Archive for June, 2008

Is Ben Bernanke bluffing about inflation ‘fighting?’

Thursday, June 12th, 2008

As we all know, global stock markets have been in a downtrend for quite a short while already. Last Friday’s almost 400-point plunge for the Dow Jones index was the worst day for Wall Street since March this year. Other than oil, the commodity market (especially the base metals) and gold (and silver) was not doing too well. The market was spooked by Ben Bernanke and Henry Paulson’s rhetoric about ‘fighting’ inflation and ‘defending’ the US dollar. There was some rumours that perhaps Ben Bernanke may soon turn his big guns away from deflation and start aiming at inflation (i.e. raise interest rates). In addition, record high oil prices did not help either as the market fretted that this will hasten the arrival of a recession.

The question for today’s article is this: will Ben Bernanke really dare to fire his guns at inflation? Will he have the guts to do what Paul Volcker (the chairman of the Federal Reserve in the 1980s) did to crush the mighty inflation of that day?

In some ways, today resembled what happened in mid 2006. Gold prices was sprinting very rapidly towards the then record high of US$730+. Then all of a sudden, Ben Bernanke, who was then a rookie Federal Reserve chairman, talked tough about fighting inflation. All of a sudden, there was a panic in the commodity (base metals) and gold (and silver) markets. Gold prices fell like lightening from its record high US$730+ to a low of US$545 at one point. Then it spent around a year range bound between the US$600 to $700 range before sprinting again to yet another high of US$1030. In mid-last year, the sub-prime crisis and credit crunch arrived. At the lowest point in January this year, with the global stock markets crashing, Ben Bernanke was bullied into making an ’emergency’ interest rate cut for the stock market.

We wonder, if that was the Ben Bernanke who was bullied by the market in January, how can this be the same Ben Bernanke who is now talking tough on inflation? Can the leopard change its spots so quickly?

We believe that humans, like the leopard, cannot change its spot so easily. As we said before in Peering into the soul of Ben Bernanke,

As we peer deep into the soul of Ben Bernanke, we see a money printer in his heart. The next question is, how deep is his money printing heart? We cannot really quantify the answer to this question, but seeing that a couple of days ago, he surprised the market by giving it a gift of ?emergency? interest rate cut of 0.75 percent, we guess his money printing heart is pretty deep.

If Ben Bernanke is a real inflation fighter, he would not do what he did (see Watch the US government). Therefore, 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.

It has been said that if you put a frog into a pot of boiling hot water, it will react quickly and jump off the pot. But if you put it into a pot of cold water and slowly boil it, the frog will not notice the rising temperature and eventually get cooked. Likewise for the US economy, under the watchful eye of Ben Bernanke, it is slowly being boiled in a pot of rising price inflation.

A resemblance of the beginning of Weimar-style inflation

Monday, June 9th, 2008

As we can all learn from the news media, inflation seems to be infecting every nation in the world. Despite the destruction of credit (deflation) in the United States through asset write-downs, bad debts and wealth destruction through home price deflation, price inflation is still turning into a more and more serious problem not only in the United States, but also in the rest of the world. Most notably, with the prices of oil (which is an input for many stages of production, for example, see Can rising oil prices undermine the benefits of globalisation?) in an upward warpath, government ministers are murmuring of the threat to global growth, as this Bloomberg article, Soaring Oil Price `Dangerous’ for Growth, Steinbrueck Says, reported:

Soaring oil and food prices will spur inflation and could imperil economic growth, German Finance Minister Peer Steinbrueck said.

“We are facing a very dangerous situation caused by these tremendously increasing prices for commodities, food and oil,” Steinbrueck said today at the St. Petersburg International Economic Forum.

Here in Australia, our Prime Minister is putting the blame on oil producers, as this article reported,

As the bowser price of petrol climbs towards $1.80, the Prime Minister, Kevin Rudd, and the Treasurer, Wayne Swan, have blamed a lack of supply from oil-producing countries.

Can increasing production really solve the problem? Based on the simplistic supply-demand curve taught at first year economics courses, it is easy to conclude that rising prices is due to rising demand without the corresponding rise in supply. But there is far more than meets the eye in this problem.

Here we must make one point clear: There are indeed fundamental reasons why the prices of commodities, food and oil are rising (see The Problem that can throw us back into the age of horse-drawn carriages, Why are the poor suffering from food shortages? and Example of a secular trend- commodities and the upcoming rise of a potential superpower). But monetary inflation accentuates price inflation and distorts the price signals for demand and supply. As we explained 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 [and other fiat money e.g. Australian dollars, Euros, etc] can be expanded [inflation] and contracted [deflation e.g. credit contraction] at will by the Federal Reserve, how useful do you think it is as a calibration for measuring the value of oil?

