Archive for August, 2008

How are gold lease rates quoted?

Sunday, August 31st, 2008

Back in Get paid to borrow gold and silver?, we mentioned that

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…

One of our readers alerted us to this forum discussion, Anybody like to explain the negative lease rates:

Many people, even those that seem to understand the gold market seem to get confused on how the gold least rate is quoted… It is the LIBOR rate minus the gold lending rate for the duration quoted. Normally gold is loaned at less than LIBOR and that results in a positive figure for the lease rate (designated as GOFO by the LBMA).

Actually, that explanation from the forum is not accurate too. So, what are the gold lease rates all about and how are they quoted? We did some digging and found this commentary. To explain lease rates, we will start off with the definitions:

GOFO– according to the London Bullion Metal Association, the GOFO is the

Gold Forward Offered Rate. These are rates at which contributors are prepared to lend gold on a swap against US dollars. Quotes are made for 1-, 2-, 3-, 6- and 12-month periods.

GOFO is basically the interest rate for borrowing money using gold as collateral. For example, a central bank will enter a swap position with a bank by swapping its gold for US dollars with the bank. At the end of the period, the swap has to be reversed with the central bank paying an additional certain percentage above the original amount of US dollars. That “certain percentage” is the GOFO rate. The GOFO rate is related to the gold futures price. This is because if the GOFO rate is too much higher than the gold futures price, then the central bank will be better off selling the gold in the spot market and simultaneously buy gold futures.

LIBOR– this is the London inter-banking lending rate

Derived Lease Rate (DLR)– this is the lease rate that you see quoted at The DLR is defined as LIBOR – GOFO.

Now, this is where it is getting complicated. So, we’ll use an example. Let us suppose, this is the current situation:

GOFO- 1%
DLR- 5 – 1 = 4%
Gold price- $1000/oz

Let’s say Bank A has 100 oz of gold. It then enters a swap with Bank B. So, Bank A will end up with $100,000 and Bank B has 100 oz of gold. At the end of the period, Bank A has to pay $101,000 to get back its gold. Now Bank A invests the $100,000 in the market markets and receives LIBOR interests. At the end of the period, it will have $105,000. Then it pays $101,000 to Bank B to get back its gold. The net ‘profit’ in this transaction is $4000, which is 4% of the original total gold purchase price.

The net effect of these transactions is this: Bank A lend gold at 4% lease rate. To end it all, the lease rate, as explained in is:

The lease rate is the cost of borrowing gold. In much the same way that individuals borrow dollars, pay an interest charge, and then return dollars to the lendor, gold bullion participants will borrow ozs of gold, pay a borrowing cost, and return the ozs of gold to the lendor. The debt is measured in terms of ozs as opposed to dollars. The value of the metal when it is being borrowed or returned is not a factor.

Is the falling dollar good for the economy?

Thursday, August 28th, 2008

In the financial news media, we often hear reports that give the impression that the fall of the dollar (whether US dollar or the Australian dollar) is good for the economy because it benefits exporters. In reality, this is only half-true- exporters may benefit, but it may not be necessarily be good for the economy as a whole.

To see why, take a read at Chapter 6 (The Depreciation of the Mark and Germany’s Foreign Trade) of this 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:

The relations between exports and production deserve to be considered in greater detail. Three principal cases may be considered:

  1. The increase of exports of a given article, which is the consequence of the divergence between the internal and external values of the national money, is not followed by an increase in the production of that article. The rise in exports signified in this case a corresponding fall in the quantity formerly consumed at home.
  2. The possibility of increasing the exports of a given article provoked an increase in the production of it, but at the expense of other articles, the export of which is less attractive. On the whole, the production of the country is not increased; only the direction of economic activity is changed.
  3. The rise in exports is accompanied by an increase in the total production of the country with a depreciated currency.

Before we continue, we must first explain the concept of internal and external value of a currency. Basically, the internal value of a currency is its purchasing power domestically. Let’s say an apple cost 1 dollar domestically. This is the internal value of the dollar. Let’s say an apple cost 2 marks in a foreign country and the exchange rate is 1.5 mark for 1 dollar. Therefore, the cost of an apple overseas is 1.33 dollar. This is the external value of the dollar. In this example, the internal value of the dollar is greater than its external value.

