Archive for May, 2009

Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber’s view

Thursday, May 7th, 2009

In our previous article, “Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model”, we promised to explain Marc Faber’s view on why inflation (rather than deflation) will be outcome in the years to come. As he wrote in his most recent Gloom, Boom, Doom market commentary,

Now, from the numerous emails I get I have the impression that most investors are leaning toward the view that ?deflation? will be the problem in the future and not ?inflation.? An ?expert? [Editor’s note: For the sake of peace, let us all assume he was not referring to Professor Steve Keen] even opined that whereas it was possible under a pure paper money system (large quantity of banknotes in circulation) to create high inflation rates, this was not possible under an electronic banking system.

First, let’s take a look at Professor Steve Keen’s view that the destruction of credit (IOUs) will overwhelm any money printing by the government. As Steve Keen said in “The Roving Cavaliers of Credit”,

To make a serious dent in debt levels, and thus enable the increase in base money to affect the aggregate money stock and hence cause inflation, Bernanke would need to not merely double M0, but to increase it by a factor of, say, 25 from pre-intervention levels.

Our view is that while massive deflation of credit will occur, it will not happen overnight. Instead, while the deflationary pressures will continue, it can be slowed down via unconventional monetary policies (see “Bernankeism and hyper-inflation”), gigantic fiscal policies, bailouts and even government fraud. The result will be a long drawn out affair, akin to a grinding trench warfare and a war of attrition on the real economy as credit contraction (IOU destruction) collide head on with money printing, massive government spending, stimulus and bailouts. In fact, this is what is happening right now in the US as optimism for “green shoots” of economic recovery fuels a rally from the depths of the panic of 2008. To make this saga even more confusing, despite the credit destruction in the second half of 2008, prices on the street have yet to make a meaningful decline. Simply speaking, money ‘printing’ will be spread out over a number of years until deflationary pressure subsides. Thus, Bernanke is not going to increase M0 by 25 times in a flash- he is going to do so over an extended period of time until it is no longer deemed necessary.

Next, credit contraction will not go on forever. As Professor Steve Keen commented before, he expects deflation to end eventually and inflation to return after say, a few (or several or dozen or whatever) years.

Now, we will talk about Marc Faber’s argument. Consider what’s happening as the Global Financial Crisis (GFC) unfolds:

  1. Economy contracts
  2. Interest rates are cut
  3. Fiscal policy is stepped up to assist failed monetary policy (see “What makes monetary policy ?loose? or ?tight??”). Then as Marc Faber said,

    But for the fiscal stimulus to even have a small chance of succeeding at reviving economic activity it has to be larger than the private sector credit contraction.

    With that, he had a chart to show that “US Private Sector Credit Contraction Is Offset by Public Sector Credit Expansion!”

  4. Government spending going up when tax receipts declines.
  5. Upward pressure on interest rates (see “How are governments driving up fixed mortgage rates?”)
  6. Governments forced to monetise debt (i.e. print money, which is already happening in the US, UK and Japan) in an attempt to force long-term interest rates down. See “Why are nothing-yielding US Treasuries so popular?”.

That’s where the crux of Marc Faber’s argument,

And here lies the crux of the problem most deflationists do not understand. By keeping short term rates artificially low and by monetizing the growing fiscal deficits a central bank digs its own grave in terms of its ability to pursue tight monetary policies when such policies become necessary.

If the US Fed failed to tighten monetary policies after the US economy began to recover in November 2001, what are the chances of tight monetary policies in the future (which would significantly increase in the short run the cost of servicing the government?s debt) when both the US government and the Fed will be loaded with toxic assets and burdened by all kinds of other liabilities? The chances of the US government implementing tight monetary policies in the next few years are exactly zero.

But my point is simply this: Once a government embarks on highly expansionary fiscal policies which entail government expenditures vastly exceeding revenues (leading to enormous budget deficits and soaring government debt) and simultaneous monetization (?printing money?), the reversal of these inflationary policies becomes for all practical purposes impossible. Inflation and higher interest rates follow. At this point the reader should clearly understand that any upward pressure on interest rates brought about by the market participants will actually force a central bank that embarked on monetization to monetize even more [Editor’s note: This is the time when money supply will increase exponentially!]. The other point to remember is that the longer an economy does not respond to such ?inflationary? fiscal and monetary policies, the larger the ?doses? will become.

