Posts Tagged ‘Ludwig von Mises’

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Does rising house prices imply a housing shortage?

Thursday, August 27th, 2009

There is a common argument that Australia has a housing shortage because prices are rising. The flawed reasoning goes like this: “Under the ‘irrefutable’ law of demand and supply, if prices rise, it must be due to demand outstripping supply i.e. shortage situation.”

This flawed reasoning has its roots in the mainstream Neo-Classical school of economic thought. Under this school, the market is assumed to be in equilibrium. As we wrote in Soft landing hope built on faulty framework assumptions

But this is a very erroneous assumption built into the framework of mainstream neo-classical economic thinking. Does the economy always have to return to equilibrium the way an elastic band spring back into its previous relaxed state? Can there be other forces that can pull the economy further and further out of equilibrium until a breakdown occurs?

In Neo-Classical reasoning, equilibrium is when the supply curve meets the demand curve. If prices go up, and the market has to be in equilibrium as assumed, then it has to imply that the supply curve had shifted left and/or demand curve had shifted right. Subsequently, prices had to rise to ease the demand-supply imbalance. With rising prices, many of these housing ‘experts’ then go hunting for reasons (that suits their vested interest) to explain the ‘shortages.’

In the real world, the market need not necessarily be in equilibrium. In fact, it can go out of equilibrium and remain so for an extended period of time, independent of the housing shortage/surplus situation. In Australia’s housing market, we have identified two major factors:

Price rise expectation
The first factor is price inflation expectation. As we quoted Ludwig von Mises in What is a crack-up boom?

He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief: accordingly he restricts his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding.

This observation is true for generic commodities that can be purchased with cash alone- in contrast, houses are almost always purchased with debt. The belief that prices will always go up forever and ever can create its own artificial demand. The insidious thing with this belief is that it is a self-fulfilling prophecy- belief leads to increased ‘demand,’ which in turn leads to higher prices, which reinforced the belief, which in turn leads to increased ‘demand’ and so on and so forth. When this happens, higher prices lead to even higher ‘demand.’ Such artificial demand can act as a sink-hole for whatever quantity of supply until money runs out in the financial system (which is not possible under today’s a fiat credit system). The Dutch Tulip Mania (which burst in 1637) is an example of the power of belief. Indeed, there must a ‘shortage’ of tulips at that time, according to Neo-Classical supply-demand ‘fundamentals.’

This is the same dynamic working in hyperinflation, where everything (not just houses) rises in prices. It was just last year that there’s talk of food shortages (see Who is to blame for surging food and oil prices?). Today, we hardly hear of food ‘shortages’ after deflationary Panic of 2008.

Availability of credit
As we all know, almost everyone borrow money to buy houses. Very few buy them with cash. What if banks decide to withdraw all credit in the economy? Obviously, people’s purchasing power of houses will fall as they can only rely on their cash savings to buy houses. Consequently, the ‘demand’ for housing will collapse immediately. As we said before in Another faulty analysis: BIS Shrapnel on house prices,

Where is the housing ‘demand’ going to come from as credit becomes more expensive? The only way for most people to buy a property is to borrow money. If credit becomes more expensive (i.e. harder to borrow money), obviously the ‘demand’ for properties will fall as well.

Conversely, when there’s more and more easy credit are available, more and more borrowed money can be used to bid up house prices. This can go on until the debt servicing burden becomes too big to bear.

How the two factors interact with each other
People’s expectation that prices will rise (abetted by belief that there’s a housing ‘shortage’) will lead to higher prices. Unlike the Dutch Tulip Mania of the 17th century, today’s financial system can spew out more and more credit continuously (see Marc Faber vs Steve Keen in inflation/deflation debate- Part 1: Steve Keen’s model). This means that self-reinforcing artificial demand can be fuelled by more and more credit, which helps prices to rise.

Then, through the principle of imputed valuation, increase in house prices at the margins will result in every other house to be re-valued upwards. As we said before in Spectre of deflation,

One thing many people fail to understand is that values of financial assets can vanish as easily as they are created in the first place. It is a fallacy to believe that just because money has to move somewhere from one asset class to another, the overall valuation in the financial system cannot contract. The very fact that all the money in the world cannot buy up all capitalisation is proof of that fact. This leads us to the next question: how do financial assets derive their value?