Let’s say the dollar depreciate in value. As a result, there is a divergence between the internal and external value of the dollar. Since in the short term, the domestic economy cannot increase its production, effect (1) will be the result. In other words, using the example above, domestic apples will be exported, resulting in less apples domestically. The outcome is price rise for domestic apples. As Costantino explained,

The first case appears when a divergence between the internal and external values of money occurs suddenly and after a short time stops. The influence of that divergence is shown only in the sale of goods already in the warehouses; given the brief duration of the phenomenon, production in general does not feel it.

In the longer term, either effect (2) or effect (3) will be the outcome. That will depend on the situation of the domestic economy. Let’s say the economy has plenty of spare capacity. Perhaps there are far too many unemployed apple growers and land laying idle. In that case, all these idle resources will be put to work to produce more apples, which will raise national income. The nation becomes wealthier as a result. This is effect (3). As Costantino explained,

On the other hand, in a country where only a part of the machinery is occupied and where there is a considerable number of unemployed, a depreciation of the exchange, by stimulating foreign demand, can really provoke an increase in the total production.

What if the economy’s productive capacity is completely used up and can no longer increase its production of apples? In that case, the economy has to free up resources in order to produce more apples. This may mean that for example, clock makers may have to change their professions into growing apples. This means a restructuring of the economy whereby some industries will have to decline in order for the export industry to expand. This is effect (2). As Costantino explained,

But in a country where plant is already fully occupied, where unemployment does not exist, and where available resources are scarce, the effects on total production cannot be very considerable. If the divergence continues, a displacement of production is slowly produced: capital and labour move towards the production of those goods for which the divergence [in the internal and external value of the domestic currency] is most conspicuous.

In the next article, we will apply these insights into the study of real-life economies.

Sydney’s house price in real terms

Wednesday, August 27th, 2008

In our previous article, Do property price always go up?, we showed you that property prices do not always go up. Today, we will show you a chart of the house price of Sydney since 1979:

Is it better for potential first home-owner to save first or jump first?

Tuesday, August 26th, 2008

Among the different class of property buyers, first home-owners are the most vulnerable. This is because they have the least outstanding equity, which means there is a greater chance of negative equity should they have to sell their home in a hurry. The equity portion of your property is its market price less the outstanding debt you owe on it. Let’s say the market price of a property is $500,000 and you have an outstanding debt of $450,000 remaining on the mortgage debt, your equity is $50,000. Negative equity occurs when the market price of the property falls so much that it is below your outstanding debt. This means that if you liquidate the property, you will still owe the bank money.

Worse still, for first home-owner, at the initial stage of the debt repayment, most of the payments goes to servicing the interest, leaving very little for reducing the principal of the debt. For example, for a 30-year $450,000 at 8.5% interest p.a., the first monthly repayment of $3460.11 consists of $3187.50 of interest payment. At the end of 3 years, the interest payment is $3111.11. In other words, in the first 3 years, the first home-owner gets to reduce the outstanding debt by only $11,000 while paying a total of around $124,000!

So, given the amount of bad news regarding the economy lately, many potential first home-owners are becoming more cautious about jumping into the property ladder. Some may opt to delay their purchase in order to save more to ensure that they have a greater equity when the time comes to buy the property. But what if the property prices climb too fast while they save, resulting in them being priced out of the market by the time they are ready to buy? Or, should they jump in now or should they delay?

Well, the answer to this question will depend on these factors:

  1. How much they save
  2. Savings interest rate
  3. Mortgage rate
  4. How fast property price rise
  5. How much deposit they already have

To answer this question, we constructed an Excel model to simulate the financial outcome between jumping in now or delaying to save. Our Excel model contains the following parameters:

  1. Wage inflation rate- this determines the growth of monthly savings due to wage rise
  2. Property price inflation rate- this is the rate at which property price rise per year
  3. Savings rate- this is the interest paid on the savings
  4. Mortgage rate
  5. Initial deposit for the property
  6. Extra repayment- the extra amount above the mortgage repayment that you can pay/save
  7. Amount of to borrow
  8. Loan period in number of years

So, we punch in the following numbers for our simulator:

