Posts Tagged ‘mal-investments’

Hazard ahead for Australia- interim crash in China

Sunday, January 3rd, 2010

This is the first major post of 2010 (the previous post was more for our readers’ entertainment). Today, we will look ahead at a likely hazard facing Australia in 2010 and beyond- an interim crash in China.

First, you may wonder why we used the word “interim” before the word “crash?” To answer this question, you may recall what we wrote in June 2007 at Will the China boom go in a straight line?,

… one of the common stories we hear is this: since China is an ascendant superpower, its demand for commodities will increase in the decades to come, and hence, the commodities super-cycle will have a lot more room to go for a very long time.

…

However, the market always latches on to the generalities of a story and takes a simplistic projection of the story too far into the indefinite future. What do we mean by that? Put it simply, we do not believe that the rise of China will take on the path of a straight line. Instead, there will be ups and downs, booms and bust and progress and setbacks. Anytime when the path does not look like a straight line upwards and take a temporary dive, the market will flip to the other extreme of this story and project extreme pessimism into the indefinite future.

In other words, when we say that a “crash” is coming in China, we do not mean that China will collapse into a heap of total anarchy, civil war, foreign invasions, internal divisions by warlords, etc as in the first half of the 20th century. Instead, as we wrote before, such a “crash” will be a major setback in the bigger scheme of things.

In this new year, this is the theme that investors (especially the highly leveraged property speculators in Australia) should be watching out for. Australia is highly leveraged to the Chinese growth story, both in terms of financial leveraged (look at Australia’s debt level) and population leverage. The word “population leverage” will sound alien to you because this is a phrase that we invented in this article. To understand this phrase, consider this: the entire population of Australia can fit into population of just one major Chinese city (Shanghai) if you include the ‘unofficial’ migrant workers. Because of the colossal size of China, if every Chinese reduce their consumption by 1%, then its effect will be much more than 1% reduction in income on Australia. Therefore, investors should understand this basic principle: because of the leverage that Australia is exposed to China, any slowdown in China will have a leveraged effect on Australia.

The Panic of 2008 should be the year whereby a major correction in the Chinese economy could have occurred. Indeed, in late 2008, one newspaper headline in the Sydney Morning Herald was screaming of a great “stall” in the Chinese economy. Indeed, it seemed at that time that what we wrote in January 2008 at Can China really ?de-couple? from a US recession? was coming into fruition.

However, what stopped the major correction in the Chinese economy in its track was a massive government stimulus and ultra-loose monetary policy. The former is concentrated on fixed asset and infrastructure investments (e.g. construction boom, bridge building, etc), while the latter is basically force feeding loans into the economy (see How big is the credit bubble in China? and Is China setting itself up for a credit bust?).

The problem with these government policies is that, while it may have averted a major correction, the structural imbalances in the Chinese economy are being exacebated. To understand the gravity of this situation, consider this simplified line of thought:

  1. Prior to the GFC, the Chinese economy was highly geared towards capital investments in the form of productive capacity for exports.
  2. A contraction in demand in the US/Europe led to a disproportionate contraction in Chinese economic activity (see Can China really ?de-couple? from a US recession? to understand the theory behind this reasoning).
  3. Chinese economic activities that are related to exports suffered the worst of this contraction.
  4. Chinese government stimulus and ultra-loose monetary policies led to increased economic activity in the Chinese economy mostly in the area of capital investments for infrastructure.
  5. Overall the economy ‘grew’, but a lot of them are wasted and ‘leaked’ into mal-investments, asset market bubbles, corruption (see Will China succeed in navigating its way out of the Global Financial Crisis (GFC)? for a juicy story about corruption in China) and trophy projects.

You see the problem here?

Chinese government policies are accentuating the gap between investments in future productive capacity and current consumption of the Chinese people. To further complicate the picture, infrastructure investments produces capital goods (e.g. bridges, roads, highways) that cannot be exported. If Chinese consumption cannot grow fast enough to catch up with huge expansion in productive capacity and American consumption cannot recover enough to fill the gap, then what will happen to those investments?

Obviously, these investments will, at best result in a dismal return and at worst, result in bad debts. And we know bad debts are the roots of a credit crisis.

