Posts Tagged ‘GFC’

Why is the modern economy so dependent on ever-lasting growth?

Tuesday, August 11th, 2009

Have you ever wonder why economists and policy makers are so obsessed with economic growth? Why is it such an acute problem if the economy is not in a treadmill of growth (i.e. ever-lasting increase in the quantity of goods and services produced)? What is so bad with zero economic growth (i.e. an economy that takes it free and easy)?

As one of our readers wrote in our previous article,

This is all to say that the [modern capitalist] system is much more fragile than anyone would have guessed and that the cult of markets and efficiency have left the world with a system that is less and less resilient. The crisis that has begun over the last couple years begins to bear that out. In fact we’ve become dependent on efficiency and without it the system may just fail under it own weight. Time will tell but the process has begun.


We believe the root of the problem lies in the monetary system. Today, we have a monetary system that is at its heart a system of credit. That is, the ‘money’ that flows around the system is loaned out of existence. To understand what this means, read on…

Originally, mankind started with commodity money. Money was a physically tangible thing. In the 15th century, Spain found gold in the New World. As gold was money back then, Spain found a lot of money and became ‘rich’ as a result. Today, most of our money has become virtual, intangible and in the form of electronic information. The overwhelming values of transactions are made in the form of electronic fund transfers instead of exchange in physical paper cash.

Now, think of your cash at bank- it is an asset to you and a liability of the bank. Say, when you make a non-cash purchase (either with cheque, credit card, bank transfer, etc), that transaction ultimately becomes a transfer of liability from one entity to another. This text-book idea implies that assets have to exist first before it can be loaned out as someone’s else’s liability.

The real world does not conform to this text-book idea: liabilities are created by banks first (in the form of loans) before the assets exist (we recommend you read Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model if you need a deeper understanding). After the liabilities are created out of thin air, the bank then go hunting for the assets by borrowing from another entity (e.g. central bank, depositors, another bank, investors, etc). Ultimately, either directly or indirectly, that asset (currency) originates from the central bank.

The central bank is the only institution that can create assets (currency) out of thin air to be loaned out as liabilities. Imagine you are a central bank- all you need to do is to declare $100 into existence, lend it to the banking system and then have the power to demand that the money (which you created out of thin air) to be paid back to you at an interest rate that you decide.

The observant reader will then be asking this question: “If the entire economy pays back all the currency that was borrowed into existence, but still owes the interest, where does it get the currency to pay the interest?” The answer is startling simple: more currency has to be borrowed into existence to pay back the original interest!

Now, you can see that total debt in the economy will grow exponentially (compounded interest) continuously and can never be repaid fully. That means the economy has to grow continuously in order to generate the income to pay back the continuously growing debt. Since the physical world has a finite quantity of resources, the quantity of goods and services produced in the economy cannot always grow fast enough to match the continuously growing debt. Therefore, the only way to keep the system running is to add in price inflation (growth in the nominal value of the goods and services produced) so that the nominal value of the continuously growing debt can be repaid. That’s why, as our reader observed, the “cult of markets and efficiency” in the modern capitalistic economy is there by necessity to keep the economy growing continuously.

For the past decade, total private debt is growing at a speed far in excess of GDP growth (i.e. growth in income). For a while, it seemed sustainable because asset prices (most notably, house prices) were rising fast enough to keep the financial system solvent (i.e. able to pay back the continuously growing compounding debt in nominal terms). As you can see by now, if asset prices stops rising in the context of adequate economic growth, the game is over. That game-over situation is what we all know as the Global Financial Crisis (GFC).

The GFC trigger the economic phenomenon called deflation. Once the debtors (e.g. banks, households, businesses) become insolvent, they can cause their creditors to become insolvent, who in turn threaten the creditors’ creditors with insolvency. This systemic debt defaults will now reverse the debt growth, which means the currencies that are loaned into existence will be written off into non-existence, which means money supply will shrink, which in turn will cause vast tracts of the economy to shave off its productive capacity (e.g. unemployment, idle factories, excess capacity).

If the economy is not expected to grow sufficiently and the government wants to keep the wheel running, what would they do? The only course of action is run the money printing press (i.e. create currencies out of thin air, pump them into the system for free). The risk is that without a properly growing economy, they risk igniting another asset price bubble. An asset price bubble may seem to ‘work’ because they can keep the system solvent for a while, until the bubble burst and restart the deflation nightmare again. The government will then have to start the monetary printing press again while the economy shaves its productive capacity the second time. If this process is repeated umpteen times, it will come to a point whereby the only thing to keep the system running is rising asset prices and not economic growth. When that happens, it is hyperinflation.

