Archive for February, 2010

Why oil cannot function as currency reserves?

Sunday, February 28th, 2010

Not long ago, we were talking to an analyst from a pretty reputable value fund manager. He was adamant that gold is in a bubble because “everyone is buying it.” When we heard his rationale for this belief, we knew straight away that he had not clearly thought through his underlying beliefs about gold and the nature of money.

In fact, his understanding about the nature of money is closer to the level of an uninformed person on the street than what we expect from an investment professional. For example, this analyst was completely blind to the colossal difference between the rarity of gold and the rarity of rocks, citing that there are heaps of gold in the world! It is one thing to have a different opinion about gold because one belongs to the deflation camp. But it is just simply too shocking to hear a suit-wearing investment professional from a reputable fund manager sprouting such nonsense! If a person cannot see the difference between the rarity of gold and rocks, then it will be beyond his level to even understand the properties of good money, which is critical to understanding gold.

Now, if you are new to this blog, you may wonder whether gold is a bubble or not, since there is no (or rather, very limited, to satisfy the pedantic) industrial use for it. If this is your question, we recommend that you read If gold has no intrinsic value, is it a bubble?. Or better still, you may want to read our book, How to buy and invest in physical gold and silver bullion for a fuller picture.

At this point, this analyst posed a very good question. Given that everyone agrees that the US dollar is going to depreciate further in the long run, then wouldn’t oil be a better substitute (e.g. as currency reserves) for it than gold? As that analyst said, oil should be a better substitute because it is a vital commodity, whereas gold has hardly any practical and industrial use? In other words, will oil function better as money than gold?

To answer this question, first we have to understand what money is. At the root of its nature, it is a medium of exchange. From this nature, it then follows that money functions as unit of accounting, store of wealth and so on. The question then becomes, is oil a better medium of exchange than gold?

At first glance, it seems that the answer is yes. But if you think carefully, if oil ever becomes a medium of exchange tomorrow, it will bring about disaster to humanity. To understand why, let’s have a thought experiment. Remember, back in If gold has no intrinsic value, is it a bubble?, we wrote,

Now, imagine if one day the US government decree that all tooth-pastes become legal tender for payment and settlement of debt (i.e. function as money), how would you feel if you have to physically consume your money daily for the sake of oral hygiene?

Let’s say the government declares that 30 days from now, tooth-pastes will function as legal tender money. What will happen? Firstly, the prices of tooth-pastes will sky-rocket. Next, tooth-pastes will disappear from the shelves of supermarkets. People will be hoarding and stockpiling tooth-pastes. After 30 days, when tooth-paste officially becomes legal tender money, people will start to have bad breath, especially the poor, who can’t afford to consume tooth-pastes for the sake of oral hygiene. Then the demand for tooth pastes will rise to the moon, not because the demand for oral hygiene increases, but because the demand for tooth-pastes as money increases. Not only that, no matter how much tooth-pastes Colgate produces, there will always be shortages because there will be mass-hoarding of them as money.

This may be a funny though-experiment. But if oil should ever function as medium of exchange, the outcome will not be funny. There will be an acute shortage of oil, as nations will be hoarding and stock-piling oil in a frenzy. Guess what will happen if we have acute oil shortages in a Peak Oil world that is addicted to oil? The way of life as we know will grind to halt and we will all be back to travelling in horse-drawn carriages.

That is why, when governments undermine the store-of-value function of money (something that can only be done in a fiat monetary system), investors will flock to useful, vital and scarce commodities to store their wealth. This in turn will result in those scarce commodities becoming scarcer. The food riots around the world in 2008 were an example of how this can happen (see Who is to blame for surging food and oil prices?). That also explains why the housing ‘shortage’ situation in Australia is an intractable problem (see Does rising house prices imply a housing shortage?).

That is the reason why gold and silver?functioned as money historically. The free market tried using scarce, useful and vital commodities (e.g. salt, sugar, tobacco, cattle) as money before and it didn’t work out. Those that did probably did not evolve into more advanced civilisations.

Of course, just because it is stupid to let oil function as currency reserves does not necessarily mean it wouldn’t. As Albert Einstein said, two things are infinite: the universe and stupidity.

Rise of strong man or decline of nation-state?