We believe consumption growth cannot catch up fast enough. As we wrote in Can China really ?de-couple? from a US recession?,

  1. The needs of the Chinese consumption economy is different from the US consumption economy. Some Chinese are rich. But some other parts of China are unbelievably poor. Wealth distribution in China is rather uneven and there are still many pressing social and environmental issues to be solved. Currently, the Chinese export economy is tooled towards US consumption. To re-tool and re-configure the Chinese economy towards its domestic needs requires a period of adjustment in which capitals are destroyed and built. As we said before in Overproduction or mis-configuration of production?, the issue is not a simple case of overproduction. Rather, it is the mis-configuration of production that is the issue.

Because of the structural imbalance between consumption and investments, a lot of these forced investments are leaked into asset speculation (e.g. look at the massive property bubble in Shanghai alone). To understand this point, consider what we wrote in Connecting monetary inflation with speculation,

Thus, by further inflating the supply of money and credit in the financial system at such a time, there comes a situation whereby there are excess liquidity without adequate avenues for appropriate investments.

The ultra-loose monetary policies in China resulted in too much money and credit sloshing around in the financial system. The structurally weak and mis-configured domestic consumption market means that there’s not enough avenue for appropriate investments. Hence, a lot of money and credit ended up as speculations in the asset market.

To structurally streghthen the Chinese domestic consumption market, the gap between the rich and poor has to be narrowed. Anecdotal indications suggest that the opposite is happening, thanks to inflation (see Does monetary inflation increase the rich-poor divide?). The bubble in the asset markets is worsening the situation.

By now, you should be able to appreciate the gravity of the situation. The ‘success’ of the Chinese government seems to have averted a major economic correction. But in reality, they are just postponing it for a greater bust in the future.

What is the implication of this in the financial markets? Keep in tune!

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Posted in Looking Forward, Market Observations | 6 Comments »

Fading glory of the financial services and ‘wealth’ management industry

Sunday, November 2nd, 2008

October has just passed and it will go down in history as one of the worst months in stock market history. Even many veteran traders have not seen anything that bad before. As Marc Faber said in a recent Lateline interview (on 13 October 2008),

As of last week, world stock markets became oversold. Statistically probably the most oversold condition in the last 50 years or so.

One good gauge of fear in the stock market is the Volatility Index (VIX) indicator. As you can see from the chart below, the VIX spiked to its record high level (since 1990) at above 80 in October.

VIX indicator since 1990

Consequently, such intense level of fear had provoked the government into making up policies as they go and then tweaking away the side effects as an after-thought. For example, when the government gave unlimited guarantee to bank deposits, fearful money began to defect away from investment funds into banks. As these funds reacted by freezing redemptions from investors, prompting a crisis on their investment business. Some of these investment managers then pleaded with the government to guarantee their investment funds. We could sense the underlying sarcasm of the government officials as they replied by ‘taunting’ these investment funds to become banks if they want to fall under the protective umbrella of the government.

The global financial market had never been subjected to so much fear for a very long time. The sheer terror of a global financial meltdown had provoked knee-jerk reactions from governments, regulators, central banks, investors, traders and the humble savers. Beneath the raging waters of fear, panic, reactions and counter-reactions, the many decisions made on the spur of the moment by governments, regulators, and central banks will be judged by history to be turning points. These decisions will have many long-term side effects that are not immediately apparent. At this point in time, although there are signs that the panic is starting to melt away and calm gradually returning to the market, the lingering smell of mass ‘wealth’ destruction will still remain for a considerable period of time.

As we mull through the long-term ramifications, our thoughts are drawn to the future of the investment and financial service industry. The first effect we can think of is the loss of trust and confidence on the idea of ‘wealth’ management. Much of the panic selling in October was contributed by investors redeeming their money from managed funds and stuffing them towards the proverbial cash under the mattress (i.e. treasury bonds, guaranteed bank deposits and even gold). The number one priority was not return on their money. Rather, it was return of their money.