As we mentioned in The Bubble Economy, we have to understand the principle of imputed valuation. Suppose you have a house which you bought for $100,000. What happens if one day, your neighbour decide to sell his house (which is similar to yours) for $120,000? When that happens, your house would have to be re-valued upwards to $120,000 even though you had done absolutely nothing. The same goes for stocks. All it needs for a stock to increase in value is for a pair of buyer and seller to transact at a higher price. As long as the other shareholders do absolutely nothing, that higher price will be imputed into the values of the rest of the stocks. Thus, when asset values rise, all it takes is a handful of them to trade at higher prices in order for the rest to be re-valued upwards. If assets can ?increase? in value that way, it can ‘decrease’ in value that way too.

What is more worrying is that assets of such imputed values are used as collaterals for further borrowing, which becomes the borrower’s liability.

When the values of the houses sold at the margins are imputed to the rest of the houses, it result in higher valued collateral for more granting of even more credit. More credit adds another round of self-reinforcing feedback loop.

Pre-requisites for a substantial house price fall in Australia
All we need for house price to fall substantially in Australia is (1) a reversal of house price rise expectation and/or (2) tighter credit and/or critical mass of debt servicing failure (which can be caused by rising unemployment- see RBA committing logical errors regarding Australian household finance). When that happens, the self-reinforcing feedback loop for higher prices will become a self-reinforcing feedback loop for lower prices.

Look at UK…
There are many ‘experts’ who argued that house prices are falling in the US due to ‘over-supply’ and that Australia’s housing ‘shortage’ will prevent a house price fall. These experts conveniently failed to look at the UK. Just do a Google search on “housing shortage” site:uk and you will find many reports of a housing ‘shortage’ in the UK too.

We all know what happened to the UK housing market.

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Posted in Economics/Finance, Property | 22 Comments »

Demand for money, inflation/deflation & its implication

Tuesday, December 2nd, 2008

Two years ago, we first covered the root cause of inflation in Cause of inflation: Shanghai bubble case study:

The mainstream economists? definition of inflation is rise in the general level of prices. However, according to the Austrian School of economic thought, the definition of inflation is the increase in the supply of money, in which the effect is the rise in the general level of prices.

As we have shown in yesterday’s chart in Australian money supply growth in September 2008, the supply of money in Australia had gathered momentum in the month to September 2008. In 12 months, the M3 money supply increased by 19.5%. The narrower definition of money, M1, increased by 8.3%. Does this mean that Australia is going to face runaway price inflation soon?

As a general principle, in the long run, there is a relationship between sustained monetary inflation and price inflation. In the same way, there is a relationship between a long-term lifestyle of eating excessive junk food and ill-health. In the interim, this relationship is more complicated. Using the junk food analogy, say that junk food eater dies of heart disease. What is the cause of death? Is it the heart disease? Or is it his sustained junk-food life-style?

Back to inflation, it is certainly possible to see continuing monetary inflation and slowing price inflation. In the US, the latest CPI figure even hinted of a price deflation! Therefore, in the short-term, there may not be a correlation between monetary inflation and price inflation. Part of the problem lies in the nature of how price inflation is measured and defined. As we said before in How much can we trust the price indices (e.g. CPI)?, price indices is a logically invalid idea. The implication is that it is possible to ‘define away’ price inflation and pretend that it is not a problem by torturing the statistics.

But setting aside the logical validity of price indices, what other dynamics is involved that can result in such non-correlation in the short-term? We will introduce one such dynamic- demand for money. This dynamic should not be confused with demand for credit. In lay-person’s terms, the demand for money is the desire for people to keep cash balance. As we wrote in The mechanics of deflation- increase in demand for holding cash,

Deflation happens when liquidity dries up. This can happen in a period of severe economic pessimism when the apprehension of the future drives people to increase their holdings of cash for the sake of peace of mind. When that happens, the quantity of money in circulation decreases, which means there are fewer money chasing after a given amount of goods and services. Consequently, prices have to decrease to accommodate for the decreased supply of money in circulation.