Thursday, February 25th, 2010

Here is a quick question for our readers to ask themselves: In view that the world is facing increasingly serious problems (e.g. climate change, Peak Oil, geo-political tensions, debasement of fiat money, food shortages, environment degradation, pollution, ageing population, e.t.c.), do you think these challenges will be increasingly insurmountable and as a result, lead to the:

  1. Decline of centralised government control (more disorder, more control by non-state actors, e.t.c)? OR
  2. Stronger government control of every aspect of our lives?

One of the repeated implied themes that we come across in our readings among contrarian literature is that 2007 is the peak of global prosperity. That means from now on, life is going to get harder and harder, for us, our children and grandchildren.

The basic point of this theme is actually quite simple. The amount of life-sustaining resources (e.g. clean water, oil, food, clean air, e.t.c.) for each human being in the planet is declining (due to natural forces and human stupidity). That does not necessarily mean that the absolute quantity of resources is declining. In some cases, it will be due to the fact that the increase in supply of resources is not growing fast enough to catch up with increasing needs.

With the world more interconnected than ever before and due to the global nature of the problems, everyone in this world will be affected. No doubt, humans will attempt to rise up to overcome them and there will be victories and setbacks along the way. But the important thing to remember is that governments will be increasingly unable to solve its citizen’s problems as the challenges will become increasingly insurmountable. Along with that (and because of that), the authority of the state will decline.

The big question to ask is how the journey will look like:

Increased cooperation among nation-states?
Global problems require global response. If the US and China cannot agree on Chinese tyres and American chicken, how can they possibly cooperate together to solve real problems?

The root of this is that whilst everyone agrees that something needs to be done to solve global challenges, everyone would prefer that someone else foot the bill. For example, on the issue of global warming, the developed nations want developing nations to offer their fair share of effort. But the latter sees that since it is the former that started the problem over the past couple of centuries, it is the latter’s responsibility to contribute a bigger share of the effort.

We can rule out this outcome.

Rise of a strong man/institution?
If increased global cooperation cannot be achieved, then in the face of acute global challenges, there will be increased conflict between nation-states, ethnic groups, non-state actors (e.g. terrorist, mafia, armed militias). The genocide in Dafur, Sudan is such an example.

In desperation or in an attempt to pre-empt conflict, mandate may be given to a strong man who can twist arms and pull fingernails to solve the problems that traditional nation-state governments can’t.

Can this happen? We read many accounts of life under Weimar Germany in the 1920s/30s. It was tough, brutal and erratic. Hyperinflation and the Great Depression made the people desperate. Back then, Germany was a highly divided nation. The state was weak, which allowed political parties and organisations to form disciplined armed groups. Hitler’s Nazi party was an example. Prior to the Nazi takeover, the Nazi Party already had its own uniformed thugs (e.g. the SS and SA stormtrooppers). They were also already secretly acquiring weapons. Eventually, the German people gave Hitler the mandate out of desperation.

Already, we have people like Lord Mockton alleging that the Copenhagen Agreement is part of plot to rise up a world government.

Increasing decentralisation of state power, disorder and even anarchy?
Indeed, this is the idea raised by Phil Williams from the Strategic Studies Institute of the United States Army War College. In his book, From the New Middle Ages to a New Dark Age: The Decline of the State and U.S. Strategy, he wrote that

Underlying the change from traditional geopolitics to security as a governance issue is the long-term decline of the state. Despite state resilience, this trend could prove unstoppable. If so, it will be essential to replace dominant state-centric perceptions and assessments (what the author terms ?stateocentrism?) with alternative judgments acknowledging the reduced role and diminished effectiveness of states. This alternative assessment has been articulated most effectively in the notion of the New Middle Ages in which the state is only one of many actors, and the forces of disorder loom large.

Failure to manage the forces of global disorder, however, could lead to something even more forbid-ding?a New Dark Age.

A very good modern-day example of the decline of the state is Pakistan. Today, the Pakistani government is only one of the powers in the country. There are the Pakistani Taliban, Al-Qaeda and local tribes with inter-locking and overlapping allegiances and control. Mexico is another example, with the drug cartels undermining the power and authority of the state.