Our stand is that the trust and confidence on the idea of ‘wealth’ management through ‘investments’ in financial assets was a misplaced one. The whole idea of ‘investments’ was based on a massive bubble. As we said before at Have we escaped from the dangers of inflation? in February 2007,

Today, the global spigot of liquidity (see Liquidity?Global Markets Face `Severe Correction,? Faber Says on the concept of ?liquidity?) is wide open, spewing out huge amounts of money and money substitutes into the financial system.

…

With all these flood of fiat money inundating the global financial system, we look at all these skyrocketing financial asset prices with a yawn. Price bubbles of all sorts are found everywhere in the world?from Chinese stocks, junk bonds to private equity booms. Back here in Australia, it looks to us that nowadays, everyone is ?playing? the stock market, many using leverages like CFDs and margin lending. We hear stories of novices ?investors? opening a trading account to ?learn? how to trade. The logic is simple: central banks around the world are hard at work ?printing? money. These monies first go to the financial system, creating price bubbles. The bubbles then attract speculators, gamblers and punters into the asset markets the way bees get attracted to honey. Soon, word get round to the masses and they want a slice of the action too.

Over the years, central bankers are creating copious amount of money and credit out of thin air. The masses then take on the delusion that these fiat money are real wealth. As we asked 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?

There were so much money and credit conjured from thin air that an entire industry (i.e. financial service and investment industry) has to be bloated beyond its fundamental use in order to shuffle them. As we said before in Connecting monetary inflation with speculation,

Thus, by further inflating the supply of money and credit in the financial system at such a time, there comes a situation whereby there are excess liquidity without adequate avenues for appropriate investments.

Thus, the global credit crisis is a return back to reality as the masses wake up their idea that all these ‘wealth’ are illusionary. As we quoted Ludwig von Mises at The myth of financial asset ?investments? as savings, real wealth is based on real capital formation. Shuffling money and competitive chasing after assets with fiat money do not make a nation any richer.

Alas, there are still many who still do not get it, even when the threat of a Great Depression II is gathering at the gates of the global economy. For example, in Australia, the Opposition Leader, Malcom Turnbull still speak of the ‘savings’ trapped in investment funds due to the Australian government’s unintended side-effect bank deposit guarantee. The fact that he is using the concepts of savings and investments interchangeably to refer to the same thing shows that he has no idea about what he is talking about.

Dear readers, to be a successful investor, you have to understand the difference between savings and investments. We urge you to read The myth of financial asset ?investments? as savings. The entire superannuation and wealth management industry is based on the myth that investments (especially ‘investments’ in financial assets) are savings. Consequently, the build-up of mal-investments that such a myth introduced brought about the financial crisis that we have today. Real investment brought about real capital formation, which is the cornerstone of real wealth in the future.

As far as we can see, the bull market (in real terms) on financial assets is over. What comes next is either deflation or stagflation. The implication is that peak glory (2001-2007) of the financial service and wealth management industry will be history.

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Posted in Looking Forward | 26 Comments »

Government’s contradictory messages

Wednesday, October 22nd, 2008

Back in Can China save Australia?, we mentioned about SBS’s Insight program, Greed. As we read the transcript of that program, we cannot help but realise that while the government officials are busy trying to deal with this crisis, they are sending out contradictory messages as a side effect.

For example, take a read at this:

JENNY BROCKIE:  But what sort of possibilities are we talking about here? I mean unemployment going up to 10%, 20% in the event of this taking hold in Australia? What could happen?

LINDSAY TANNER:  Definitely not. None of us can see into the future and the international crisis is obviously so unprecedented that it’s very hard to make predictions, but the fundamentals in Australia are very strong. We’re better off than virtually anybody else in the world to deal with these problems and we remain optimistic that we will be able to ride through this buffeting in reasonable shape.

On one hand, Lindsay Tanner ruled out the possibility of Australia’s unemployment going north of 10%. Yet, on the other hand, he said that no one knows the future and make predictions. If you notice, by saying “Definitely not,” he is already making a prediction!

Incidentally, in Jobless rate may double as China slows, JPMorgan Australia’s chief economist Stephen Walters said that

“We now expect the jobless rate to more than double to 9% in late 2010, from the current 4.3%,” Mr Walters said. “Softer growth in one of Australia’s leading export destinations means Australia’s export volumes will be lower, as will be the terms of trade.