Let’s say the quantity of money increases in the system. But if people want to increase their holdings of cash due to fear and uncertainty of the future, they will withdraw these cash from circulation in the economy. Consequently, prices fall. As we wrote,

When deflation mentality gets a stranglehold on to the minds of the people, no one will dare to borrow money out of fear. Also, when prices are falling, the money that one borrows will be worth more by the time the debt is due. There is no point in spending money because if one waits a little longer, prices will fall further. Central bankers can print as much money as they can, but in such a deflationary environment, no one will want to borrow them.

Today’s credit crisis is an example of this. Banks are hoarding cash and are unwilling to lend while borrowers are repaying debts with every scraps of cash that they can get their hands on. As a result, liquidity dries up in the system even though the supply of money is desperately increased by the central bank. In such a situation, some broader measures of money supply will be shown to decrease.

The opposite can also occur. As we quoted Ludwig von Mises in What is a crack-up boom?,

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ?real? goods, no matter whether he needs them or not, no matter how much money he has to pay for them.

In such a situation, the demand for money collapses. People want to keep their cash balance as low as possible as they constantly want to get rid of their cash for ‘stuffs.’ In the extreme case (i.e. hyperinflation), prices rise by the hour as people rush out to buy things the moment they are paid their wages, for fear that if they do not do so, price inflation will render their cash worthless.

Now, let’s look at what’s happening in the world. Merely 6 months ago, when oil prices was threatening US$150 and soaring food prices was driving people in poor nations to riots, the fear was price inflation. Today, with oil prices below US$50 and hardly any news on food prices, the fear is price deflation. Such extreme volatility is unprecedented in the history of humanity. It is this volatility and madness in prices that will wreck the real economy in the longer term (see Real economy suffers while financial markets stuff around with prices).

Where is the source of such extreme volatility?

As you may have already guessed by now, governments and central banks, in their attempt to solve the global financial crisis, is creating all these volatility through their interventions against the free market. Ironically, their ‘solutions’ are sowing the seeds of economic hardships for the next generation.

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Posted in Economics/Finance, Looking Forward | 11 Comments »

What is your personal price inflation rate?

Thursday, October 23rd, 2008

Yesterday, we read this news article, Inflation spike erodes savings,

With [Australia’s] inflation running at 5 per cent, savers will struggle to preserve the value of their finances due to sliding bank deposit rates.

Inflation is also running high in the rest of the Western world. Worse still, many of the official measurements of inflation run counter to personal experiences. In fact, official statistics are so often doctored up that some entrepreneur came up with a business (Shadow Stats) that “exposes and analyzes the flaws in current U.S. government economic data and reporting, as well as in certain private-sector numbers, and provides an assessment of underlying economic conditions, net of financial-market hype.” For example, if the pre-Clinton era CPI is used to measure today’s US inflation figures, it will come up with figures that are twice the official ones!

Anyway, the entire idea of price indices is logically invalid. It is a number that is the work of many arbitrary decisions. As we quoted Ludwig von Mises in How much can we trust the price indices (e.g. CPI)?,

If she [a judicious housewife] ?measures? the changes for her personal appreciation by taking the prices of only two or three commodities as a yardstick, she is no less ?scientific? and no more arbitrary than the sophisticated mathematicians in choosing their methods for the manipulation of the data of the market.

Today, we would like to hear from our readers. What is your personal experience with prices over the year? Do you think the official 5% figure accurately reflects the rising cost of living in your personal life?

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Posted in Economics/Finance | 16 Comments »

What is a crack-up boom?

Sunday, June 22nd, 2008

In our previous article, Are we past the first stage of a crack-up boom?, we explained that much of the ‘prosperity’ that the Western world (more specifically, the English-speaking nations) experienced over the past several years was an illusion of monetary inflation (see our guide, What is inflation and deflation? to understand the true nature of inflation). As we are entering the second stage of the crack up boom, we must, as investors, learn how to read the economic signs.

So, for today’s article, we will turn to Chapter 9 of Human Action: A Treatise on Economics by Ludwig Von Mises. First, we will begin with a self-evident axioms and then work our way up to the more complex economic phenomena:

The deliberations of the individuals which determine their conduct with regard to money are based on their knowledge concerning the prices of the immediate past. If they lacked this knowledge, they would not be in a position to decide what the appropriate height of their cash holdings should be and how much they should spend for the acquisition of various goods. A medium of exchange without a past is unthinkable.

