Posts Tagged ‘business cycle’

Where do we go from here? A journalist’s questions…

Wednesday, January 21st, 2009

We were asked for comments by a journalist. Here are the questions and our answers…

Is this the intellectual failure of mainstream economics, as some have argued?

We believe that at the root of this Global Financial Crisis (GFC) lies the moral failure of humanity. Through this moral failure, the world is allowed to get carried away and believe in what it wants to believe. Mainstream economics provide the intellectual framework for this belief. Strip away this faulty intellectual framework and one will be able to see clearly how humanity is magnificently capable of self-deception. As we wrote in Is this the beginning of the loss of confidence in fiat money?,

Is this crisis a surprise? If you listen to the mainstream economic schools of thought, central bankers, mainstream financial media, captains of the financial industry and so on, it looked as if this looming financial disaster is something that no one can see coming. The common underlying excuse (that was un-said, un-written but implied) goes something like this: ?No one could ever foresee this! It?s impossible! Only hindsight can tell!?

Now, we would like to make it clear that this is completely false. Please note that we are not accusing individuals of lying. Instead, our point is that this excuse is a sign of collective mass delusion. If you look at the 6000 years worth of the history of human civilisation, you will find that humanity is repeatedly capable of mass delusions.

Has the global financial crisis brought to a head a growing dissatisfaction with the corruption of money, as is also being argued in some quarters?

Let recall a story as mentioned in Understanding the big picture in the inflation-deflation debate,

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.

Today, the world runs on a fiat monetary system in which money enjoys legal tender status through the authority of the government instead of through the choice of the free market. In today’s credit system, money has become intangible, imaginary and hard to define, to the point that its supply (‘quantity’) can be inflated and deflated from thin air by central banks and the financial system. Currently, the global financial system (private sector), through debt defaults, de-leveraging and so on, is contracting the quantity of ‘money’ (deflation) while governments and central bankers are trying to do the opposite (inflation). The result of such government intervention is extreme volatility in prices. Once this happen, money can no longer function as a yardstick for unit of accounting and store of value. For example, take a look at oil prices from July 2008 till today. Such extreme volatility cannot be simply explained with traditional economic model of supply and demand, which assumes that the integrity of ‘money’ trusted. Once this integrity is broken, prices can no longer convey vital information to the free market. Without this information, the free market breaks down and no long-term planning can be performed (see Real economy suffers while financial markets stuff around with prices).

As long as governments keep on intervening, the situation will get worse and the dissatisfaction will grow.

Will things ultimately stay in the same after some adjusting, or will  the global economy (and the Australian economy) look dramatically different in 12 (24) months time?

We doubt the status quo can be maintained. The genie is already out of the bottle. In due time, we believe the global economy will be very different. The only thing we are not sure is the time-frame. Today’s GFC is the accumulation of decades of unsound monetary system, starting from the severing of the final link between the US dollar and gold in 1971. That breakdown was accelerated after 2001, with Alan Greenspan’s unsound monetary policy.

If it?s true that laissez faire capitalism was given its head to a dangerous degree, what needs to be done now – and can we trust governments and central banking systems to get it right?

Firstly, the laissez faire capitalism was not really laissez fair in the first place. As we explained in What cause booms and busts? Introduction to the Austrian Business Cycle Theory,

If we generally let market forces set the price of things (e.g. stocks, consumer goods, bonds, real estates, etc), then why is it that the price of money (interest rates) should not be chosen by the market? Does the central bank know better than the market to set the ?right? price of money?

We have a centralised command economy (for the price of money) in the midst of a laissez faire free market. True laissez faire will not give so much power to one man (Alan Greenspan) to mismanage. The worst thing we can do is to give more power to the government. Alan Greenspan set the price of money to be too cheap for too long. Credit became too cheap and too easy to get. Obviously, supply more cheap credit is the wrong medicine. The GFC is a correction to what had been distorted for too long. Government interventions to prevent this distortion will prolong the agony and cause other unintended side-effects.

How do you regulate better?

Today, there is one country totally unaffected by the GFC. That country has the most stringent regulation in the world. That country is North Korea.

How does bailing out banks and businesses make sense?

In a free market, the incompetent businesses will go bankcrupt and cede control to the competent. By bailing out businesses and banks, the government is giving an unfair advantage to the incompetent. This introduces moral hazard by rewarding incompetency. As we all know the rest of the story, communism became a failed experiment.

