Posts Tagged ‘bust’

Jamming on brakes and accelerator simultaneously

Sunday, February 8th, 2009

A few years ago, we were chatting with our friends on the topic of personal finance and investments. Back then, it was a global financial bull market in which the savings (made compulsory by law in the form of superannuation) of millions of Australians were ploughed into ‘assets.’ Our friend’s attitude is that she will leave it all to the ‘experts’ and ‘professionals’ to invest her savings and would not want to bother herself with it. The prevailing thinking was that, as we described in The myth of financial asset ?investments? as savings (in February 2007),

… there are some who argued that if we include financial asset ?investments? such as home equity, pension and managed investment funds, stocks and so on, the savings rate is actually positive.

As we elucidated in that article, we had strong reservations on this fallacious idea. In essence, many people’s savings were (and still are) thrown into chasing prices of intangible financial assets, which hardly result in real capital formation. By chasing and bidding prices upwards, it gave rise to the illusion that ‘wealth’ had increased when in actual fact, there were no corresponding accumulation in capital goods (see The myth of financial asset ?investments? as savings to understand the meaning of capital goods). The global financial crisis (GFC) is a correction to this grand illusion.

Think about it: Why is it that after the years of ‘prosperity’ (economic boom) the state of infrastructure is so poor and neglected that governments today have to spend billions in nation building to ‘stimulate’ the economy? After all these years of boom in ‘asset’ prices, wealth and prosperity, is that what our nation (including the US, UK and Australia) has to show for?

Where had all the money gone to?

Once you understand the Austrian Business Cycle Theory (see What causes economic booms and busts?), you will be able to see that limited resources in the economy are being mal-invested into wasteful and unproductive use. So, this bust is the period when mal-investments are in the process of liquidation (e.g. deflation in asset prices). Very unfortunately, governments are hell-bent in preventing this liquidation process and at the same time, trying to redirect resources into urgently needed area via central planning.

The governments’ actions are akin to jamming on the brakes and accelerator simultaneously. No prize for guessing what will happen to the car.

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).

Is the world already in recession?

Wednesday, July 30th, 2008

The answer to that question depends on your definition of recession. Sticking to the technical definition favoured by central bankers, the world growth is just “slowing.” But as we argued in Example of precisely inaccurate information,

Now, if the price index is a logically invalid number (let alone accurate), then how accurate will real GDP growth figures be for capturing the growth of output of an economy? If this figure is inaccurate, then how accurate will it be for defining when an economy is technically in recession? In that case, how useful will it be to be so precise in defining the exact point for which the economy is in technical recession?

What about the people on the streets? In a recent interview with Marc Faber at Faber Says Fannie, Freddie Should Split Up, Not Get Aid, he said

I travel a lot as you may know. And I can tell you in the last two months I was around the world twice. Everywhere I ask how is business and business is down everywhere. Everywhere it slowed down very considerably. And it is lower than a year ago. So I suppose you can say the world is in recession already.

One of our contacts in China told us stories about factories being forced out of business due to the falling US dollar and falling US demand. Many of these factories have very low profit margins. One particular factory is currently losing money. Yet, if it closes down, it will lose even more money. Therefore, it is forced to continue production at a loss. This anecdotal evidence is consistent with the numbers and our outlook (see China?s slowdown & its implication for Australia).

What will be the worst case scenario for the world economy? As we said before in June 2007 at Epic, unprecedented inflation,

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!

Marc Faber believes that the end of this universal boom will be a “colossal bust.” As he explained in the interview at Faber Says Fannie, Freddie Should Split Up, Not Get Aid, the worst case scenario is that this colossal bust will be

… with inflation. I think there is a very good chance that we will have bad economic environment but still rising prices simply because we have money printing institutions around the world called central banks.

At the same time, Marc Faber has scathing remarks about Ben Bernanke and the Federal Reserve,

… the Fed is totally ineffective and inept organisation. That has to be said, they don’t understand simple economics. Because Mr Bernanke reads and writes about the Depression years; the difference between the Depression years and today is that commodity prices had peaked out in 1921 and they were in well-established down trend. Today’s situation is that there are 3 billion people are joining the global economy who are eating and driving around more and more and they put pressure on commodity prices. This is an inflationary environment, not a deflationary environment. And if some Fed member does not understand that, then he shouldn’t be at the Fed in the first place.

It looks like Marc Faber is in the long-term inflation camp (see Are we heading for a deflation or inflation? for the quick run-down on the inflation-deflation debate). And we must emphasize the adjective, “long term,” in the previous sentence, just in case others will think that we do not believe deflation can happen.