Clearly, some people may say this is laughingly obvious. But this is just the beginning of the economic method from the non-mainstream Austrian School of economic thought. Next, having established this self-evident axiom, we move on to the next axiom:

He who believes that the prices of the goods in which he takes an interest will rise, buys more of them than he would have bought in the absence of this belief: accordingly he restricts his cash holding. He who believes that prices will drop, restricts his purchases and thus enlarges his cash holding.

If you hear the boring and meaningless talk of central bankers, this will be what they call “inflation expectation.” Central bankers are desperate to control “inflation expectation” of the masses. Obviously, if the masses expect price inflation, then they will reduce their cash balance and buy more things to pre-empt it. There is an old-fashioned word for this: hoarding. Hoarding often exacerbate the economic rot (see Connecting monetary inflation with speculation).

As we can all observe, the ‘boom’ of the past several years was possible because of the low price inflation expectation that was made possible by the rise of Chinese manufacturing. As Ludwig Von Mises continued,

As long as such speculative anticipations are limited to some commodities, they do not bring about a general tendency toward changes in cash holding.

As long as speculative anticipations are limited to property (see The Bubble Economy) and stocks (e.g. the booming record highs on the ASX 200 just before November last year), the masses are generally comfortable. In fact, we argue that this make the masses (e.g. individuals with their property ‘investments’ and businesses with the ridiculous amount of borrowing) more reckless with regards to their cash holdings. The sub-prime crisis and the credit crunch is a fine example of the consequence of the widespread underpricing of risks in the global financial system.

The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services, as has been shown, at different dates and to a different extent.

This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation

As we said before, at this first stage, the masses were fooled into thinking that the asset price inflation was ‘prosperity’ and they failed to understand that the underlying cause was actually monetary inflation. During that time, prices have not yet fully adjusted according to the increase in the supply of money and credit.

There are still people in the country [world] who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services.

Today, the masses are slowly getting more aware of this price revolution. It may not be that clear for the fortunate few in Australia, but for the millions of poor starving Asians, Mexicans and Indians, this price revolution screamingly obvious.

These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.

We are at the crucial point whereby the masses are gradually losing hope that prices will one day stabilise and fall. In other words, using central bankers’ talk, inflation expectations are in danger of getting entrenched. This is the greatest fear of Ben Bernanke and all his other accomplices in the other central banks. The last stage of inflation occurs when:

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ?real? goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.

As we can hear very often in the media, high oil prices are blamed on speculators and the rising demand of China and India. There are fundamental supply and demand factors for the rise in oil prices. But oil price speculation is a sign that some among the masses are waking up to the fact that inflation is still an ongoing policy. Since oil (and we can say commodities in general) is a major root input cost for much of the activities that are going on in the global economy, it will soon result in consumer price inflation. Sustained consumer price inflation will be a very clear signal to the rest of the masses that inflation is a deliberate policy. When that happens, the die is cast. As Ludwig Von Mises wrote,

It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last.

What is the only way to avert hyperinflation? Very unfortunately, the only way is to abandon inflation as a policy (i.e. raise interest rates aggressively), which will be devastating to the credit market and worsen the credit crunch. The outcome will be severe deflation. When that happens, the word “depression” will appear in the media continuously. Do you think the masses will opt for a painful cleansing voluntarily? As we said before in A painful cleansing or pain avoidance at all cost?,

Even if Ben Bernanke is an Austrian economist, political pressure alone will do the job of forcing him to act otherwise. This is the Achilles? heel of democracy. The mob will scream at the Fed to bail them out by ?printing? money (i.e. pump liquidity into the economy in the form of cutting interest rates). Should the Fed refuse to comply, we can imagine the mob storming the Federal Reserve to demand the head of Ben Bernanke. Therefore, the Fed will have no choice but to acquiesce to the desire of the mob, whose aim is to avoid immediate pain as much as possible.

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Posted in Economics/Finance, Looking Forward | 15 Comments »

Are we past the first stage of a crack-up boom?