The current asset price rebound around the world is the stage where rising asset prices are keeping the debt wheel running. We don’t know how long that gig will keep running.

Is the GFC over? And what about the recession?

Sunday, August 2nd, 2009

In our previous article, we wrote about the coming looming disaster that will eclipse the Global Financial Crisis (GFC). This prompted one of our readers to ask,

Editor, you believe that the GFC is over?

What about the recession?

We realise that there’s plenty of room for misunderstanding regarding our stand on the GFC. So, we are writing this article in the hope that all misunderstandings will be clarified and also provide a road map to help you understand the big picture.

First, we believe that 2007 will be the year of peak prosperity in the real economy. The decade leading to 2007 was indeed a time of euphoria for many. It is a time of low price inflation, thanks to the massive ramp up of China’s industrial productive capacity, flooding the world with cheaper and cheaper Chinese made products. It is also a time of low interest rates (thanks to Alan Greenspan) and cheap credit (thanks to the advances in ‘innovation’ from Wall Street). Consequently, through the current account deficit of the US, the world was flooded with liquidity to send a high tide of ever-rising asset prices. As we wrote back 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! Today, even artwork is also in a ?bull? market (if you consider artwork as an asset class)!

All these confluence of factors made the world go merry in drunken excesses. But unbeknown to most except the contrarians, the rot was already setting in (see our guide, What causes economic booms and busts?).

Then, as we all know, the GFC struck. Our long-time readers are certainly not caught by that- they’ve been warned as early as January 2007 at Spectre of deflation. The panic culminated in the Panic of 2008 (which ended with a final low in March 2009).

Currently, emboldened by the ‘green shoots’ of recovery, there is another powerful rally in stocks and commodity prices all over the world. Optimism returned, speculations returned and confidence turned up again.

So, is the GFC over?

It depends on what you mean by GFC and which part of the world.

If by “GFC” you mean another panic in scale and intensity as the Panic of 2008, then we believe it is ‘over’ (notice the quotation marks). Statically, the Panic of 2008 resulted in a more oversold condition than the 1987 and 1929 crash. That is, the selling pressure was worse than 1929 and 1987. Therefore, based on statistical probability, another panic that is worse than the Panic of 2008 is unlikely to return for quite a while yet.

Does that mean stock prices will never revisit the March 2009 lows? That depends on how successful the Keynesian reflation attempts (government stimulus, printing of money, bailouts, etc). If deflationary pressures gains the upper hand against governments’ reflationary efforts, then stocks can still drift lower to below the March 2009 low in say, a couple of years time. In such a scenario, this current “green shoots” rally will certainly meet with a major correction- currently, prices are at extremely overbought territory. After that major correction, then can be a counter-rally, than correction than counter-counter-rally (i.e. a saw tooth movement) until the ultimate low. If March 2009 turns out to be the ultimate low, we may end up with indecisive whipsaw movement for quite a while. The stock market may end up hyperinflating if governments are too ‘successful’ (see Can we have a booming stock market with economic calamity?).

So far, we are focusing on the financial markets. The real economy, on the other hand, will continue to grind down slowly, thanks to never-ending government stimulus (see Are governments mad with ?stimulating?? and Preserving jobs at all costs leads to economic stagnation). It is unlikely to fall off the cliff in the same manner as during the Panic of 2008. We remembered someone saying that had the real economy continue to deteriorate that way (i.e. fell off a cliff), the world will return to the stone-age in a few decades time. As the real economy grinds down, we expect price inflation on the street will continue to make life more difficult.

Now, can you see that asset prices in the financial markets and the real economy are walking on two different independent tracks? This observation has yet to be noticed by the mainstream. Many investors still think that rising asset prices imply a recovering economy and falling asset prices imply a deteriorating economy. As we have taken great pains to point out to our readers, asset prices and conditions in the real economy can go in opposite direction (as they are doing right now) for an extended period of time. We are more certain of what will happen to the real economy than what will happen to asset prices.

So, what follows next? We will continue this story in the next article. Keep in tune!

Will China fall under popular revolt?

Wednesday, May 20th, 2009

There is no doubt that the Global Financial Crisis (GFC) has hit China very hard. As reported in China’s Way Forward,

Idle factories, moored container ships, widespread bankruptcies, massive migration back to the hinterlands, strangely clean air?the signs of depression are everywhere in China. Because it makes so many of the goods the world isn?t buying now, China stands to be worse hit than the rest of the world ?just as America was during the Depression, when it was the world?s sweatshop.