The presence of index speculators in the commodities futures market (see Who is to blame for surging food and oil prices?) is an example of how prices are distorted by monetary inflation. As we explained before in How to secretly rob the people with monetary inflation?, such price distortions ultimately harm societies (and by extensions, nations) in the end. Today, it is the poor nations that are bearing the brunt of commodities price inflation as the richer ones hoard them (see Price fluctuations and hoarding), which lead to even more price inflation, which further encourages even more hoarding. Ultimately, all these will result in further global mis-allocation of resources for production. As we said in The economics of inflation, that was what happened in Weimar Germany in the 1920s:

In the acutest phase of the inflation Germany offered the grotesque, and at the same time tragic, spectacle of a people which, rather than produce food, clothes, shoes, and milk for its own babies, was exhausting its energies in the manufacture of machines or the building of factories.

Our fear is that the world may be embarking on a similar path. Countries like China and Middle East are embarking on massive investment spending sprees as they spend their hoard of rapidly depreciating US dollars. This is probably the answer to the question we posed in What to do with US$ raised from dumped US Treasuries?. Soaring commodity prices may induce massive mal-investments into the commodity producing industries. For example, massive amount of capital could be further poured into the extraction and refining of lower quality oil in hostile terrains. Wars may even be fought for the sake of securing commodities (well, we wonder whether the root of Iran’s war rhetoric and US invasion of Iraq related to the fight for commodities?). Meanwhile, investments into alternative energy are languishing and dragged slowly by other seemingly more urgent agendas.

If this hyper-inflationary crack-up boom continues, all of us here know where the root of the problem begins: lack of honest monetary system (see Why should you invest in gold?).

Australia’s money supply growth in March 2008

Thursday, June 5th, 2008

Today, we will continue from Australia?s monetary growth update?February 2008 and report on the growth of Australia’s money supply for March 2008. In that month, Australia’s broad and M3 money supply has reach yet another record high of AU$1080.8 billion and AU$992.2 billion respectively (see What is money? on the explanations of the various measures of money). Between March 2007 and March 2008 (i.e. the year-to-date), Australia’s M3 money grew by 21.1%. The year-to-date growth for February 2008 and January 2008 was 21.6% and 23.2% respectively.

From the news media, you can read a lot of reports that Australia’s credit growth (and hence, has a relationship on the money supply growth) has slowed down due to the string of interest rates hikes and slowing economy. Well, the fact remains that credit growth is still growing, although growing at a slower pace. We can argue that it is still growing too rapidly.

Think about this: if real GDP growth is growing at 3% per year while the M3 money supply grows at 21.1%, guess what will happen to price inflation? Hint: take a read at Cause of inflation: Shanghai bubble case study.

Can rising oil prices undermine the benefits of globalisation?

Tuesday, June 3rd, 2008

Right now, there is much talk about price inflation. As you read the news media headlines, you will get to see a lot of talk about the soaring oil and food prices. There are rumours that the Fed is going to raise interest rates to fight inflation. Some people are comparing today with the infamous stagflation of the 1970s. We have heard of inflation in the Middle East, China, Singapore, South Korea and even Japan. It seems that the world is infected with the inflation bug.

Today, we read a news article, China, Starbucks and inflation, of which one of its paragraphs caught our attention:

“In many rural economies, you have farmers who go in their trucks with the produce they grow to the market to trade it,” said Lawrence Eagles, head of the International Energy Agency’s oil industry and market division. “But if it no longer becomes profitable because of the cost of gas, they’re going to simply return to subsistence farming, which would be a significant development.”

It is obvious that if most of these rural farmers return to subsistence farming, the price of food will rise, thanks to the rising price of oil. This led us to mull about the inflation problem.

Nowadays, we live in the modern age of globalisation. One of the characteristics of globalisation is specialisation. Countries specialise in producing things that they are particularly skilled at or can do so at a relatively lower cost than the others (see the theory of comparative advantage). Individually, our jobs are becoming more and more specialised. We see more and more experts at narrower and narrower fields of discipline.

No doubt, globalisation can bring about a lot of prosperity and wealth (and a lot of other negative side effects as well). For example, we have a case whereby Australia grows macadamia nuts (because it has a comparative advantage), ships them to China for packing (where the low cost of labour allows packing to be done at a much lower cost) and them ships them back to Australia for sale. Producing and packing macadamia nuts in either country alone will result in higher costs. But thanks to the globalisation, we can enjoy lower prices than otherwise.

But we see a weak point in globalisation. In the above example, it only works if the cost of shipping things is not prohibitive. As oil prices rises, the cost of shipping increases. As shipping cost increases, the benefits of specialisation and comparative advantage cannot be exploited just as easily.