So, by implication, any global recovery from the Global Financial Crisis (deflation) will bring forth another crisis (inflation)!

Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model

Tuesday, May 5th, 2009

One of the strongest leanings among investors is the view that deflation (instead of inflation) will be the problem of the future. The best argument for deflation we have seen so far is Professor Steve Keen’s “The Roving Cavaliers of Credit” article. We highly recommend that you take a read at that article if you have the time. If not, we have a summary as well as our additional commentary of that article below. Keen’s view is that in today’s GFC context, inflation, while it is possible under a pure paper money system, is impossible under the credit system of today.

To understand why, you have to understand the conventional textbook model of how money is created through the banking system through the fractional reserve money multiplier model. Our article, “The difference between money and credit” is the best illustration of how it works. In this conventional textbook model, banks can only lend out of their existing deposits. The inference of this model is that quantity of money will always be more than the quantity of credit in the system.

Unfortunately, the conventional textbook model is wrong. In the real world financial system, the quantity of credit is greater than the quantity of money. In today’s modern financial system, banks do the lending first before coming up with the ‘deposits.’ This sound very counter-intuitive, but let us explain how it works. Suppose you borrow $100 from the banks. All the bank has to do to ‘lend’ you money is to create an accounting entry of the $100 loan on their books. Suppose you transfer $50 out of the loan to your friend’s bank account:

  1. If your friend’s account reside in the same bank as yours, then it’s just a matter of the bank adjust the accounting entries between your loan account and your friend’s cash account. Simultaneously, you have to pay interest for the $50. A neat way of making money isn’t it?
  2. If your friend’s account reside in a different bank and let’s suppose the bank is short of say, $50 at the end of the day after all the bank transfers are netted out in the system. All the bank has to do is to borrow $50 from either another bank, the central bank, investors or depositors (or perhaps even run down its existing cash reserve). In the end, you will owe an IOU to the bank and the bank will owe an IOU to another entity. The interest rate that you pay for your IOU will be greater than the interest rate that the bank pays for its IOU. The difference is the bank’s profit.

So, you can see that ‘money’ in the financial system is just a long chain of IOUs. The quantity of ‘cash’ (or technically, monetary base) to back up the IOU is unimportant as long as trust reigns among participants of the financial system. A growing quantity of IOU relative to ‘cash’ implies greater leverage in the financial system, which further implies greater level of trust. But then, as we explained in “What is the role of real assets in preserving your wealth?” trust breaks down during the Global Financial Crisis (GFC):

Interestingly, the word ?credit? comes from the Latin word ?cr?dere,? which has the meaning of trust (?to believe?). Therefore, the credit crisis implies a crisis in trust in the global financial system. Without trust in the financial system, the value of financial assets becomes suspect.

With the breakdown of trust, institutional participants in the financial system began a mad scramble to reduce their vulnerability caused by their trust of others. This is what we call de-leveraging. De-leveraging implies that you reduce your obligations to others so that you don’t have to trust on others who have obligations to you to remain solvent. Also, you reduce your trust on others to protect yourself. As the quantity of IOUs in the system far exceeds the quantity of ‘cash’ in the system, many participants will be caught short in the scramble for cash to settle their IOUs. That’s why central bankers (e.g. The Federal Reserve, Bank of England, Bank of Japan) are busy printing money (technically called “quantitative easing”) to flood the system with ‘cash’ so that market participants can use them to settle their IOUs.

Now, Steve Keen reckons that this printing of money will not cause inflation. Because the quantity of IOUs far exceeds the quantity of newly printed ‘cash,’ which means market participants will still hoard the ‘cash’ to protect themselves. Unless the central banks print enough money to match the scale of IOUs destruction, then inflation will not happen. This has the same effect as what we described in “Demand for money, inflation/deflation & its implication”

Let?s say the quantity of money increases in the system. But if people want to increase their holdings of cash due to fear and uncertainty of the future, they will withdraw these cash from circulation in the economy. Consequently, prices fall.