There is a school of thought that believes that if the Chinese government is not able to maintain economic growth, then the government will lose legitimacy in the eyes of the people and there will be political upheaval as a result. The extreme views in this school of thought even envisage the break-up of China by comparing it with the Soviet Union. As that article says,

Its unspoken premise is that average Chinese people just barely tolerate the social bargain the government now offers?limited freedom, potentially unlimited wealth. So if the regime ever falls short on its material promises, the deal will be off and people will rebel.

But as this article noted, this school of thought do not understand the cultural and political reality of modern China. In the 20th century, China suffered civil wars, foreign invasions, tyranny, human-induced starvation (Mao’s Great Leap Forward). It was only more than 30 years ago that the brutal Cultural Revolution ended. To put it simply, the tremendous sufferings of the Chinese people are still recent memories. As one Chinese businessman said during a documentary TV interview, the prosperity of today’s China seems like a dream to him as it was only recently that he was living in relative poverty.

No doubt, the wealth gap in China has much to be reduced and there are many endemic issues yet to be solved (e.g. inequality, corruption, uneven economic growth, environment, pollution, lack of political freedom, etc). But relative to what the Chinese people had to endure during their recent past, their lives have improved tremendously. As that article said,

People doing routine jobs have been through great hardships and dramatic swings of fate. Last year I interviewed a party official in Shanxi province who was laying out his regional-development plans. Every 10 or 15 minutes, he would stop and say (through an interpreter), ?Do you understand? If it had not been for Deng Xiaoping, I would be behind an ox in a field right now. I would not be sitting here wearing a necktie and talking to a foreigner.? Or, ?Do you understand how different this is? My mother has bound feet!? A scholar I know in Beijing once offhandedly remarked that he had developed self-confidence when learning that he could survive for four years as a teenager on a labor gang during the Cultural Revolution. People in their teens and 20s were not on the labor gangs?kids today!?but they have heard the stories.

From this perspective, the ‘economic depression’ caused by the GFC is hardly worth a mention compared to the sufferings even 30 years ago. Despite the discontent and protests of many Chinese, the object of their fury is usually not against the ‘system.’ As that article said,

But when people complain, it is usually about those crooked bosses, reporters, mayors, or bureaucrats?not about the system or its rulers. Principled protests against the system and its repression certainly do exist, as with the daring ?Charter 08? petition for civil liberties signed by more than 300 intellectuals late last year. But that is not the norm.

Perhaps these workers are missing the big picture, but for now they generally act as if they expect the national system to protect them against lapses at the local level.

Thus, if the Chinese economy still has much room to deteriorate, we doubt there will be any mass revolts that will fracture China.

Are government interventions the first steps towards corruption & inefficiencies?

Tuesday, January 27th, 2009

The global financial crisis (GFC) has seen governments all over the world engaging in stimulus, special plans, guarantees, rescues, bailouts, nationalisation and other forms of interventions. The Australian government is no different. The first was the guarantee of all Australian bank deposits and loans. Next was the AU$10 billion economic stimulus. Then recently, there was a plan to set up a special purpose fund to help banks refinance as much as AU$75 billion worth of loans. Other plans include help for certain industries (e.g. car, construction, child-care, property sectors) cope with the global shortage of money (credit crisis). In addition, the Reserve Bank of Australia (RBA) is busy cutting interest rates. In the US and Britain, massive banks and GSEs were gobbled up through nationalisations while their limping peers have their incompetence covered by the monetary printing press. As Australia approaches a hard landing (see Realisation of hard landing ahead for Australia), we can expect what happened overseas to happen in Australia.

Among the various forms of government interventions, we have the strongest reservations against bailouts and rescues. While they ease the pain in the short term, they are detrimental to the economy in the long term. While the sting of this GFC may be soothed by each government intervention, there will always be longer term side-effects, many of which will be unintended and initially unforeseen. All these unintended side-effects will eventually accumulate and turn the GFC into a long-term economic malaise that result in a bleak future for the next generation. In other words, anyone who is concerned for the next generation will have strong reservations for today’s bailouts and rescues.

Here are some of the issues with bailouts and rescues:


They are inherently unfair because the government will have to act as the judge and decide which businesses/industries should live and which ones should die. Unfairness, by its very nature, implies preferential treatment. What is the government’s basis for favouring one business/industry over the other? Due to the ’emergency’ nature of bailouts and rescues, transparency over such government decisions will be in short supply. This will open the door for corruption as lobby groups and vested interests jostle and fight over the government’s preferential treatment. This is not to say that the current government is corrupt. Instead, our concern is that this will open the door for future governments to be corrupt.