Using the quote from the above-mentioned news article, we can imagine that with specialisation and comparative advantage, the farmers specialise in growing food for the city dwellers, while the city dwellers specialise in producing white goods in the factories for the farmers. Both benefits. But as the price of transport shoot up, this cosy arrangement can potentially break down.

So, as we can all see, this is another example of to show that much of the prosperity and comforts of modern life depends cheap and abundant energy. Take that away, and the good life as we know will be under threat.

How the CDS global financial time-bomb may explode?

Monday, June 2nd, 2008

Back in Potential global economic black hole: credit default swaps (CDS), we first introduce credit default swaps (CDS) and warned that it is a potential global financial time bomb that is waiting to explode. Should it explode, we will see another major panic in the global financial system, possibly even surpassing the panic back in January this year. So far, the CDS market has not yet been tested through a trial of fire and the risk is that it may turn out to be a house of cards when put under stress.

Satyajit Das, a character whom we introduced back in Is the credit crisis the end of the beginning?, has this to say about CDS in The Credit Default Swap (?CDS?) Market – Will It Unravel?:

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought.

As we explained before in Potential global economic black hole: credit default swaps (CDS), the buyer of a CDS is basically buying insurance against the default of a debt. The problem is that how do you define what a “default” is? If a defaulted debt cannot fulfil the technical conditions to satisfy the trigger of insurance payment, then the insured party may find themselves in danger of insolvency. As Satyajit Das wrote,

The CDS contract is triggered by a ?credit event?, broadly default by the reference entity. The buyer of protection is not protected against ?all? defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan.

As a result, this will have widespread systemic implication:

A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract.

As with most financial crisis and panic, decisions that make sense at an individual level will result in catastrophe if repeated en masse. If enough businesses are pushed into bankruptcies in order to fulfil the technical requirements of default, then losses will be exacerbated, triggering another around of credit deflation.

Then there is another problem. Since CDS is a derivative, the buyer of a CDS need not necessary owns the bond (debt asset). But in order to receive insurance payment for the debt payment, the bond has to be delivered. But what if there is more CDS than bonds (this may happen due to securitisation)? Then when the bond defaults, there will be a mad rush among the CDS holders to grab a slice of the defaulted bond (figuratively speaking), which pushes up the price of the bond. As a result, the CDS holder may not be as fully hedged as assumed to be.

If you think this is complex, this is because the murky world of derivatives is complex. Even central bankers do not understand it all.

How the rich make their killing from soaring oil prices?

Sunday, June 1st, 2008

Take a look at this article from the news media: Opportunities in crisis as oil stocks dwindle,

A new oil shock that is sweeping the world has sent airline tickets soaring, car drivers reeling and retailers bemoaning the shrinking purses of customers. It is an oil shock of rare proportions.

It is in such events that investors thrive: surely there is an opportunity here for an investor to make a profit from the rising oil price?

Well, how would the rich profit from the soaring oil prices?

There is one rule of thumb that all investors, especially the budding ones, should take note: by the time you get to read about profit opportunities on the media, the biggest and most lucrative killings have already been made. What remains are the leftover scraps. The best investors hop on to the long term major trend long before the mainstream media screams about it. As early as the end of 2006, we had already whispered about the future of oil prices at Is oil going to be more expensive?. The world-class investors who are making a killing from soaring oil prices now would have made their move two years ago.

So, now that mainstream media are talking about how to profit from soaring oil prices, what will the world-class investors be looking at right now? No doubt, they will be thinking steps from the crowd. We believe they will be casting their eyes on alternative energy.

Back in April last year, we examined the idea of alternative energy- see our currently evolving guide, How to profit from rising energy prices?. In particular, take a read at Part 3 (Centralised or Distributed Power) of the “Smart money in alternative energy” series to see how the future of energy will look like in the long run. Regardless of whether you believe the former model (centralised power) or the latter model (distributed power) will be the outcome of the future, there is one problem for the investor: currently, there is no certainty on which forms of alternative energy (e.g. wind, solar, geothermal, nuclear, clean coal, biofuels, etc) will be implemented or commercially successful in the future. By the time the world work them out, the most lucrative profits would have already been made.

But how would the best investors invest in alternative energy? Remember the concept of the asymmetric pay-off strategy in our guide, How to profit from a stock market crash?? The same applies to alternative energy. We do not know which alternative energy will be the winner, but we know that the winner (or winners) will probably win a whopping big victory (or victories). The losers may end up discarded and forgotten (we believe ethanol will probably go the way of the losers). Therefore, the way to invest in alternative energy will be to allocate fractions of your capital into each and every alternative energy candidate that you believe will have good chances of winning. Eventually, one or more of the candidate will win so big that your combined losses on the losers will pale in comparison to the combined wins.

Obviously, this strategy will work only for those who have large enough capital.