What happens when the bailout money runs out?

Remember, the world is running on a fiat monetary system. ‘Money’ will not run out as long as governments are willing to do whatever it takes to destroy its integrity. Already, Bernanke and company have already thought of what it means by “whatever it takes” (see Bernankeism and hyper-inflation). He once said this,

The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning.

…

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

And what happens to those in the finance world who have done nothing but take risks and do the deals that make the money…how will they cope?

As we questioned before in The myth of financial asset ?investments? as savings,

Can the printing of money, which spawns the growth of an industry to shuffle it, cause a nation to be richer in the long run?

Real prosperity lies in real capital formation and the accumulation of capital goods. Shuffling of ‘money’ is not the path to long-term sustainable wealth. The GFC clearly shows it. It’s time the world gets back to the honest basics.

Who?s MAKING money now (apart from those running insolvency practices)?

There will be bound to be some smart (or lucky) short-term traders who profit from all these volatility. But look at the big picture, no one benefits in a depression- everyone’s standard of living will decline. In such a day, ‘money’ becomes meaningless.

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Posted in Economics/Finance, Looking Forward, Market Observations | 4 Comments »

Are government bailouts good for the economy?

Wednesday, October 1st, 2008

Back in June last year (2007), we wrote in Epic, unprecedented inflation that

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

The implication is, as Marc Faber opined, this synchronised inflation will eventually lead to a synchronised deflation i.e. price deflation for all asset class in all major nations. This is something that contrarians have been warning all along (see Spectre of deflation in January 2007).

This synchronised monetary inflation leads to a mighty economic boom that mainstream economists called (and cheered for) the “asset-driven” growth. But again, we were sceptical about this kind of boom. As we explained back in November 2006 in How will asset-driven ?growth? eventually harm the economy?,

Thus, when housing prices [asset price in general] increased due to the increase in ?demand? for housing, the common people are misled into thinking that the value of housing had increased as much as the increase in its prices. That collective error in judgement resulted in the economy misallocating scarce resources into housing sector?in the case of the US, a significant proportion of the jobs created during the asset-driven ?growth? was related (both directly and indirectly) to the housing boom. Since economic resources are always scarce, any misallocation of it implies an opportunity cost on the other sectors of the economy. The result is a structural damage to the economy that can only be corrected through a recession.

The dark side of this boom is the dangerous build up of debt and leverage in the global economy. As we explained in January 2007 at Myth of asset-driven growth,

As asset price growth outpaces income growth by an ever-increasing margin, increasing issue of credit (i.e. the flip side of taking up of debt) is required to bridge the gap between the asset price and income. What is most often overlooked is that the uptake of debt, which is required for asset-driven growth, has to be serviced. There are two kinds of debt?investment debt and consumption debt. Investment debts are being used for investments that will generally add value to the economy by increasing its productive capacity. Thus investment debts are self-servicing loans?they will generate the necessary economic returns to make repayments possible. The problem with asset-driven growth is that much of the debts are consumption debts. Since such debts are acquired for consumption, they do not add value to the economy because they do not increase its productive capacity. As such, asset-driven growth magnifies the consumption debts of the economy, which will have to be serviced in the future. By deferring the burden of debt servicing to the indefinite future, it can only mean that the nation?s wealth will shrink in the future. Hence, asset prices cannot rise in perpetuality. Eventually, the weight of future debt servicing burdens dooms the bubble to collapse under its own weight.

For those who are new to this publication, these explanations are from the classic business cycle theory of the Austrian School of economic thought. Followers of the Austrian School will look at today’s financial crisis with a yawn because it is obvious to those who understands the Austrian Business Cycle Theory. To understand this theory, we highly recommend our guide, What causes economic booms and busts?.

Currently, we are in the bust phase of the business cycle. In this phase, we will see a much needed painful restructuring of the economy as wasteful and unsustainable mal-investments of the prior boom time get liquidated. Real-life example of mal-investment liquidations can be seen in this news article, Frozen-out expats return to Australia for jobs,

A generation of young Australian expatriates are being forced home from New York and London due to the tightening job market in the finance industry.

