth written in January 2007). As long as price inflation was conveniently confined to asset prices, no one complained. In fact, the masses loved it because it made them feel rich. However, the ‘prosperity’ that those in the West enjoyed was an illusion. Back then, while the Western masses enjoyed soaring asset prices and benign price inflation, they failed to notice that their ‘wealth’ was borrowed from and paid by the Chinese. Millions of rural Chinese left their farming villages to toil in the factories in conditions that we in the West will find appalling. It was these factories that churned out cheap goods that gave us the illusion of low price inflation. As we said before in The Bubble Economy,

In recent years, Chinese productivity had soared, which means overall, the Chinese economy was producing more and more goods at lower and lower costs. In China itself, that had a good deflationary effect – the fall in the consumer price levels. As China exported more and more of its cheaper goods to Australia, the effect on Australia was disinflation (decelerating growth in consumer price inflation). That helped keep a lid on the Australian consumer price inflation.

We have to remember that much of the rise in Chinese productivity could be attributed to their seemingly endless supply of labour procured from their vast countryside.

Today, the generous credit that the Chinese had extended is coming to an end. They are running out of skilled labour to continue churning out goods to match our inflation in money and credit (if they can continue to inflate at all). Also, it’s time that they start to look after themselves by investing on their own nation. Now, price inflation all over the world is spilling over to consumer prices with a corresponding deflation in asset prices. The masses’ mood is souring. This is hardly surprising to us. As we explained (back in November 2006) in How will asset-driven ?growth? eventually harm the economy?,

When central banks expand the money supply artificially, it creates distortions in the economy which will eventually result in a recession, which is a correction to the distortion. In the case of the US (and the British and Australian as well) economy, the housing bubble was caused by the inflation of money supply.

The correction of this distortion manifests itself in the form of credit crisis and deflation. To fight this deflation, central bankers have been desperate to pump more liquidity into the global financial system. But the asset bubble can no longer be re-inflated with this new pumping. This time, it is oil and commodity prices that are being inflated. Inconveniently, such price inflation will lead to the inflation of consumer goods. It is indeed worst of both worlds for the masses in the West- deflation of asset prices (which makes them feel poorer) and inflation of consumer prices (which make them feel yet even poorer). This is what we call stagflation (see Supplying never-ending drugs till stagflation).

We are now entering the second stage of what Ludwig Von Mises calls the “crack up boom.” In the next article, we will explain to you what this crack up boom is all about in more detail.

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Harmful effects of inflation

Tuesday, June 17th, 2008

Lately, price inflation around the world looks to be getting out of hand (see A resemblance of the beginning of Weimar-style inflation). When price inflation was affecting asset prices, nobody complained because it conveys an illusion of prosperity. But when it spills over to the prices of daily living, it provokes a reaction of kicking and screaming among the masses. Indeed, 15 months ago, before the mainstream masses had any idea that the ravages of inflation will eventually hit them hard, we warned in Have we escaped from the dangers of inflation? that

… we are very sure that as all these liquidity work its way to the rest of the real economy, it will only be a matter of time before price inflation will show its ugly head. Yet we are simply amazed with Wall Street?s obliviousness to this danger and Ben Bernanke?s incredibly sugar-coated words in his recent economic report to Congress. Can we rely on the Chinese to forever keep the price of importable things down to save us from inflation?

Make no mistake about this: central banks around the world are still inflating the supply of money and credit. With such a colossal amount of debt in the global financial system, there is no other choice but to continue inflating in order to remain solvent. As inflation worsens, we will all pay the price for the harmful effects of inflation.

Today, we will look back into history and learn how inflation nearly destroyed a country. We will turn into an old book, The Economics Of Inflation- A Study Of Currency Depreciation In Post War Germany, written by Costantino Bresciani – Turroni, an economist who lived through the German Hyperinflation of the 1920s. In chapter 5 of that book, he wrote,

The inflation profoundly altered the distribution of social saving. It is true that at first a certain mass of “forced saving” was created. But it cannot be said that these savings became available to the most productive firms and to those entrepreneurs who were most able to employ rationally the capital at their disposal. On the contrary, inflation dispensed its favours blindly, and often the least meritorious enjoyed them. Firms socially less productive could continue to support themselves thanks to the profits derived from the inflation, although in normal conditions they would have been eliminated from the market, so that the productive energies which they employed could be turned to more useful objects.

Nowadays, the less socially productive businesses include investment banking, money shuffling (hedge funds) and home building (in the US). Inflation allow mal-investments, which consumes resources wastefully for unwanted ends. Since an economy has a finite amount of resources, such wastage means that they will not be deployed in means that really matters. Also, Constantino wrote,

Also the continual and very great fluctuations in the value of money made it very difficult to calculate the costs of production and prices, and therefore also made difficult any rational planning of production. The entrepreneur, instead of concentrating his attention on improving the product and reducing his costs, often became a speculator in goods and foreign exchanges.

…

Success was the lot not of him who increased the productivity of society’s efforts, thus contributing to the increase of general welfare, but to him who had the capacity for organizing and directing great speculations on the exchange and for using wisely, with the object of personal gain, the variations of the value of money.

The surging asset prices (e.g. stocks, bonds, properties, commodities and yes, even artwork!) of the past several years are not signs of a strong economy. Rather, they are symptoms of inflation, brought about by speculation (see our guide Are Australian residential properties good investments? for an example of such speculation). Indeed, the pain of rising food and oil prices were made worse by hoarding and speculating (see Who is to blame for surging food and oil prices?).

With inflation, there is less incentive to be productive and more incentive to hoard, speculate and gamble. This in turn will reduce productivity and increase price inflation, which further increase the incentive to be less productive. In addition, as we said before in How to secretly rob the people with monetary inflation?, inflation re-distribute wealth unfairly and exacerbate the divide between the rich and the poor.

As time goes by, the economy will be structurally damaged one step at a time. This process can take many decades to completely play out. Of course, with economic mismanagement, it can be accelerated, as in the case of Zimbabwe. Sadly, the world is still committed to inflation.

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Posted in Economics/Finance, Looking Forward, Market Observations | 20 Comments »

What type of recession is coming?

Monday, June 16th, 2008

Currently, there is a lot of chatter on the topic of recession in the United States. A wide spectrum of opinions on this topic exists, from the belief that the US will avoid a recession (e.g. Matthew Johnson- his view is at Treasury Two-Year Notes Head for Biggest Weekly Loss Since 1982) to the conviction that the US is already in recession (e.g. Warren Buffett). What is our view on that? They can be found at Example of precisely inaccurate information.

Among those who believe that the US is heading for a recession, there are wide ranging views on what type of recession it will turn out to be be, namely V-shape, U-shape or L-shape recessions. What do these shapes mean?

A V-shape recession is one that is short and sharp, which is then followed by a rebound back into economic growth. An example of such a recession is the one in 2001. Right now, the stock market is roughly priced in for such a recession. This is also the official viewpoint of the Federal Reserve.

A U-shape recession is one that will be deeper, longer and thus more painful. But eventually, there will be a recovery back into economic growth. This is the opinion of one of the more bearish economist, Nouriel Roubini, who, up till now, has a very accurate forecasting track record.

A L-shape recession is one that will be deep, long, prolonged and drawn-out period of economic stagnation. An example of such a recession is what happened in Japan since the 1990s. It suffered economic contraction for the past 15 to 16 years and had recently climbed out timidly out of recession. Now, Japan looks to be falling back into recession again.

So, since the stock market has priced in a V-shape recession, guess what will happen to it if the recession turns out to be a U-shape, or even worse still, L-shape?

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