Posts Tagged ‘government interventions’

Will governments be forced to exit from ‘stimulus?’

Tuesday, August 25th, 2009

Currently, there’s a belief in the financial markets that the worst of the Global Financial Crisis (GFC) is over and that it’ll be blue sky from now on. Indeed, it is possible that the the US economy may see a positive GDP growth in the next few quarters to come.

But here, as contrarians, we see a different picture. As we quoted the Bank for International Settlements (BIS) in Bank for International Settlements (BIS) warning on stimulus spendings, the ‘green shoots’ of growth is largely contributed to government bailouts, ‘stimulus’ spendings, money printing and cheaper money (e.g. zero interest rates in US).

Make no mistake about this: Government interventions cannot be sustained forever without increasing negative consequences in the longer term. Governments cannot ‘stimulate’ the economy. In fact, the word ‘stimulus’ is the most misleading word in economics lexicon because it conveys the idea of a surgeon ‘stimulating’ a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch. The longer the economy leans on the government crutch, the more dependent it will be on the government. Eventually, the government will become the economy. For those who haven’t already, we encourage you to read Preserving jobs at all costs leads to economic stagnation and Are governments mad with ?stimulating??.

Letting the economy lean on crutches indefinitely will result in decreasing economic health as time goes by. Furthermore, there’s always the risk that the side-effects will pressure governments to remove the crutches. As we quoted the BIS in Bank for International Settlements (BIS) warning on stimulus spendings,

Perhaps the largest short-term risk associated with the expansionary policies is the possibility of a forced exit. Monetary and fiscal authorities of the major economies have so far been relatively unconstrained in their ability to follow expansionary policies. This need not last. An extended period of stagnating economic activity could undermine the credibility of the policies in place. Governments may find it hard to place debt if market participants expect the underlying balance to remain negative for years to come. Under such circumstances, funding costs could rise suddenly, forcing them to cut spending or raise taxes significantly.

How will a pressure for a “forced exit” from crutches (bailouts, stimulus, money printing and cheaper money) happen? We can look no further than China as an example where ‘stimulus’ is most effective. As we wrote in Will August 2009 be the top for the year in China?,

Forcing credit growth in this case does not result in economic ?stimulation.? Instead, the result was a dangerous asset price bubble. Apparently, the Chinese government flipped its position and decided to rein in the bubble before it’s too late.

China is right now in a dilemma. Turning the credit tap off will result in many projects failing, which in turn will result in bad debts. Not turning the credit tap off will result in price inflation and asset price bubbles.

The problem with economic crutches is that there will be negative side-effects. It is only a matter of time before excess liquidity leaked into asset and commodity prices. Initially, this may not be a problem. But as we saw last year (see Who is to blame for surging food and oil prices?), this will eventually result in acute problems of price inflation (unless the next deflation pressure comes, for which it will be déjà vu again). If governments decide to withdraw the economic crutches, they risk letting the already weakening economy fall into deflation. If they decide not to withdraw them, they risk letting acute price inflation run amok.

What is likely to happen is that governments will attempt to walk on the middle ground by pretending to ‘fight’ inflation (e.g. raising interest rates too slowly and talk tough on inflation) and support the economy at the same time, hoping that the economy will turn out fine. It may work initially, but it’s a matter of time before the public will see through it.

Tougher times is ahead for everyone.

What will be the impact of government interventions on investing?

Thursday, January 29th, 2009

In our previous article (Are government interventions the first steps towards corruption & inefficiencies?), one of our readers asked,

… I have been wondering what the impact on government interventions will be for investing… What if one was to invest in Blue Chips, with the idea that they are ?too big to fail? (gov. intervention likely) and are therefore very safe?

He had brought a very good point.

Let’s say you have very strong reservations regarding investing in Australian banks (see How safe are Australian banks?). Based on your own assessment of the fundamentals, you make the decision not to invest in banks (if you are a trader, you may decide to short the banks). But then, you receive some tips from banking ‘insiders’ that the recent flight out of bank stocks is a fantastic buying opportunity. You are told that bank shares are so cheap that you will make a lot of money in a few years time if you buy them today. Naturally, you laughed at those ‘insiders.’

But they were right.

A few years later, they end up laughing at you instead. Let’s suppose that your fundamental analyses of the banks are correct. So, what went wrong?

Government intervention.

As we said before in Are government interventions the first steps towards corruption & inefficiencies?,

They [bailouts and rescues] 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?

So, in your case, the government bailed out the banks (which is happening right now in the US and UK) in such a way that shareholders are protected. If you are a trader, shorting the banks will lead to heavy losses.

From this example, you can see that when government intervenes, the market is no longer completely free. When the market is no longer completely free, it means that the rules change abruptly in the middle of the game. When that happens, those who ought to lose become winners and vice versa. Incompetency is rewarded and competency is punished (indirectly through taxes).

Imagine, what will happen if there’s a soccer match whereby the umpire is allowed to change the rules abruptly any time he wants? In such a world, it’s either that bribery will abound or no one wants to play the game. The same goes for the economy. A half-free market will discourage the capitalists and entrepreneurs and encourage cronyism, corruption and speculation.

That’s one of the reason why in such an environment, the Warren Buffett way is dead. That’s why Marc Faber said this is a traders’ market. It’s possible that we will see Warren Buffet’s long-term track record flounder in the years ahead.

Government intervention leading to more risk for banks?

Tuesday, December 23rd, 2008

Back in How do you define risk?, we wrote,

In today?s financial services industry, a large part of risk is defined by the volatility of the price?the more volatile the investment is, the more ?risky? it is.

Also, as we wrote in Real economy suffers while financial markets stuff around with prices,

Right now, deflationary forces are acting on the economy while at the same time, central bankers and governments are attempting to inflate. Consequently, the result is extreme volatility in prices. Volatile prices hinder business calculations, which in turn hinder long-term planning.

Paradoxically, government interventions, for all their good intentions, are making the situation worse by introducing unintended consequences into the global financial system. For example, in the case for banks, Satyajit Das wrote in Fear & Loathing in Financial Products: Banks – The ?V?, ?U? or ?L?,

Risk models in banks are a function of market volatility. The low volatility regime of recent years reduced the amount of capital needed. Increased market volatility will increase the amount of capital needed. This may restrict the level of risk taking and therefore earnings potential.

Everything else being equal, the increase in the amount of capital needed implies a reduced availability and amount of credit to the real economy. This in turn will have an effect on economic activity.