Painful as it is, liquidation of mal-investments is a necessary evil so that the global economy can get back on its feet towards a sustainable growth path. The manifestation of this painful process is deflation. The magnitude of the coming deflation reflects the monstrosity of the prior unsustainable inflation. The fact that the media is now murmuring about the infamous “D” word (Depression) shows that the massive boom of the past few years is a cruel illusion that fooled many, including many of the mainstream economists and government.

But what are the governments around the world doing? They are fighting this necessary evil by stalling the inevitable liquidation of mal-investments by the free market with bail-outs and even more attempts at monetary inflation! This will delay the long-term recovery of the global economy. How can they solve the problem with more attempts at inflation when inflation is the cause of it in the first place?

Should they ever succeed in their attempts at inflation, the end result will be as we described in Supplying never-ending drugs till stagflation:

Students of the Austrian School of economic thought will understand that indiscriminate ?printing? of money (i.e. [inflation]) will worsen the plague of mal-investments and structural damage in the economy. Like drugs, the more you ?print? money, the less effective it will be in stimulating economic growth (see What causes economic booms and busts?). Eventually, it will come to a point that the economy will not respond positively any more no matter how much money is being ?printed.? That is the nightmare of stagflation (low or negative real growth with sky-rocketing price inflation- look at Zimbabwe).

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Posted in Economics/Finance, Looking Forward | 10 Comments »

Do sentiments make the economy or the economy makes the sentiments?

Thursday, September 4th, 2008

Not long ago, we had lunch with one of our friends. Invariable, the conversation turned into the economy. Judging from the quantity of bad news (e.g. sub-prime, credit crisis, inflation, recession threats, oil prices, falling stock prices, etc.) from the media lately, our friend remarked that “I can tell something is wrong with the economy.” Indeed, we believe large segments of the population are thinking the same too. That’s why surveys are reporting falling business and consumer confidence.

Clearly, sentiments are turning for the worse.

In the midst of economic uncertainties, it is very easy to blame the cause of worsening economic conditions on sentiments. Politicians are fond of using this myth (whether deliberately or out of ignorance). For example, Malcolm Turnbull (Australia’s shadow Treasurer) accused Wayne Swan (Australia’s Treasurer) for “talking up” inflation, as if the tongue of Wayne Swan has the power to move economic forces. But is sentiment so powerful that it can move economic mountains? On Tuesday’s ABC 7:30 Report, Malcolm Turnbull stated in an interview that had it not been Wayne Swan’s talk, consumer confidence confidence would not be so low and the RBA would not have to raise interest rates that much.

But do sentiments make the economy or the economy makes the sentiments?

We do not subscribe to the theory that sentiments alone are the root cause of the business cycle. In fact, as we explained in What causes economic booms and busts?, the business cycle has its roots on human decisions and actions. It is not swayed by the cyclical tide of sentiments. But having said that, sentiments can accentuate the effects of the underlying root causes.

This remind us of a story by Marc Faber,

It was autumn, and the Red Indians on the remote reservation asked their new chief if the winter was going to be cold or mild. Since he was a Red Indian chief in a modern society, he couldn?t tell what the weather was going to be. Nevertheless, to be on the safe side, he told his tribe that the winter was indeed going to be cold and that the members of the village should collect wood to be prepared.

But, being a practical leader, after several days he got an idea. He went to the phone booth, called the National Weather Service and asked, ?Is the coming winter going to be cold??

?It looks like this winter is going to be quite cold indeed,? the meteorologist at the weather service responded.

So the chief went back to his people and told them to collect even more wood. A week later, he called the National Weather Service again.

?Is it going to be a very cold winter??

?Yes,? the man at the National Weather Service again replied, ?It?s definitely going to be a very cold winter.?

The chief again went back to his people and ordered them to collect every scrap of wood they could find. Two weeks later, he called the National Weather Service again.

?Are you absolutely sure that the winter is going to be very cold??

?Absolutely,? the man replied.

?It?s going to be one of the coldest winters ever.?

?How can you be so sure?? the chief asked.

The weatherman replied, ?The Red Indians are collecting wood like crazy.?

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Posted in Market Observations | 8 Comments »

Should value investors be ‘bullish’ in a bear market?

Tuesday, July 15th, 2008

Some of you may have subscribed to value-oriented stock research newsletter. One thing you may notice is that as the market enters deeper into the bear market, the number of “Buy” recommendation increases. From that perspective, these value-oriented stock research are ‘bullish.’