The BookDepository

Editor’s note: Thanks to Kevin Rudd’s parallel import laws, which makes books in Australian bookshops even more expensive than books ordered through the Internet. We found one technical/professional book that is 33% cheaper in Book Depository than from the local Dymocks book shop! If you find any Internet book shop that is even cheaper than Book Depository, please let us know.

Regardless of whether we will face the decline of the nation-state or not, the first symptoms we will face are price inflation, which will be exacerbated by monetary inflation. Even our friend, Professor Steve Keen, who is firmly in the deflation camp, believes that the only things that can potentially wreck his deflation economic model are global warming and Peak Oil.

When we see the challenges facing the world in the years to come, we believe that there is a high chance that the current way of life and standard of living, is the best it can get and that it will be downhill from now on. In other words, life will be harder, more volatile and we can expect less help from the government. Therefore, to thrive well in the future, you will have to acquire self-sufficiency equipment/skills, stockpiling of supplies and self-defence equipment/skills.

For our Australian readers, it may look like this is the view of survivalist nuts. But if we are not wrong, the mood in the United States turning towards increasing anxiety, as if the modern world is on thin ice. The good news is, the downward path will be very gradual, which means we have plenty of time to prepare. The bad news is, the slow pace will lull the majority into complacency.

We will explore this theme more in the future. With this, we will show you a video of Marc Faber’s interview by ABC’s Ali Moore 11 months ago:

Mental pitfall to avoid: mental accounting

Tuesday, February 23rd, 2010

Following feedback from our readers, we learnt that many are interested in learning more about the mental pitfalls that afflict every human being. To be a good investor, one has to overcome or at least be aware of his/her vulnerability to mental pitfalls in order to make rational investment decisions. If you can do that, it will, by definition, make you a contrarian investor.

Today, we will look into mental accounting. In mental accounting, individuals tend to divide up their current and future assets into separate accounts and then assign different subjective values to these accounts.

Let’s look at the following scenarios:

  1. You divide your total wealth into two accounts: Retirement Account and Speculation Account. The former is meant to be ‘safe’ place to store your wealth for future retirement while the latter is for you to gamble in the financial markets. Say, you gamble $10,000 and lost the entire lot. Which outcome will make you feel better: (1) you lost $10,000 on the Retirement Account or (2) you lost $10,000 in the Speculation Account?
  2. Say you invest in stock A and B. The price of stock A decreased by 10% whereas the price of stock B increased by 10%. Let’s say you have to raise cash in a hurry. Everything else being equal, which stock will you liquidate in order to raise cash?

In the first scenario, chances are, a person using mental accounting will feel more pain in outcome (1). In the second scenario, one is more likely to sell the winning stock. But if one looks at them rationally, there’s no different between either outcomes in both of the scenarios.

The root characteristic of mental accounting is that it violates the principle that money is fungible. Recall that in Properties of good money, we wrote that

Any commodity that functions as money ought to be fungible. That is, you can trade or substitute it for equal amounts of like commodity.

To put it simply, a dollar is a dollar, no matter where it pick it up from. A dollar you deposit in the bank is not exactly the same physical dollar when you withdraw it three days later. But for all intention and purposes, both of them can be substituted for each other.

Diamonds, on the other hand are not fungible. Each is unique from the other and hence, cannot be substituted for another. Your pet dog is not fungible too. If it died over the weekend, you cannot simply pick a similar one from the pet shop and substitute it for your dead pet.

In the same way, a dollar in the Retirement Account is fungible from a dollar in the Speculative Account. But the fact that one is more likely to feel more pain from a loss in the Retirement Account then an identical loss in the Speculative Account shows that both dollars are no longer fungible in one’s minds.

Arguably, mental accounting helps make Kevin Rudd’s free $900 stimulus cheques more effective (in ‘stimulating’ the economy) then it would have been. Tax-payers who received $900 tend to put the that in the “Free Lunch” mental account. Money in the “Free Lunch” account is more likely to get splurged on consumer items that make one feel good. What if the government made that $900 be automatically credited into tax-payers’ debt account (e.g. mortgage debt, credit card debt)? In that case, most will be reluctant to spend $900. In both cases, the government spends $900 and each tax-payer’s network increased by $900. But the latter will result in most people choosing to close up their wallets. The rational choice in the former case would be to repay debts.