  1. Loan period- 30 years
  2. Amount to borrow- $450,000
  3. Initial deposit- $50,000 (i.e. 10% deposit for a $500,000 home)
  4. Mortgage rate- 7% (this is far below the current mortgage rate)
  5. Savings rate- 5% (this is far below the current term deposit rate)
  6. Property price inflation- 6% (this assumes that property prices will increase 6% p.a. forever and ever)
  7. Wage inflation rate- 0% (this assumes that your wage rate get frozen for 30 years and thus, cannot increase your monthly savings amount or make extra monthly repayment for the next 30 years).
  8. Extra repayment-0

These numbers are intentionally unrealistic to illustrate a point. Guess what is the outcome? By the 359th month, the property price will be $2,709,193.95. If you choose to save, your savings will be $2,711,133.30. This means, if you buy with cash on that month, you will have $1935.35 left over. But if you choose the borrowing route, you will still have $2,976.50 in outstanding debt.

Let’s tweak the figures a little. Let’s say your wage inflation rate is 3%. This means you can make extra loan repayments or increase your monthly savings as your wage grows. You will then find that your debt balance is always higher if you jump into the market now. Now, let’s make the property price inflation rate be 7%. You will find that it is more advantageous to save than to jump in for the first 6 years.

Playing around with the simulator, we find that if you are a high-powered saver, you can still be better off delaying your purchase for several years even if property prices appreciate (up to a certain point) in those years.

Do property price always go up?

Monday, August 25th, 2008

One of the most entrenched superstitions is that property is a safe and secure asset class that always go up in price over time. It has come to a point that some people believe that property prices never come down. Some people will even cite the trend of the past 10 years to prove the point of this superstition.

But as Nassim Nicholas Taleb said in his book, The Black Swan: The Impact of the Highly Improbable, all you need to prove that not all swans are white is to find a black swan. In the same vein, all we need to prove this superstition false is to come up with examples of the opposite happening. The fact is, history is on our side- with the bursting of the Japanese bubble economy of the 1990s, property prices in Tokyo was said to have collapsed by 70% over the course of the decade. As of today, median house prices in the US has fallen around the order of 15% in one year.

For today’s article, we will draw out another big gun to blast away this superstition. At the beginning of the year, the ABC had a documentary about 350 years of Dutch experience- Dutch history pointing to real estate fall. In that documentary, it reported

The house sugar merchant Cornelis Sasbout built in 1617 at number 150 on Amsterdam’s Herengracht canal tells a cautionary tale about investing in property – prices fluctuate wildly, but are ultimately flat.

In that documentary, when it said “flat” prices, it means “flat” in real terms.

Mind you, the Herengracht is not some piece of forsaken real estate built in the middle of nowhere. It is a prime real estate for over 350 years, as this documentary reported:

Eichholtz says what makes his index stand out from house price histories in other cities is what he calls “constant quality” – the Herengracht has always been prime real estate. The index corrects for rising consumer prices but not wages.

What is the lesson here for Australia? Well, Australia is still sitting on an unprecedented debt bubble. For those who still need convincing, please take a look at Professor Steve Keen’s scary debt charts at Debtwatch No. 25: How much worse can ?It? get? and our commentary at Aussie household debt not as bad as it seems?. When the debt bubble burst eventually, we can be sure the frequently parroted justifications of this superstition (e.g. housing ‘shortage,’ immigration, etc.) will be revealed as hogwash. We would love to see those ‘experts’ who wrote reports that justify this superstition be paraded as clowns when they are proved wrong in due time (see Another faulty analysis: BIS Shrapnel on house prices).

Understanding the big picture in the inflation-deflation debate

Sunday, August 24th, 2008

Right now, there are just too much confusion over the inflation-deflation debate. In fact, this debate is so polarising that many of our readers are thoroughly confused and bewildered by the many millions of conflicting reports, chatter and opinions on the blogs, forums and media. As one of our readers said in Will deflation win?,

I’m getting more and more conflict signals from bases put forward by those who argue for inflation and those who argue for deflation.

So, which will win? Inflation or deflation? Today, we will attempt again to explain the big picture so that you can understand what is going on. 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.