Thursday, June 19th, 2008

Around 15 months ago (when we first wrote Have we escaped from the dangers of inflation?), there are many people who believed that the world was in an unprecedented boom and prosperity. Indeed, many economists called this the “asset-driven growth.” The truth is that, this boom was nothing more than inflation in disguise (see Myth of asset-driven growth written in January 2007). As long as price inflation was conveniently confined to asset prices, no one complained. In fact, the masses loved it because it made them feel rich. However, the ‘prosperity’ that those in the West enjoyed was an illusion. Back then, while the Western masses enjoyed soaring asset prices and benign price inflation, they failed to notice that their ‘wealth’ was borrowed from and paid by the Chinese. Millions of rural Chinese left their farming villages to toil in the factories in conditions that we in the West will find appalling. It was these factories that churned out cheap goods that gave us the illusion of low price inflation. As we said before in The Bubble Economy,

In recent years, Chinese productivity had soared, which means overall, the Chinese economy was producing more and more goods at lower and lower costs. In China itself, that had a good deflationary effect – the fall in the consumer price levels. As China exported more and more of its cheaper goods to Australia, the effect on Australia was disinflation (decelerating growth in consumer price inflation). That helped keep a lid on the Australian consumer price inflation.

We have to remember that much of the rise in Chinese productivity could be attributed to their seemingly endless supply of labour procured from their vast countryside.

Today, the generous credit that the Chinese had extended is coming to an end. They are running out of skilled labour to continue churning out goods to match our inflation in money and credit (if they can continue to inflate at all). Also, it’s time that they start to look after themselves by investing on their own nation. Now, price inflation all over the world is spilling over to consumer prices with a corresponding deflation in asset prices. The masses’ mood is souring. This is hardly surprising to us. As we explained (back in November 2006) in How will asset-driven ?growth? eventually harm the economy?,

When central banks expand the money supply artificially, it creates distortions in the economy which will eventually result in a recession, which is a correction to the distortion. In the case of the US (and the British and Australian as well) economy, the housing bubble was caused by the inflation of money supply.

The correction of this distortion manifests itself in the form of credit crisis and deflation. To fight this deflation, central bankers have been desperate to pump more liquidity into the global financial system. But the asset bubble can no longer be re-inflated with this new pumping. This time, it is oil and commodity prices that are being inflated. Inconveniently, such price inflation will lead to the inflation of consumer goods. It is indeed worst of both worlds for the masses in the West- deflation of asset prices (which makes them feel poorer) and inflation of consumer prices (which make them feel yet even poorer). This is what we call stagflation (see Supplying never-ending drugs till stagflation).

We are now entering the second stage of what Ludwig Von Mises calls the “crack up boom.” In the next article, we will explain to you what this crack up boom is all about in more detail.

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Posted in Economics/Finance, Market Observations | 10 Comments »

What makes a nation wealthy?

Monday, April 14th, 2008

For many people in the West (and including China as well), rising asset values are associated with wealth. As we showed in The Bubble Economy,

Over the course of the past several years, the ?wealth? of many people in the Western English-speaking countries (mainly the US, Australia and Britain) had increased, thanks to the real estate price boom. Consequently, the economies of those countries had been growing and expanding over that period. This type of economic growth is what the IMF called the ?asset-driven growth.? One manifestation of this kind of growth is the rise of ?wealth-creation? fades, which advocate the attainment of riches through property ?investments.?

But what really makes a nation wealth? Recently, we bumped into this article, Once the World’s Great Factory, China Is the Next Great Innovator,

Everyone knows about China’s emergence as a global manufacturing power. Well, guess what: the People’s Capitalist Republic isn’t just emerging or ascending ? it’s exploding. And not only with boatloads of flatscreen TVs and great gusts of atmospheric carbon. The world’s go-to source for low-cost labor is generating mountains of capital, squads of hot new companies, and ? surprise! ? glimmers of innovation.

As we quoted Ludwig von Mises in The myth of financial asset ?investments? as savings,

At the outset of every step forward on the road to a more plentiful existence is saving?the provisionment of products that makes it possible to prolong the average period of time elapsing between the beginning of the production process and its turning out of a product ready for use and consumption. The products accumulated for this purpose are either intermediary stages in the technological process, i.e. tools and half-finished products, or goods ready for consumption that make it possible for man to substitute, without suffering want during the waiting period, a more time-absorbing process for another absorbing a shorter time. These goods are called capital goods. Thus, saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material conditions of man; they are the foundation of human civilization.