In another real-life example, one of our Chinese friends made an investment in physical gold and managed fund in 2007. As we all know, both the Chinese stock market and gold fell in the second half of 2008. By early 2009, he had made some paper profits in gold while the managed fund was still in the red. Due to some personal circumstances, he had to raise funds. So, he sold his gold for a tiny profit. Today, gold is at a much higher price than when he sold it and his managed funds is still in the red. The reason why he sold his gold was not because he believed that managed funds had a better prospect. Instead, he the reason was because he did not want to realise the losses in his managed fund.

Advertising/Affiliate policy

Sunday, February 21st, 2010

We would like to thank our readers for their feedback and support in Supporting this blog and reader feedback. More importantly, we would like to give special thanks to our donors for their support. After thinking through over the past few days, we reckon that this blog can only be supported in the long-term by a mixture of donations, advertising, affiliates and micro-payments:

  1. Donations– Donations make our day. It’s not just the money that makes us happy. Donations are a sign that our work is valuable to and appreciated by others. We agree with one of our readers that donors must be rewarded in one way or the other.
  2. Advertising– From our reader poll, most people do not mind the current level of advertisements. At least one reader finds the advertisements useful! This means most people accept that advertising is a necessary ‘evil’ (not that advertising is intrinsically evil). Also, the majority prefer articles and advertisements to be separated. We interpret it to mean that readers want to know clearly that they are being ‘advertised onto.’ Some advertising (e.g. banner ads) are very obvious. Therefore, most readers will have no problem distinguishing them. The tricky part is affiliate promotions…
  3. Affiliates– We receive compensations from affiliates to promote their products. But as you can read from our Advertising & Affiliates policy page, not any product/service provider can be our affiliate. We have to like their products/services first and we must have reasons to believe that they are relevant to some of our readers.Affiliates’ products/services are usually promoted in the form of links embedded within articles. Such promotions, by its very nature, are subtle. One of the reasons for this is because some of the links point to pages that actually contain useful information to some readers. Articles with embedded affiliate links can come in the form of (1) just a passing mention of products/services to (2) more direct and active promotion. Therefore, to ensure transparency to our readers, we will adhere to the following policy (as mentioned in our Advertising & Affiliates policy page):

    To alert our readers/subscribers of possible conflict of interests, articles that contain subtle embedded links to our affiliates will have the “Advertising/Affiliates” tag attached to them (this exclude links that can be easily recognised? as advertisements). Tags are displayed at the bottom of every article.

    For example, Market Club is an affiliate link and consequently, the ?Advertising/Affiliates? tag is present in this article. On the other hand, affiliates links that are clearly advertisements will not be subjected to this rule (see this article as an example). To put it simply, when affiliate links are subtle, we will use that tag.

  4. Micro-payments– One business model we are thinking about is the idea of micro-payments on selected articles. So far, web sites that charges micro-payment are relatively rare. The pricing point we are thinking of for micro-payment is in the range between 25 cents to 50 cents, depending on the article. Of course, donors will be exempted from micro-payments.We want to avoid going towards the paid subscription model. This is because, as one of our readers suggested, paid subscription implies a commitment in terms of consistent quality and regularity. Micro-payments, on the other hand, is flexible for us, flexible for our readers (because they can pick and choose which articles they want to read) and low-risk for our readers.

Please contribute feedback below. And also, the reader poll is still open.

How is Jim Chanos going to short China? (Australia: take note)

Thursday, February 18th, 2010

As we all know, the infamous short-seller (who made the famous short call on Enron), Jim Chanos, has declared publicly that he is shorting China. The question is, how is it possible for him to do so in a practical sense?

For one, there is no market mechanism to short Chinese A-shares in mainland China. Currently, the ability to short-sell shares in China is on a trial basis, with no exact time-table announced for a transition to a full basis. As this Financial Times article reported,

The regulator said it would follow the principle of ?test first, then expand?, and would select some companies to launch products on a trial basis.

But the statement left many questions unanswered, including which companies will participate, whether foreign groups will be included, and the exact timetable.

The only practical way to short China is to short-sell Chinese A-shares on the Hong Kong stock exchange.