Before we comment on the wisdom of their recommendations, we will have to explain the philosophy of value-oriented stock research. As we explained to one of our reader’s comment in Confidence back? Beware of bear market rally,

… for long-term value investors, they follow the ?bottom-up? approach. That is, they (i.e. the value investor) invest in businesses based mainly on its individual merits (i.e. is it a good solid long-term safe businesses whose stock price is undervalued? Bear Stearns is definitely ruled out in this case) and not worry about the macroeconomic big picture, the business cycle, e.t.c. … In that sense, such value investors are neither ?bullish? or ?bearish.? Rather, they have a neutral view on the business cycle and other macroeconomic big-picture.

Here, we see a potential trap for the unwary value investor. Back in February last year, as we explained in What to avoid at the peak of the business cycle?,

One of the common mistakes that novice investors often make is to extrapolate the past earnings of cyclical stocks into the indefinite future during the turning points of the business cycle. Since the stock market always anticipates the future earnings of companies, cyclical companies will look ?cheap? (i.e. low P/E ratio) during the peak of the boom.

During the turning point of the business cycle, the P/E ratios of good quality companies in a bear market may look very enticingly cheap. But as we explained in Why accumulating stocks on the ?cheap? can be deadly to your wealth?, during such a time,

… a falling average P/E ratio does not imply that stocks in general are cheap. Yes, with careful and judicious stock picking skills, you may be able to find really cheap stocks. But do not let falling average P/E ratio fool you.

Low P/E plus the “Buy” recommendations from the value-oriented stock research may make buying stocks of good quality companies look like astute contrarian moves.

But this is where the Achilles? heel of value-oriented stock research lies. Because they hold a neutral view on the macroeconomic big picture and business cycle, they can severely underestimate the effects of a protracted downturn in the earnings of businesses. This news article, Bottom-up analysts ignore the big picture, sums it well:

“You have got a set of numbers that assumes some sort of recovery,” Macquarie’s equity strategist, Tanya Branwhite, said when releasing the report. “Unfortunately, that’s premised on the cycle we have seen in the last five to 10 years. What is facing the economy at the moment is nothing like we have seen in the last five to 10 years.”

One value-oriented stock research (which we will not name) believes that this current bear market will be like any other ‘typical’ bear market in the past- the downturn will last only 12 to 18 months. In other words, their position is that this coming recession will only be a V-shape or U-shape recession (see What type of recession is coming?). If they are wrong about that (i.e. the coming recession is an L-shape one), then their current “Buy” recommendation will be very wrong.

To illustrate this point, we will give you two examples.

After the stock market crash of 1987, the world economy did not fall into a Depression as initially feared. By 1989, stock markets had more or less recovered. If you bought into the market after the crash, you would have profited greatly.

But what if you bought into the market after the stock market crash of 1929 (see The Great Crash of 1929)? Or you bought Japanese stocks just after the bursting of the bubble in the late 1980s? The outcome will be completely different if you had done so.

In short, not all bear market purchase will turn out to be astute if the timing is way too early.

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Posted in Investor Education, Looking Forward, Value Investing | 6 Comments »

Why does the central bank (RBA) need to punish the Australian economy with rising interest rates?

Tuesday, March 4th, 2008

Today, the Reserve Bank of Australia (RBA) just announced yet another rise in interest rates. There are signs that this is hurting, as many people on the street (especially those who are straining under enormous debts) are screaming at the madness of the RBA for doing so. Many economists are worried that the RBA may accidentally tip Australia’s economic boom into a bust. Why is the RBA spoiling the party by raising interest rates?

Think about this: if raising interest rates is ‘bad’ and cutting interest rates is ‘good,’ then why don’t the RBA set interest rates to zero, thereby putting the economy into a path of eternal boom (plus runaway inflation)? For those who think this is a good idea, then this article will set to let you understand why this is a bad idea.

Now, at this point, we recommend that you read our guide, What causes economic booms and busts? because what follows will not make sense unless you understand the Austrian Business Cycle Theory (ABCT).

Back in February last year, in Where are we in the business cycle?, you can see that we already knew that Australia (and the US) was already at the top of the business cycle:

How can we restore the economy back to equilibrium and ensure that it remains in a firm footing for the future?