First, let’s take a brief look at the history of money at A brief history of money and its breakdown- Part 1. As that article explained, humanity started off with bartering, which was highly inefficient. Eventually, for whatever reason, the free market chose gold and silver as money. It is interesting to note that gold and silver was the coincidental choice across almost every ancient civilization. In any case, regardless of your view on gold, the point is that in most of the 6000 years worth history of human civilization, money always existed in the form of a physical commodity. That is not to say that monetary inflation cannot happen- ancient Rome debased their own silver coins by diluting the silver with some other less precious metals.

If you think about it, it was un-intuitive for money not to be in the form of a commodity. In one of the movies about Marco Polo, it showed a scene whereby Marco Polo was astonished to see his Chinese slave exchanging goods for pieces of paper:

He ask, “What are you doing??!!!?”

His slave replied, “I am buying something.”

“But money is gold and silver! How can a piece of paper be money?!?!”

If you lived back then, it was obvious why money should not be pieces of paper backed by nothing. Firstly, such money is vulnerable to forgery. Secondly, it can be re-produced at almost no cost. Thirdly, as we said before in Recipe for hyperinflation, the integrity of such money depends on the integrity of the authority that issues it:

To illustrate this point further, imagine you are the only person in town who has the authority to create money out of any piece of paper with your own signature. Wouldn?t this make you a pretty powerful person in town? With such power, you can acquire anything you wish at the expense of others.

Basically, it WAS obvious why paper money, especially the ones backed by nothing but ‘confidence’ and made legal tender by government decree, is not a good form money. Such money is called “fiat money.” The free market, if left to its own devices, will never favour it. But that did not stop ancient governments from dabbling with fiat money. The ancient Chinese was probably the first to try that (see Ancient Chinese fiat paper money) and failed. Today, the entire world is back to using fiat money again (see A brief history of money and its breakdown- Part 2). History shows that there were many attempts to make fiat money work and all of them failed. In other words, excluding the current one, the failure rate of fiat money is 100%.

To make fiat money work even for a time, some kinds of rules or ‘mechanism’ are needed to maintain its integrity (if it can really be achieved indefinitely). As we said before in Recipe for hyperinflation,

Therefore, some kinds of ?rules? are necessary to fetter and curb such vast power. Without these ?rules,? it is impossible to maintain the integrity of money. If money loses its integrity, the financial system and economy will break down and we will be reduced to primitive bartering.

That is why an independent central bank is part of this complex system of ‘mechanism’ (see Why should central banks be independent from the government?).

What are the ‘mechanisms’ that are used?

  1. Commodity backing– Technically, if a paper money is backed by a commodity (i.e. the paper can be redeemed for a commodity), it is not a fiat money. Today’s fiat money was originally warehouse receipts for gold. If too much warehouse receipts are issued than there are gold in the vault, then the issuer has essentially committed fraud and runs the risk of legal/economic repercussions.
  2. Self-expiry– In ancient China, during the Song Dynasty, paper money had a limited life-span, after which it would become no longer be legal tender. As this article from Financial Sense explained,

    The S’ung dynasty was the first to issue true paper money in 1023, and it did so at first cautiously, issuing small amounts, used in a limited area, and good for a specific time period. The notes would be redeemed after three year’s service, to be replaced by new notes for a 3% service charge, a neat way for the government to make money.

    The abuses started immediately. Though the notes were valued at a certain exchange rate for gold, silver, or silk, in practice convertibility was never allowed. Then, the notes were not retired as they printed many more of them. The government made several attempts to support the paper by demanding taxes partly in currency and making other laws, but the damage had been done, and the notes fell out of favour.

    The idea is that at any one time, certain amount of self-expiry money will be retired from circulation and thus, ‘protect’ the integrity of the money. Today, if you look at Zimbabwe’s currency, you will find an expiry date on it.

  3. Credit-system– This is the system used in today’s money (see Are we heading for a deflationary type of recession?). The basic idea is that money is created in the context of credit, which must be returned plus interest.

So, the world’s fiat money system works under the ‘mechanism’ of credit. Because money has to be returned, it acts, in theory, as a check against abuse and rampant monetary inflation. But as we all know from the sub-prime crisis and credit crunch, it got abused to the extreme in practice.