But there’s another alternative. And that is…

No, we wouldn’t give the spoiler in this article. Watch this YouTube video clip below:

Please note this is not a recommendation to short-sell Australian miners tomorrow. This is for you to understand that the short-seller sharks like Jim Chanos are probably on the alert to pounce on Australian miners.

Supporting this blog and reader feedback

Wednesday, February 17th, 2010

Recently, one of our readers seemed to be pissed off with what seems to be our attempts at getting some ‘advertising’ revenue (see the exchange at A little trick to snipe profits from the market- ?52 Week High Friday Rule?). Technically, that was not advertising in the traditional sense- what we were doing was to send relevant traffic to our affiliate business partner.

Of course, in the ideal world, information is free and there’s no hidden agenda and advertising. Bloggers would write just for love, passion and sacrificial good-will. We would love to live in such an ideal world. Many of our readers would love that too.

But unfortunately, the real world is far from the ideal. As another fellow blogger wrote,

Like many other sites recently, I am now starting a fund raiser. Blogging is a very time and effort consuming activity. And while advertising provides some revenue, it is nowhere near enough.

Like you, we are still humans who have to pay the bills, eat, sleep and suffer the demoralisation as any humans do. Eventually, our finite human limits will be breached. Worse still, the evils of inflation and moral hazards (which the governments everywhere seemed intent of achieving), is making a bad situation worse for society as a whole.

And you know what the problem for bloggers like us? As we wrote in Google vs Rupert Murdoch- who will win?,

So, here comes the crucial point to understand: information (collectively) is free and abundant, but consumers? attention (for each individual information provider) is scarce. Actually, each feed of one another in a positive feedback loop- to attract the attention of consumers, businesses are forced to give more and more information away, which in turn causes information to be more abundant (collectively), which in turn makes consumers? attention even more scarce (for each individual businesses), which forces businesses to give yet even more information away.

Unlike say 10 years ago, what is happening today is that the cost of producing free information (e.g. researching, writing, reading, etc) and services is exceeding the revenue gained from scarce attention (e.g. advertising, sending traffic to affiliates). From what we can see, information producers on the Internet are bleeding dry. Newspapers are going busts left, right and centre. If well-capitalised Rupert Murdoch is complaining, then it is very telling that a significant percentage of online information producers/service providers are in pain.

From an investors’ point of view, it is a no-brainer that Google’s business model is much better than Rupert Murdoch’s. As Jaron Lanier, a computer scientist/philosopher wrote in a FAQ of his book,

The only business model for aggregated or collectivized information- information that isn?t bought and sold directly- is the routing of advertising.? Everything but advertising becomes free.? It isn?t the advertisers who become rich in the long term, because there are fewer and fewer things to be sold, other than ads.? It is the owner of the ad exchange that becomes rich.? At the moment this means Google for most purposes, though in the financial sphere there are other parties playing an analogous role.? (I should say that I personally know the Google folks, and like them.? They didn?t have an evil plan- but they did find themselves in a niche that is problematic.)

That’s why most of the free stuffs on the Internet seems to have ‘hidden’ agenda and sales hype. As long as the price of information are pushed towards zero, such conflict of interests will be the norm.

That’s the reason why we advertise.

Some of you may find that irrelevant advertising because you are not into trading. But please look at this from our perspective. We have a wide variety of readers, many of which are into trading, forex and penny stocks (assuming that our Facebook community is indicative of the general readership of this blog). We even have a sizeable number of American real estate investors (it’s a surprise to us). So, what we were doing was to try to direct the traders (among our readers) to our affiliate business partner.

From the perspective of the non-traders, that particular business partner’s wares can be seen as sales hypes and hidden agenda. But personally, we find that we can trust them more (relatively), compared to the heaps of crap you can find on the Internet. That’s why we promote their trading products because we ourselves use them and find them useful. The truth is that, with so much sales hypes, hidden agendas and crap on the Internet that it is pretty much getting more and more difficult to tell the difference between the crap ones and the gems. To be frank, we have other businesses who wants to promote their wares through us and they either failed the hype-test or we aren’t sure whether they are scams or not.