The first thing that has to happen is to increase our national savings. As we said in The myth of financial asset ?investments? as savings, we need to restore and rebuild our stock of capital goods to ensure our future prosperity. Already, the quality of our education, health, telecommunication and transport infrastructures are in decline and they are in need of repair and upgrade. This means that the only way we are going to achieve that is to reduce our current consumptions and cut down our debt. When that happens, the economy will slow down and many businesses and investments will fail as a result. Since most of the Australian (and the US as well) is made up of consumer spending, in which much of it is funded by debt, we can see that this remedy will be painful. If the consumers do not slow down and get their act together, we can expect the RBA to impose a restraint by raising interest rates.

The Australian economy was already running at full steam. Accelerating price inflation is a sign that there are insufficient resources in the economy to allow for all investment projects to succeed and all consumptions to carry on. If this trend is not arrested, the economy will run out of resources, resulting in a crash. Therefore, in order to put the economy back into a sustainable growth path, consumptions and investments have to slow down in order to allow for the economy to catch a breather for the rebuilding of its capital structure. The rebuilding of capital structure is necessary for the economy to replenish its resources for the future so that growth can continue down the track. Unfortunately, this rebuilding itself requires resources now. Therefore, current wasteful consumptions have to be curtailed and mal-investments have to be dismantled to make way for the rebuilding. The curtailment of consumption involves consumers spending less and saving more, while the dismantling of mal-investments involves retrenching workers, liquidating businesses, e.t.c. These involve pain for the people of Australia.

That is why the RBA has to raise interest rates to ‘punish’ the economy. What if it don’t? Then the economy will crash, either in nominal terms (e.g. deflationary depression) or in real terms (e.g. hyperinflation)- see Recipe for hyperinflation.

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Posted in Economics/Finance | 1 Comment »

Another sign of the business cycle top

Friday, February 23rd, 2007

In our previous article, Where are we in the business cycle?, we explained why we believe that Australia is probably at the peak of the business cycle. We also believe that the United States is also at the peak too. At the top of the business cycle, we will often be bombarded with reports about companies making record profits, even beyond analyst expectations. Consequently, share prices may rise as a result.

Do not be deceived.

In a business cycle peak, company profits as a whole are as good as it can get. If you expect the profit trend to continue and pay a premium price for stocks in anticipation for higher earnings next year, chances are, you will be disappointed.  It is now time to hunker down in your bunker in preparation for the economic downdraft. If you must stay invested in stocks, avoid outright cyclical stocks (see What to avoid at the peak of the business cycle?). Instead, choose companies whose earnings are more robust in the face of an economic slowdown and can survive through the tough times?even then, in such a pessimistic economic environment, even their stock prices will be depressed. Above all, avoid companies who are heavily laden with debt.

Already, we see another big warning sign: More US firms fail to meet Wall St’s earnings forecasts.

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Posted in Looking Forward | No Comments »

Example of mal-investments?dot-com bubble

Wednesday, February 14th, 2007

In our previous article, The first step in an economic slowdown?mal-investment in capital, we mentioned that one of the causes for slowdowns in the business cycle is the presence of mal-investments. Mal-investments will eventually have to be liquidated, resulting in a cyclical slowdown of the economy. In that article, we discussed about the structure of capital, which gives rise to the concept of mal-investments, which is unique to the Austrian School of economics. It should be emphasised that unlike other schools of economics, the Austrian School makes a distinction between overinvestment and mal-investment. It is the latter that is of primary concern in Austrian theory. Today, we will look at a real-life example of mal-investments and its effects.

During the dot-com bubble of 1996-2000, the NASDAQ flew from around 1000 to around 5000. Credit for ?investments? were abundant and plentiful. Any stocks related to the Internet were soaring well beyond its fundamentals. Spending on IT projects were mushrooming up everywhere; loss-making dot-com companies were floated; consumer spending, which were fuelled by the monetary print press (and not from sound savings), remained strong; Real-estates in the Silicon Valley sky-rocketed. Indeed, IT investments were running very high.

This is an example of a mal-investment.

Entrepreneurs, as a whole, invested as if all capital goods will be available at their disposal to ensure the success of all their plans. From the hindsight of today, it is clear that this was not true?there were shortages of programmers, network engineers, and technical managers. We recalled the days when a fresh IT graduate, who hardly had any experience and skills on the latest technologies, could fetch a salary of more than AU$50,000! Consequently, all the idealism of wealth through technology crumbled when reality sets in. As many IT start-up companies realised, the cost of staying in business was so prohibitive that eventually, a large number of them had to be liquidated. Today, only a few survivors remained alive. The resulting deflation of the bubble led to a recession (albeit the mildest one ever).