Thus, the very symbols of ‘wealth’ in a nation may actually hide real poverty.

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Posted in Economics/Finance | 8 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 »

The myth of financial asset ?investments? as savings

Friday, February 2nd, 2007

Today, the savings rate of the United States has never been lower since the Great Depression. This is a very serious concern that should never be underestimated. However, 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.

Here, we wish to dispel this myth.

First, we would need to understand what the true nature of savings is. In Chapter 15, Section 2 (Capital Goods and Capital) of Ludwig von Mises?s book, Human Action: A Treatise on Economics:

At the outset of every step forward on the road to a more plentiful existence is saving?the provisionment of products that makes it possible to prolong the average period of time elapsing between the beginning of the production process and its turning out of a product ready for use and consumption. The products accumulated for this purpose are either intermediary stages in the technological process, i.e. tools and half-finished products, or goods ready for consumption that make it possible for man to substitute, without suffering want during the waiting period, a more time-absorbing process for another absorbing a shorter time. These goods are called capital goods. Thus, saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material conditions of man; they are the foundation of human civilization.

Goods that directly relieve a need or want are called consumer goods. Capital goods, on the other hand, are goods that help in the production of consumer goods?they increase the future productive capacity of the economy. As we all know, the economy has a finite quantity of resources. It has to choose between producing consumer goods for current consumption or capital goods which will help in producing future consumer goods. Furthermore, capital goods depreciate over time?resources are required to maintain them. The extent in which the people in the economy choose to produce (and maintain) capital goods over consumer goods constitutes the savings rate of the economy.

For example, let?s say we save $100 in the bank. The bank then lends out $90 to an entrepreneur who uses it to set up a business enterprise that will produce goods that consumers want down the track. In this case, the $100 that we save is a sacrifice on our current consumption. Part of that $100 of ours is then put in good use to add value to the economy in the future. In return for my sacrifice, we are paid interest.

In another example, let?s say a company decides to raise money in the stock market to fund its expansion plans. We invested $100 in that company?s IPO. That company then uses our $100 to build a new manufacturing plant that will produce consumer goods in the future. In this case, that $100 that we invest is considered savings since it involves us sacrificing current consumption worth $100. In return for our sacrifice, we are paid dividends from the company?s future earnings.

Now, based on this understanding on savings, can our home equity be considered savings? We have ‘equity’ in our homes if its current value exceeds the amount we owed. But the problem with such ‘equity’ is that it depends on the home’s current value, which is merely a paper value based on the principle of imputed valuation (see Spectre of deflation for the concept of imputed valuation). As we said before in The Bubble Economy, since the phenomena of inflating home values is mainly due to the increase in money supply (colloquially known as ?printing money?), they cannot be considered as savings as they do not have any resulting influence in the increase of capital goods in the economy. In the same way, if we buy and sell existing stocks (as opposed to newly issued ones in an IPO) in the stock market, are we in any way contributing to the accumulation of capital goods in the economy?

As the financial side of the economy (see Analysing recent falls in oil prices?real vs investment demand on the concept of the real and financial side of the economy) becomes increasingly influential in the economy, we wonder how much this side contributes to the amassing of capital goods, which is the foundation of building the future wealth of the nation? 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?

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Cause of inflation: Shanghai bubble case study

Tuesday, December 5th, 2006

A few days ago, we learnt about the mad speculative fervour over real estates in Shanghai. From what we hear, the annual salary of an average middle-class worker in Shanghai is somewhere in the order of 50,000 to 100,000 RMB. However, apartments over there can cost up to prices to the order of 1 million RMB. We were simply astounded at the relativity of these two anecdotal figures, which we obtained from people we know who live in Shanghai. How is it possible for people to afford such exorbitantly priced housing? More amazingly, even at such sky high prices, many people over there feel that apartments are still ?cheap? and consider them good ?bargains!? We learnt further that the prevailing attitude over there was that real estate prices can never fall and that if you do not buy today, you will lose out because they will be more expensive tomorrow. Therefore, people piled themselves with debt to buy real estates that they cannot afford. With their assumption that prices will be going up indefinitely, they reckon that if the worst should ever happen, all they need to do is to liquidate their property at higher prices to the next buyer.This is a gigantic bubble that defies all rudiments of proportion, common sense and prudence. We suspect that with the Olympics in 2008, there will be a need for the authorities to at least keep up the spectacle and illusion of prosperity till then. Meanwhile, as we expected, inflation is experienced everywhere in Shanghai. We heard that this scenario is working out in other Chinese cities as well.