And here is our problem. In the Internet, everyone can remain anonymous. But we can’t tell the traders among the investors (other than the few who engage in conversations in the comments). What we see from our statistics are a sea of faceless numbers. Whenever statistics are involved, the only way to go is to run on statistical probability (in reality more towards guestimates). So, for example, if we guestimate that x% of our readers are traders, then we will ‘advertise’ a specific way so as to ensure that the least number of readers are pissed off. If the percentages are much higher for a specific segment, then our ‘advertising’ will be louder because based on statistical probability, the chances of the ‘advertising’ being relevant are much higher and therefore, less likely to piss off someone.

One of our readers suggested going to the donation route. Well, we are not sure whether this is a better route. Certainly, it will piss off less people. But would that be even less sustainable in an already unsustainable situation? Also, some of us are resistant to the donation route because it smells like begging. But would that be worth a try?

One fellow blogger is going along this route:

So, to enable this blog to continue at the current rate of activity or to expand, readers really need to start donating. I am letting future activity depend on this. No donations means no blog. Few and/or little donations means little activity.Many and/or large donations means unchanged or more activity. The future of the blog is in your hands.

Donate according to how much value this blog gives you and your ability to donate. So, press the “donate”-button in the right side bar, and donate now (or as soon as possible)!

We are going to try donation as an experiment and let our readers’ donations drive the level of activity and quality of this blog as well as the level of advertisements (i.e. more donations, less advertisement). In other words, donate according to how much value this blog gives you and your ability to donate. Please note that a few advertisements cannot be removed immediately due to contractual obligations with the advertisers.

Also, please leave feedback on what you think in the comments below. Without feedbacks, what we see are just a sea of statistically faceless numbers. Also, to help us understand our readers, we are conducting an anonymous poll here.

European politicians hammered from both sides

Tuesday, February 16th, 2010

As observers of what’s happening around the world, we find the spectacle of what’s happening in Europe as juicy as soap opera plots. With so many internal contradictions within the cast of characters, we can be sure the outcome will be unpredictable and explosive (literally). Even if the Greeks get bailed out tomorrow, you can be sure that there will be another episode in the drama that will throw a surprise twist to the story.

We will look at the first character in the cast- Germany. At the heart of the European Union is Germany. Without Germany’s economic strength under-girding the union, the euro-zone economy would only be a pointless rump. Under-girding the German economic strength is the Teutonic spirit of discipline and efficiency. The brutal efficiency of the Germans allowed their exports to increase steadily both as a share of total European consumption and as a share of European exports to the wider world. Reflecting the Teutonic discipline of the German people, most of them are against the idea of bailouts. As Most Germans want Greece thrown out of euro reported,

A poll for popular newspaper Bild am Sonntag found that 53pc of Germans wanted Greece to be expelled from the euro if necessary in the coming months. Two-thirds were adamantly against German money being put towards a bail-out of the troubled country, the paper also found.

Thus, any German politician contemplating a bailout on Greece will have to keep one eye on the public opinion. This is something that will be looming on the back of Angela Merkel’s mind during the negotiations for a bailout package.

German politics is only one impediment to bailouts. There are also legal impediments to bailouts. Article 104 of the Maastricht Treaty (and Article 21 of the Statute establishing the European Central Bank) actually forbids one explicitly. Thus, for legal reasons, a bailout cannot be called a “bailout.”

Yet, despite the reluctance of the German people to save Greece, the German banking system (and by extension, the European banking system) is reportedly to be exposed to Greece. This is another dilemma faced by the German government.

Contrast the Teutonic spirit of the Germans with the profligate and undisciplined ways of the Greeks. The Greek government’s budget crisis did not arise out of the blue. It was several years in the making. As European Central Bank Chief Economist J?rgen Stark said in an interview (see European Central Bank Chief Economist: ‘Everyone Is a Sinner at the Moment’),

An economy doesn’t lose its competitiveness overnight. Greece covered it up for a long time with an extremely generous spending policy. For example, consumer spending was stimulated with pay increases in the government sector. We here at the ECB were vocally critical of this development several years ago.

Today, we even heard from a foreign news report that the Greek government, with the aid of Wall Street, used Wall Street’s dodgy tactics of using currency derivatives to disguise loans. Not only that, there were accusations of the Greek government using doctored statistics to cover up their dismal economic performance. The rot was reportedly extended to the grass-roots level- Greek citizens as a whole, tend to under-declare their tax liabilities. We have no comment on how true these allegations were, but all these are indicative of the rot in the system.