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Posted in Economics/Finance, History | 4 Comments »

The first step in an economic slowdown?mal-investment in capital

Tuesday, February 13th, 2007

In our previous article, The real story behind the phenomena of booms and busts, we mentioned that when the central bank finally raise interest rates, the economy will slow down as ?entrepreneurs will slow down their rate of investments, which means that employees will be laid off, projects cancelled, and cost being cut.?

Why would entrepreneurs have to slow down their rate of investments, which result in an economic slowdown? To answer this question, we have to understand that capital can be mal-invested. The reason why capital can be mal-invested is because it has structure, which is one of the key insights of the Austrian School which is not found in other school of economics.

What is the structure of capital?

Recall that in The myth of financial asset ?investments? as savings, we mentioned that capital goods are ?goods that help in the production of consumer goods?they increase the future productive capacity of the economy.? Capital goods that are directly used in the production of consumer goods are termed ?first-order? capital goods. An example of a first-order capital good is a sewing machine that is used to produce clothing for consumers. Capital goods that are used in the production of first-order capital goods are called ?second-order? capital goods. An example of a second-order capital good is the robot that put together the sewing machines in the assembly line. The third-order capital good are then used in the production of second-order capital goods and so on. Thus, capital goods can be arranged from the first-order up to the higher orders?this is the vertical structure of capital. Capital can also have horizontal structure. Some capital goods are complementary to other capital goods in the production of other goods. For example, computer software and hardware are complementary capital goods. In reality, the capital structure can be more complex?capital goods can play different roles in the horizontal and vertical chains simultaneously and may perhaps function as a consumer good at the same time.

As Ludwig von Mises said in Chapter 20 (Interest, Credit Expansion and the Trade Cycle), Section 6 of Human Action: A Treatise on Economics:

It is customary to describe the boom as overinvestment. However, additional investment is only possible to the extent that there is an additional supply of capital goods available. As, apart from forced saving, the boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in wrong lines, i.e., malinvestment. The entrepreneurs employ the available supply of r + p1 + p2 as if they were in a position to employ a supply of r + p1 + p2 + p3 + p4. They embark upon an expansion of investment on a scale for which the capital goods available do not suffice. Their projects are unrealizable on account of the insufficient supply of capital goods. They must fail sooner or later. The unavoidable end of the credit expansion makes the faults committed visible.

Now, we return to our original question: why do entrepreneurs have to slow down their rate of investments? Based on our new understanding capital structure, it is more accurate to say that entrepreneurs not only have to merely slow down their rate of investments, they may even have to liquidate their investments due to their errors in judgements. As the economy booms, entrepreneurs make plans and invest in the belief that the economy’s capital structure will provide the necessary higher-order and complementary capitals in the future. What happens when capital are mal-invested, leading to an unbalanced structure of capital in the economy? The entrepreneurs’ plans will fail, which mean they will have to liquidate their investments. When that happens en masse, it will result in what we see as layoffs, cancelled projects and so on.

How would this work out in real life? Stay tuned!

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Posted in Economics/Finance | 4 Comments »

What to avoid at the peak of the business cycle?

Sunday, February 11th, 2007

In our last article, Where are we in the business cycle?, we mentioned that we are now probably at the peak of the business cycle. Given that this is the case, how should that affect our investment decisions?

In Peter Lynch?s book, Beating the Street, he wrote:

When the economy is in the doldrums, the professional money manager begins to think about investing in the cyclicals. The rise and fall of the aluminiums, steels, paper producers, auto manufacturers, chemicals, and airlines from boom to recession and back again is a well-known pattern, as reliable as the seasons.

Therefore, cyclical stocks are the ones in which their earnings follow along with the peaks and troughs of the business cycle.

One of the common mistakes that novice investors often make is to extrapolate the past earnings of cyclical stocks into the indefinite future during the turning points of the business cycle. Since the stock market always anticipates the future earnings of companies, cyclical companies will look ?cheap? (i.e. low P/E ratio) during the peak of the boom. This is because the market will have by then factored in the fall in earnings. The key is to identify which types of businesses are cyclical in nature and avoid them during the peaks? turning point. As Peter Lynch said:

When the P/E ratios of cyclical companies are very low, it?s usually a sign that they are at the end of a prosperous interlude. Unwary investors are holding on to their cyclicals because business is still good and the companies continue to show high earnings, but this will soon change. Smart investors are already selling their shares to avoid the rush.