Now, it comes to the topic for today: inflation.

The mainstream economists? definition of inflation is rise in the general level of prices. However, according to the Austrian School of economic thought, the definition of inflation is the increase in the supply of money, in which the effect is the rise in the general level of prices. For the sake of discussion, let us call the mainstream definition as ?price inflation? and the Austrian School?s definition as ?monetary inflation.? We see that the Austrian School?s definition is far more accurate and correct because it goes right down to the root of the problem.

If the economy?s money supply increases relative to the increase in production of goods and services, then prices in nominal terms will have to increase because there will be more money chasing after the same amount of things in demand. As this article, Defining Inflation, said:

Consider the case of a fixed money supply. Whenever people increase their demand for some goods and services, money will be allocated toward other goods. Thus, the prices of some goods will increase?i.e., more money will be spent on them?while the prices of other goods will fall?i.e., less money will be spent on them.

As Ludwig von Mises said in his essay, Inflation: An Unworkable Fiscal Policy:

Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation’ to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. . . . As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.

Therefore, because the approach that mainstream economists take to define inflation is deficient, the benchmark that they use to measure it (an index of the price levels e.g. CPI) is also deficient. Does the CPI (or whatever the alternative price index that central bankers prefer to use) measure the price levels of assets? The answer is no! As a result, the conventional yardstick that mainstream economists use does not fully disclose the full extent of the economy?s inflation problems.

The mainstream economists do not see monetary inflation as an evil?as long as price inflation is not a problem, they do not see the need to care about monetary inflation. But Austrian School economists see that the inevitable consequence of monetary inflation is price inflation because the former is the root cause of the problem and the latter is the effect. That is the reason why Austrian School economists are strong advocates of gold-backed monetary systems because such systems will have automatic built-in checks to prevent undisciplined monetary inflation (aka printing of money).

In the case of Shanghai, we are not the least surprise to see price inflation happening. In fact, if the Chinese central bank does not control monetary inflation (that fuelled the property speculation in the first place), price inflation will get worse before it gets better. When that happens, the common people, especially the poor will suffer. On the other hand, if the Chinese central bank decides to raise interest rates to rein in price inflation, they run the risk of bursting the property bubble, which will have a destabilising deflationary effect. In that case, the speculators (of which many of the middle-class common people are) will suffer first, followed by the rests. It looks to us that the Chinese central bankers may have trapped themselves into a box.

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How will asset-driven ?growth? eventually harm the economy?

Monday, November 27th, 2006

In Chapter 15, Section 2 of Human Action: A Treatise on Economics, Ludwig Von Mises wrote:

The economists were and are still today confronted with the superstitious belief that the scarcity of factors of production could be brushed away, either entirely or at least to some extent, by increasing the amount of money in circulation and by credit expansion.

Indeed, as we mentioned in our previous article, The Bubble Economy, this is exactly what the Federal Reserve is currently doing to the US economy. In 2001, when the US economy was faced with a threat of recession, the Federal Reserve embarked on an expansionary monetary policy (aka ?printing money?) in an attempt to prevent it from happening. We believe this policy does not prevent a recession?it merely postpones it, in which the upcoming one will be more severe instead.

When central banks expand the money supply artificially, it creates distortions in the economy which will eventually result in a recession, which is a correction to the distortion. In the case of the US (and the British and Australian as well) economy, the housing bubble was caused by the inflation of money supply. For the common people in the street, such inflation manifests itself in the form of ultra low interest rates, which in turn encouraged an increase in ?demand? for housing. As we explained in How is inflation sabotaging our ability to measure the value of things?, an expandable supply of money derail our ability to accurately assess the value of things. Thus, when housing prices 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.

This is the reason why we believe a recession is on its way.

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