The fact that the global financial system is facing acute deflation threat shows that this credit-system ‘mechanism’ is working to protect the integrity of fiat money! From that perspective, we can see why the US dollar is appreciating in the context of deflation. But at the same time, if the integrity of money is to be protected, then all these years of credit abuse will come home to roost in a colossal economic pain for the masses.

The issue is, do the masses want to avoid great financial pain or does it want to maintain the integrity of fiat money? Reality dictates that it can only choose one but not both. If they choose the former, the only way to do that will be to repeal the credit-system ‘mechanism,’ which will mean the loss of integrity for the current fiat monetary system. Such loss of integirty will manifest itself in the form of hyperinflation.

In summary, whether you believe the end game is deflation or inflation will depend on your faith in human nature.

Will deflation win?

Thursday, August 21st, 2008

In just a few months ago, the talk in town was price inflation. Oil, food and commodity prices were rising, as we wrote Who is to blame for surging food and oil prices?. Today, the talk is different. US house prices have never stop falling. Gold, oil and base metals are falling. There is even talk about the end of the commodity boom, the end of the commodity “super-cycle.” Economic slowdown and recessions are the expectations of the market.

Long time readers of this publication should never be surprised to see this is happening. As we said back in March last year in Inflation or deflation first?,

If you have been with us long enough, you may have heard us mulling over both the threats of inflation and deflation on the global economy (see Spectre of deflation and Have we escaped from the dangers of inflation?). You may be wondering whether we are contradicting ourselves. How can both threats exist simultaneously? Since one is a general rising of prices and the other is the opposite, are they not mutually exclusive?

At this current phase of the financial crisis, we are experiencing deflation. It is reported that the US M3 money supply is currently “collapsing.” A falling money supply is the definition of deflation, for which the symptoms will be falling asset prices, which if prolonged enough, will lead to falling consumer prices. But before we go off to celebrate falling prices, remember that this is an evil type of deflation because it is the type that is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on. The angelic type of deflation is caused by rising output and production, which is clearly not the case in the debt-addicted Western economies but more true for China with its government-forced savings.

When the US money supply shrinks, it increases in value relative to the other currencies as the US dollar gets repatriated back to make up for the dwindling supply of cash back in the US. That’s why we are witnessing a rally in the US dollar and a fall in commodity prices as there is a mad scramble to liquidate whatever assets to raise cash.

With the current legal powers, the US Federal Reserve is quite powerless to stop deflation (see Are we heading for a deflationary type of recession?). It can cut interest rates, but it cannot force people to borrow. Even at 2% Fed fund rate, the shrinking M3 money supply is proof that monetary policy is still tight (see What makes monetary policy ?loose? or ?tight??). Will the Fed continue to cut interest rates? It had already tried but failed a few months, which resulted in skyrocketing oil and gold prices. We doubt Ben Bernanke is going to try it again.

Meanwhile, the US Treasury is preparing open up the bottomless coffers of the US government to nationalise Freedie Mac and Fannie Mae, who are essentially insolvent. The question is, with the US budget deficit already in the red (plus the massive current account deficits), where is the money going to come from to do that? If a savings-less individual spend more than he/she earns, that individual is basically bankrupt. But for governments, it is a completely different story. They can make up for the shortfall by borrowing from the public by selling newly issued government bonds. As a last resort, it can sell the bonds to the Federal Reserve, which is called “monetising debt” or printing money.

Will it get that bad? It can if the deflation threatens to shock and awe the entire nation into a Greater Depression. By then, 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.

Therefore, as we advised before in Recipe for hyperinflation,

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

Why is the RBA backflipping on interest rates?

Wednesday, August 20th, 2008

It was just a few months ago, the Reserve Bank of Australia (RBA) was very hawkish on interest rates. Its priority was to fight price inflation and with that, even approved of the banks raising their mortgage rates. It was said that if not for the mortgage rate rises, the RBA would have raised rates even more.

It seems that all of a sudden, the RBA began to hint strongly about cutting interest rates. What is going on? As this article,  The Great Interest Rate Forecast Back Flip, reported,

Indeed, the Macquarie analysts are actually concerned the sudden turnaround in RBA intention suggests it might know something about the economy we don’t. “Has the RBA’s business liaison program revealed some financial fragility in the economy that has not yet been unveiled?” while suggesting that “for this reason lower interest rates are unlikely to be the green light for growth investors might hope for”.