In Australia, the economy has been expanding for the past 16 years already. This current expansion is twice as long as the previous two expansions. Thus, it is very easy for investors to believe that business cycles no longer apply and become complacent as a result. When we see that the stock market is continuously making record highs, as if the boom time will still continue indefinitely, it is time to become wary.

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Posted in Analysis - Stocks, Investor Education | No Comments »

Where are we in the business cycle?

Friday, February 9th, 2007

Yesterday, in our article, The real story behind the phenomena of booms and busts, we asked this question. Today, we will look at the indications of where we may possibly be in the business cycle in Australia (which is applicable to the US as well).First we look at the November 2006 Statement of Monetary Policy from Reserve Bank of Australia (RBA):

What does seem clear, however, from several sources of information, is that the economy is operating with very limited spare capacity.

Clearly, as in the metaphor we gave in What cause booms and busts? Introduction to the Austrian Business Cycle Theory, the bus is running low on fuel i.e. the economy is reaching its limit of productive capacity. This is also the same situation that the United States is facing right now. Further down the statement:

Demand in some sectors has been especially strong over a number of years, reflecting the growth of the domestic and international economies. If firms cannot bring new factories or mines immediately on line when capacity constraints become binding, they may decide to hire more labour to work their existing production processes more intensively. This would lead to strong employment growth, but also a fall in the growth rate of average labour productivity because only relatively modest additional output can be produced by hiring more labour without additional capital.

To cope with the strong demand, businesses are forced to increase output. Unfortunately, the effectiveness of the existing capital stocks in the economy is reaching its limit and the only way to increase production further is to employ more labour and pressure the existing employed workers to produce more. As the statement says, without complementary capital, these extra labours are constrained in its effectiveness in increasing output.

Recently, we read in this news report, Consumer confidence ‘lowest since 2003’, ?dragging sentiment down in the half was a sharp 14 point fall in the quality of life rating to 25.5 points… But (they are) finding it more difficult to achieve due to the demand for longer working hours and more intense competition in the job market.? Anecdotally, many of us are feeling the increasing strain of work. Though Australia may be experiencing the lowest unemployment rate, it comes with a cost at our quality of life. Worse still, according to our personal experience, we can feel that price inflation is more pronounced lately.

With the economy struggling to increase output and the money supply still growing, we can expect price inflation to still remain a threat. But price inflation has been quite benign during the past few years. Why is it so? As in the United States, price inflation has been ?controlled? by importing of goods from China. As we said in The Bubble Economy, the rise of the Chinese economy?s productive capacity has a disinflationary effect on prices worldwide. But such low inflation can only be achieved at the cost of incurring a ballooning trade deficit?our imports exceeding our exports. But make no mistake about it: we cannot always rely on the Chinese to save us from price inflation by blowing out our current account deficit even further. So, the greatest danger to Australia?s economy right now is price inflation. As we said in The real story behind the phenomena of booms and busts, if interest rates persistently remain out of sync from the natural rate of interest for too long, we can run into the danger of hyperinflation.

How can we restore the economy back to equilibrium and ensure that it remains in a firm footing for the future?

The first thing that has to happen is to increase our national savings. As we said in The myth of financial asset ?investments? as savings, we need to restore and rebuild our stock of capital goods to ensure our future prosperity. Already, the quality of our education, health, telecommunication and transport infrastructures are in decline and they are in need of repair and upgrade. This means that the only way we are going to achieve that is to reduce our current consumptions and cut down our debt. When that happens, the economy will slow down and many businesses and investments will fail as a result. Since most of the Australian (and the US as well) is made up of consumer spending, in which much of it is funded by debt, we can see that this remedy will be painful. If the consumers do not slow down and get their act together, we can expect the RBA to impose a restraint by raising interest rates.

Thus, we believe that Australia (and the US as well) is at the top of the business cycle. For investors, we have to bear in mind that we are now probably at the cyclical top. If we assume that the current trend of companies? profit growth will extend indefinitely into the future, we will be in for a nasty surprise.

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