Thus, from the German perspective, any rescues will have strings attached. In fact, the strings will be very stringent. The highly disciplined German people will undoubtedly not tolerate anything less. In practice, this may mean German control of the ECB and Greek fiscal policies. Whatever the outcome of the conditions imposed on a bailout, it has to be as unpalatable as possible so as to send a signal to the other profligate PIIGS countries (see Currency crisis: first countries in the line of fire- PIIGS) not to expect any moral hazard.

If only it is that simple.

The Greek people, on the other hand, are already protesting against any austerity measures to rein in their government’s budget deficits. As this BBC news article reported,

Thousands of Greeks have rallied against deficit-cutting measures during a national public sector strike.

The unions regard the austerity programme as a declaration of war against the working and middle classes, the BBC’s Malcolm Brabant reports from the capital.

He says their resolve is strengthened by their belief that this crisis has been engineered by external forces, such as international speculators and European central bankers.

“It’s a war against workers and we will answer with war, with constant struggles until this policy is overturned,” said Christos Katsiotis, a union member affiliated to the Communist Party, at the Athens rally.

We can imagine that should there be any German-style discipline imposed on them, the entire nation will descend into flames. This is something that will be looming in the back of Greek Prime Minister George Papandreou as he enters the negotiation table. Judging from the mood of the Greek people, they are ripe for the rise of a demagogue blaming their country’s woes on international ‘speculators’ and European central bankers. So, even if the Greek government accept the stringent conditions attached to a bailout, the Greek people will not. The question is, will the Greek government collapse as a result? Investors buying into the ‘good’ news of a Greek bailout may well be confronted with such a Black Swan event within a relatively short space of time.

So, would the path of least resistance be an excommunication of Greece from the euro?

Again, there are complications. Firstly, there is no clear-cut legal mechanism to ‘expel’ a nation. Next, the question will be what to do with the debt owed by the Greek government? Also, should that happen, what will the other PIIGS nations (that are next in the line of fire) think?

There are many twists and turn in this drama. That’s why, up till now, the only progress so far are announcements of solidarity and intention.

An economy doesn’t lose its competitiveness overnight. Greece covered it up for a long time with an extremely generous spending policy. For example, consumer spending was stimulated with pay increases in the government sector. We here at the ECB were vocally critical of this development several years ago.

A little trick to snipe profits from the market- “52 Week High Friday Rule”

Tuesday, February 16th, 2010

Yesterday, we were given the heads up from our friend, Adam Hewison, of a little trading trick to snipe little profits from the stock market. That little trick is called the “52 Week High Friday Rule.” Based on statistical probability, there is little risk of loss with that strategy.

For those who are into trading, click on this link.

How is the Fed going to keep the lid on inflation? Part 2- Paying interest on bank reserves

Sunday, February 14th, 2010

In our previous article0 (How is the Fed going to keep the lid on inflation? Part 1- Losing control of the Fed Funds Rate), we discussed about how the Fed is considering using the interest rates on reserves (instead of the Fed Fund Rate) as the benchmark rate. Some observers may ask this question: with so much excess bank reserves in the financial system, how is the Fed going to drain them out of the system in order to contain price inflation?

As it turns out, the Fed has one trick up its sleeves. The jury is still out on whether this trick will work or not. We guess this trick may work in the short term, but in the long run, we have our reservations. The trick is this: increase the interest rates on the bank reserves. How will it work in theory?

You see, traditionally, the Fed did not pay interests on bank reserves. As we mentioned before in How is the Fed going to keep the lid on inflation? Part 1- Losing control of the Fed Funds Rate,

… the whole point of banking is to get the banks to lend out their money to the wider economy. By not paying interest on reserves, they became unproductive assets. Thus, that prodded the banks to lend out their reserves to make their assets more ?productive.?

In the post-GFC world, the Fed pays interests on bank reserves. If you are a commercial bank, you will only lend money to someone if the returns on the loan is greater than the returns on your reserves. Therefore, the more the Fed increases the interest rates on your reserves, the less likely you will lend it out. That will result in short-term interest rates to rise.