One thing many experts even fail to understand is that a fall in interest rates does not automatically mean a loosening monetary policy. As we explained 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).

What had been happening is that the demand for credit in the Australian economy is decelerating very rapidly. That is, Australian households, individuals and businesses scaling back on their borrowings. When the demand for credit slows down tremendously, what was before a ‘loose’ monetary policy can become ‘tight’ all of a sudden.  If credit demand falls further, the RBA can still cut interest rates and still have ‘tight’ money. If you are confused by this, please read our earlier article, What makes monetary policy ?loose? or ?tight??.

The best way to explain this concept is to use Japan as an example. In the 1990s, Japan famously cut interest rates to zero. Yet, asset prices kept on falling for 16 years straight. That is an excellent example of deflation whereby credit became a dirty word. Even when interest rates was zero, Japan’s monetary policy was still ‘tight.’

For Australia, a rapidly decelerating credit growth is very bad news. Since a lot of Australian consumer spending is financed by the growth of credit, this will mean a severe slowdown in the Australian economy. Furthermore, rising asset prices is fuelled by exponential increase in credit. A rapid deceleration of credit growth will result in asset price deflation.

We can imagine the RBA worrying about the storm clouds gathering ahead- US is in recession, UK is going to fall into recession, Europe is stumbling into recession, Japan is feared to fall into recession, falling commodity prices, China is slowing down, etc. If the rest of the world economy is slowing down significantly, there is no way Australia can escape.

Fox’s method of solving hen’s housing affordability

Tuesday, August 19th, 2008

Recently, we saw this article in the news media: First home buyer affordability still at 24-year low

“Affordability will only improve if all governments work together to remove the onerous tax burden and regulatory imposts on new residential construction.”

This quote was said by Housing Industry of Australia (HIA) chief economist Harley Dale. Is that a conflict of interest? This is the same problem that we mentioned before in News media contradiction regarding the Australian rental crisis?:

Rather, we believe that due to the way the human brain is wired, conflict of interests can often result in biased information, especially when the issue concerns money and wealth.

Asking the HIA for a solution to the housing affordability problem is the same as, in the words of one of our readers, asking “yet another fox to guard the hen house.” Basically, the HIA wants the housing affordability problem to be ‘solved’ by:

  1. Reduce government taxation burden on homebuilders so that there is a greater incentive to build homes.
  2. Release more land for housing construction.

What is the underlying assumption of this ‘solution?’ Well, this ‘solution’ assumes that there is a housing ‘shortage.’ But what if the assumption is wrong? In that case, this is what we said in Australian housing shortage myth,

When it comes to solving Australia’s housing problem, there is an entrenched superstition that makes many believe that there is a housing ‘shortage’ in Australia. This superstition has resulted in many proposed solutions to the housing affordability crisis that are completely useless, wasteful and counter-productive.

As we said, in that article,

In reality, the housing ‘shortage’ superstition is the result of an illusion. The illusion arises from the fact that there is a mismatch of housing demand and supply. In some parts of Sydney, there is an over-demand for housing, which gives rise to the housing ‘shortage’ illusion. In other parts of Sydney, there is an over-supply of housing (some of them brand new) that are unwanted.

Let’s imagine the government decides to remove all taxation burdens on builders and release all land for house building tomorrow. This will be a builders’ paradise. But will that be a home buyer’s paradise? If the government really do that, do you think the builders will begin a house building spree and solve the housing shortage and affordability problem? Well, consider one of our reader’s protests in Australian housing shortage myth:

Mis-investment, who wants to live on Paramatta Rd, especially where this building is, it’s on Parramatta Rd and miles from the city. Would you live there?

All the empty dwellings on the outskirts of the city are just mis-investment, they are overprice houses in areas where people don’t actually want to live or they can’t afford them anyway.

The context of this comment lies in the fact that there are a lot of brand-new apartments and houses in the outer suburbs of Sydney that remain unsold. They remained unsold because these brand new homes are undesirable for various reasons (e.g. too far from city, no transport infrastructure, etc.). Obviously, these builders are losing money because of insufficient demand for these homes. That could be a contributing reason for current recession in the home building industry.