Moral hazards

Bailouts and rescues introduce moral hazards because by not letting the free market punish incompetent, reckless and stupid business behaviours, they are making conditions ripe for more of such nonsense to continue. After all, why bother be good when bad behaviours are not punished?

The whole point of free market capitalism is to let the incompetent businesses be eliminated so that the competent ones can take over the incompetent ones and be rewarded. This competition forces the survival of the fittest and most efficient. By bailing out and rescuing, the government is taking precious economic resources (which is scarce in such a time) from the competent (via taxes) and awarding them to the incompetent. The net result is that the economy as a whole will become more and more inefficient. This is precisely the reason why communism ultimately fails.

Now, there are talks of the need for more government regulations to curb such nonsense in order to prevent future financial crisis. The idea is to bailout and rescue first, then come up with more rules and regulations to ‘prevent’ another global financial hazard from happening again.

The problems with rules and regulations are:

  1. Administering, monitoring and enforcing them are costly. They are a drag on economic growth as they introduce more red tape for businesses to handle.
  2. Rules and regulations may be so effective that while they prevent the bad things from happening, they cab also stifle the good things from bearing fruit too. Those entrepreneurs with brilliant ideas who have to battle government red tape to get their projects moving another step forward can relate to that.
  3. As we said before in Where do we go from here? A journalist?s questions…,

    … 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.

    Rules and regulations can only work up to a certain extent because beyond that, it is impossible to legislate morality.

  4. No matter how tight and comprehensive rules and regulations are, there will always be loopholes and gaps to allow circumvention. For example, as Satyajit Das revealed in his book Traders, Guns & Money, derivatives routinely make a mockery out of laws. It has come to a point that poking holes at the legal system via derivatives has become a sport!

As we quoted Jimmy Rogers in Jimmy Rogers: ?Abolish the Fed?,

More regulations? You want Alan Greenspan and Ben Bernanke? These are the guys who got us into this situation. They are supposed to be regulating the banking system for the past 50 years. These are the guys who let it all happen. I don?t want more regulations. Let the market regulate it. If xyz needs to go bankrupt, let them go bankrupt. I promise you, that will send a very straight signal and you will have a lot of self-regulation when these guys start to go bankrupt.

If the Federal Reserve did not bail out LTCM in 1998 and let it go bankrupt instead, it would have sent a very strong signal to the market back then.


One day, the GFC will end. But this generation will leave a legacy of corruption and inefficiency for the next if today’s governments continue to intervene in such an unprecedented scale.

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.

Global Financial Crisis (GFC) is real in China

Tuesday, January 13th, 2009

In our previous article, Visit to Shanghai- observations, we promised to reveal more about the insights on the Chinese economy from the conversations we have with the locals in Shanghai.

In all the meaningful conversations we had with the locals, we were asked whether Australia is affected by the Global Financial Crisis (GFC). Those people whom we talked to are just normal everyday folks across different walks of life. Chinese President, Hu Jintao, in his new year speech, mentioned about the challenge China faces with the GFC. The local newspaper talked about the Great Depression of the 1930s. Indeed, there are real concerns about the GFC among the Chinese people.

There are anecdotal evidences that the GFC is hitting the real economy in China. We learnt that freshly graduated university graduates in China are having trouble finding jobs. Although the government is encouraging them to start business enterprises, we doubt many can make it through successfully without any experience. One career woman even had to put her ambitious career plans on hold due to the GFC. Another expressed her opinion that this GFC is not one that can be over in just a few years- i.e. it is so serious that it can drag on for much longer than that.

Although the GFC is hitting the Chinese economy hard, we could feel from the streets that economic activity was still much ‘hotter’ than Australia. The reason is because of the sheer size of the population in China. We were told that the number of registered residents of Shanghai is 17 million. We guess if you include the unregistered residents, the population of Shanghai could easily exceed 20 million. Imagine cramming the entire population of Australia into one city! Thus, the colossal size of the population in China means that there will always be colossal amount of economic activity relative to tiny countries like Australia. On the flip, this means that any problems will be colossal as well.

The most interesting conversation we had was with a retiree. The question was, will China succeed in navigating its way out of this economic crisis? That retiree had his own opinion which he reckoned many foreigners have yet to fully appreciate. This insight will require another piece of article. So, keep in tune for the next one!