The destruction of IOUs causes the quantity of credit to contract in the economy, which in turn causes asset price collapses and if not arrested, ultimately result in the fall in prices in the real economy. This is deflation. The second half of 2008 witnessed the destructive effects of deflation as the prices of assets and commodities collapsed, and the real economy deteriorated at an unprecedentedly rapid rate.


Last month, we took the liberty to forward Steve Keen’s “The Roving Cavaliers of Credit” to Marc Faber and asked for his opinion on Steve Keen’s deflation view. His reply was very short: “In my opinion, he is wrong.” Please note that this does not automatically imply that Steve Keen’s model is wrong. We think Steve’s model is highly valuable in understanding what is going on in the real world. It just mean that Marc Faber disagrees that the result will be deflation.

We did not get any further explanation from Marc Faber from his short reply. But in his latest Gloom, Boom, Doom market commentary, he finally explained his view further. We will present Marc Faber’s view in the next article. Keep in tune!

Two major Black Swans looming ahead for the global economy

Sunday, May 3rd, 2009

When you look at today’s global market rally, it seems that the bottom of the global financial crisis has already reached. In reality, the global economy had not improved by many measures. It had merely become less bad, compared to the precipitous decline in the second half of 2008. Financial markets tend to anticipate the future by recovering before the actual recovery of the real economy. That curious phenomenon should not be interpreted as foresight. Instead, the market has the habit of jumping the gun- the presence of bear market rallies is a testament of that fact.

This bottoming makes the market more vulnerable to Black Swans. Currently, we see two Black Swans that the financial market has not yet factored in. This is probably the time to put in their contingency plans for adverse reactions from the market (e.g. hedging, stop-losses, etc), especially for traders.

The first one is very well-known- the probability of a swine flu pandemic. In the 1918 Spanish Flu pandemic, killed anywhere from 20 to 100 million people. Half the world’s population was sick. Nobody knows how this swine flu will turn out. Should the virus reach Asia, the crowded and unsanitary conditions make it an ideal ground for further mutation and proliferation. Medical experts pointed out that the world is overdue for a pandemic. Since we have more faith in medical experts than in financial market pundits, our belief that this time round, the death toll may not be as bad as the Spanish Flu pandemic. Whatever the death toll of this potential pandemic, we believe the bulk of the economic damage will be caused by disruptions on daily life and the human fear factor.

The second Black Swan has received less prominence from the media- the situation in Pakistan. Last month, the Taliban had captured the Buner district in Pakistan (not Afghanistan!), which is merely a few hours drive from Islamabad, the national capital. Other reports revealed that the Taliban had advanced to within 96 km of Islamabad. This event is part of the bigger picture of the Taliban’s consolidation of control of north-western Pakistan. With the Pakistani army larger than the US army, the audacity of the Taliban shows how internally weak the Pakistani government is. The situation is so bad that the US Army’s General David Petraeus commented that “there may be just two weeks left to prevent the Taliban from overthrowing Pakistan’s Government” (see “Two weeks to save Pakistan”).

This is a very worrying situation because Pakistan is a nuclear-armed nation. The control of Pakistan’s nuclear weapons by the Taliban is a very dire scenario. Not only that, such an event can potentially fracture the huge Pakistani army (the Pakistani population is fractured too). India will be very worried because they have their own insurgency to fight in the Kashmir region and are always at odds with Pakistan since independence- the Taliban will be a much less rational and predictable enemy. China shares a very long border with Pakistan and will be very worried too. The US and its NATO allies, already having difficulty containing the Taliban in Afghanistan, may lose Afghanistan to them. The Taliban, who shares the same Wahabi school of the Sunni IslamicĀ  fundamentalism, is at loggerheads with the designs of the Iranians for influence in the region. Iran almost fought a border war with the Afghan Taliban a few years ago. Worse still, the Taliban is allied with Al-Qaeda, which will surely turn Pakistan into a haven for terrorists.

Gold will thrive in these two Black Swan conditions. But it is something no one will welcome.