Why are these homes undesirable in the first place? There are many reasons: lack of infrastructure development (especially transport), rising fuel costs that makes car ownership expensive, lack of amenities, far away from employment centres, etc. Worse still, look at the wasteful use of land in Sydney- lack of high-rise residential apartments even in places near the CBD. In Singapore, they have a population that is as big as Sydney squeezed in a land area several times smaller. It should be clear by now who had been sleeping behind the wheel to allow the situation to become what it is today.

Next, what are the many short-term solutions proposed by governments to tackle the home affordability crisis from the demand side? All the ‘solutions’ proposed so far involves boosting the ability of buyers to pay for the already exorbitant and overvalued prices of homes. Examples of such solutions include first homeowner’s grant, tax-reduced savings account and so on. These ‘solutions’ can be compared to solving hangover problems by supplying more alcohol for drinkers to drink their way out of pain.

So far, no government has the guts to propose a politically unpalatable way of alleviating this problem by encouraging further deflation of house price through a change in the tax regime. In fact, there are plenty of scope for further property price deflation. As Associate Professor Steve Keen said in Brace yourselves for recession, says Steve Keen,

I think something of the orders of 40 per cent of prices are simply financed by people’s expectations that the prices will keep on rising.

Well when this expectation goes, ultimately goodbye 40 per cent of the current price of houses.

The question is, which of these two would one want to be the trigger for property price deflation?

  • Changes in the tax regime


  • Rising unemployment, rising mortgage rates, further unravelling of the credit crisis, economic slowdown

In Australia, we have a tax regime of fully taxing savings and half taxing speculation- interest income are fully taxed whereas there is capital tax exemption/concession for property ‘investment,’ negative gearing, etc. Such tax regime encourages people to speculate, fall deeper into debt and discourage savings, which is the last thing the Australian economy needs right now. If the government is unwilling even to alleviate the housing affordability crisis in the short term by changing the tax regimes, then Australia have to rely on an inevitable economic crisis to do that, which is more painful and a lose-lose outcome for everybody.

Fooled by narrative fallacy

Monday, August 18th, 2008

This month is the first anniversary of the credit crisis. Since then, investors had experienced much volatility in the intervening months. For new investors, such see-sawing can be very bewildering. For even the seasoned traders/investors, the current bear market is in a sense worse than the infamous 1987 crash. In 1987, the crash was done over with in one big hit. After that, life carried on. But for today, the financial pain is slow and grinding- some even call it the water-torture bear market.

In such a time, investors have to be aware of a very common mental pitfall that is common to all human- the narrative fallacy. As we said before in Mental pitfall: Narrative Fallacy:

Narrative Fallacy is a natural human weakness because by default, our minds seek to form theories, jump into conclusion, seek judgements and explain what we see. It takes a conscious act will to do otherwise.

It is this natural human weakness that accentuates the confusion in such a time of market volatility. If you follow the financial media very closely, you will find plenty of narratives to ‘explain’ what is happening. In fact, some of these narratives are contradictory, as the example in our earlier article in November 2006- How much should we listen to the financial media?.

Right now, we are experiencing falling commodity prices (mainly base metals, oil, gold and silver. The most common narrative explaining this outcome is the “fear of a slowing world economy.” But is there an alternative narrative? We found one in this news article, Falling into line. In that story, falling copper price was the result of a deliberate Chinese squeezing of hedge funds. Hedge funds were reportedly squeezed in the oil market too.

So, which narrative is the correct explanation for falling commodity prices?

Well, the fact that one asks such a question shows that one has fallen into the trap of narrative fallacy. Narrative fallacy demands that the reason be found. But in reality, the reason is nothing more than a reason. Sometimes, a number of these reasons can be more dominant than the others. Other times, no dominance may emerge. In other words, short-term price phenomena can have no specific reasons. But you should not confuse no specific reasons for no reason. Some people say that market prices fluctuate randomly. Personally, we do not like using the term “random” because it conveys the idea that market prices move with without (no) reason.

Having understood this, take a read at this news article: Gold rebounds from sharp sell-off

Gold rose for the first time this month on speculation a 12% decline since the end of July that had erased this year’s gains was exaggerated. Silver rose.

Well, the news media are in the business of selling the narratives.