As you can see by now, because of the dysfunction of the financial system post-GFC, the Fed Fund Rate has less and less influence on short-term interest rates. Instead, the bank reserves interest rates become a more effect control.

The question is, will the Fed’s trick work? We will talk more in the next articles. Keep in tune.

Is China allowed to use its US$2.4 trillion reserve to spend its way out of any potential crisis?

Thursday, February 11th, 2010

Everyone knows that China has US$2.4 trillion of reserves. This has led to many (including some analysts from big financial institution) to believe that such gigantic reserves are akin to ‘cash’ that China can spend its way out of any potential crisis.

Actually, this is one big misconception that this article will address.

The US$2.4 trillion of reserves is only half the picture. Looking at that alone is analogous to looking at the asset column of a company’s balance alone. What’s also important is the liability side of the picture. When you put the two together, then you will get a better idea of how much of the ‘cash’ (i.e. the reserves) that the Chinese government can really spend.

First, we will look at the liability side of China’s ‘balance sheet.’ According to this report from Pivot Capital Management,

… the size of the Government?s debt is vastly understated. Not included in the public debt figures are the liabilities of the local governments, which the Ministry of Finance estimated at $680bn as of the end of 2008. In addition to that, a large part of the loans extended this year (estimated at $350bn) went to finance public infrastructure projects guaranteed by local governments. Furthermore, when the Chinese government bailed out its banking system in 2003, it set up Asset Management Companies that issued bonds to the banks at par for the non-performing loans that were transferred to them. These bonds, worth about $260bn, are explicitly guaranteed by the Ministry of Finance and the Central Bank and sit on the balance sheets of the big four banks. The Chinese government also explicitly guarantees $400bn worth of debt of the three ?policy banks?. In total, these off-balance sheet liabilities are equal to $1.7tn, which would bring China?s public debt to GDP ratio up to 62%, a level that is comparable to the Western European average.

These debt guarantees within the off-balance sheet liabilities are what we call “contingent liabilities.” Australia’s bank deposit and wholesale funding guarantee are examples of contingent liabilities of the Australian government (see Australian government?s contingent liability to exceed AU$1 trillion).

These off-balance sheet liabilities are not the only liabilities. The Chinese currency in circulation is also a liability. Remember what we wrote in How does China ?save?? Story of the circuitous journey of a US$? In that article, we explained how a US dollar travelled from America (in the hands of an American consumer) to China, and then exchanged as RMB and then travelled back to the US as Treasury bond purchases. The crucial intermediate step to examine in this circuitous journey is when the US dollar is exchanged for RMB. As we all know, the RMB is pegged to the US dollar at a specified ratio. Currently, the ratio is at 1:6.833. To simplify matters, let us round up the number to 1:7. What happens (in a very highly simplified form) is that for every US dollar that gets presented to the PBOC, approximately 7 RMB will be issued.

One way to look at it is that the RMB in circulation are ‘backed’ by US dollars in the form of currency reserves. That was exactly the same situation that America faced in the 1920s. Back then, under the gold standard, the US dollar was pegged against gold in the ratio of approximately 1:20. In reality, not every US dollar was backed by gold. In other words, the US dollar was partially backed by gold in the same way your ‘cash’ at bank was partially backed by physical currency and your bank’s deposit on the central bank. That is, there was a theoretical possibility that there could be a run on the Federal Reserve’s gold if every citizen decided to redeem all their currencies for gold at once. In the same way, China’s RMB in circulation are partially ‘backed’ by their US currency reserve. According to the chart provided by Pivot Capital’s report, only a little over 20% of China’s total currency (plus gross external debt) are ‘backed’ by their US dollar reserves, which isn’t spectacular compared to other emerging economies. In fact, South Africa is the winner in this aspect because their reserve coverage ratio is almost 160% i.e. it has $16 of reserves for every $10 of currency.

Of course, in reality, it is unlikely that there’s going to be a run on China’s US dollar reserves. But according to Pivot Capital, since 2007, there are approximately US$500 billion of “hot money” in China that can easily leave the country at a moment’s notice. That US$500 billion is money that China cannot spend and must be ready to meet the ‘redemption’ demand of the “hot money.”

So, in reality, the picture of China’s currency reserves is not as rosy as it seems.