“That said, on our forecasts, there will be 1 million unemployed Australians by the second half of 2010.”

The current way of measuring the employment rate includes those who are under-employed (see Nearly 600,000 Australians under-employed). When the economy slows down, it is those kinds of jobs that will be shed first, especially jobs in businesses that depend on discretionary spending (e.g. retailing). Therefore, a figure of 1 million unemployed people is not so unthinkable after all.

The next contradictory message from the government is on spending:

JENNY BROCKIE:   OK, there are quite a few things in what you’ve said that I’d like to pick you up on because we live in very contradictory times at the moment. You’re saying we should be thinking about thrift. You’ve just released a $10.4 billion package and you’re telling people to go out and spend. I mean, should Siobhan keep spending, keep getting into debt? What’s the message the Government is sending at the moment?

We believe that the government’s $10 billion stimulus package is a misguided Keynesian policy that will not solve the problem.

Firstly, as we said before in Will Australia?s own pump-priming work?, it is far too little to combat the deflationary force.

Secondly, even if it is big enough to induce the masses to spend, it is the wrong medicine. If such policies are carried out to the extreme, the outcome will be hyperinflation (see Bernankeism and hyper-inflation). As we explained in Supplying never-ending drugs till stagflation,

Students of the Austrian School of economic thought will understand that indiscriminate ?printing? of money 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 anymore no matter how much money is being ?printed.?

Without the liquidation of mal-investments and restoration of the structural imbalances that is brought about by deflation, applying bigger and bigger stimulus packages will only function in similar ways to drugs- more and more for less and less effect. The reason why Keynesian reflationary pump-priming worked during the Great Depression was that it was applied after the cleansing effects of the deflation had done its work. But today, in reaction to the financial crisis, governments all over the world are doing so before the purge of fire. As a result, the much-needed economic correction that the economy had to have will not happen.

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Posted in Economics/Finance, Looking Forward, Market Observations | 12 Comments »

Are government bailouts good for the economy?

Wednesday, October 1st, 2008

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What lies ahead for the Australian economy in the coming years?

Sunday, April 6th, 2008

As we can see, over the past several months, there had been a lot of volatility in the global financial markets. As we said before in Why is the market so easily tossed and turned by dribs and drabs of data?, without the proper framework of sound economic theory, the outcome is that the lack of deductive reasoning and insights brought about the situation where the

… market gets tossed and turned by every minute variations of statistical information from economic reports. The end result is confusion and volatility.

Clearly, this shows that the media, pundits, investors, traders and other market participants do not know what is going on.

Today, we will present to you what we believe to be the long-term big picture. Our opinion is by no means a prediction in the forecasting sense- rather, it is just our feeling, intuition and guesses (maybe one day in the future, this opinion will be famously known as ‘insight’ or ‘foresight’?). Therefore, do NOT take our opinion as financial advice- we are not financial advisers and our conviction is that one should be ultimately responsible for one’s own investment and financial decisions.

Okay, here comes the meat…

Firstly, our belief is that the US economy is heading for a hard landing. Currently, Ben Bernanke’s forecast is that economic growth will pick up in 2009 after a possible mild recession. This is also the belief of the market, as it tentatively believes that the credit crunch is abating. We are sceptical of this view. After all, years of accumulation of bad debts, over-leverage, mal-investments and structural damage of the US economy cannot be simply brushed away with the turning of interest rate levers, money ‘printing,’ bailouts and sweet talks. As we explained 13 months ago in Marc Faber on why further correction is coming- Part 2, the liquidity contraction that started in the US is resulting in the process of global asset price deflation, especially house prices in the US. As asset prices deflate, this will bring about further bad debts, which in turn will bring about further deflation in a vicious cycle.

Next, as it especially applies to the Western developed world, the financial side of the economy has grown to be a major intertwined component of the overall economy. As we said before in Analysing recent falls in oil prices- real vs investment demand, the difference between the real and financial side of the economy is that the

.. real side [is] where you find the physical market for goods, services and labour. The financial side is where you find the flow of financial capital, assets and payments.

It can be argued that today, the financial side of the economy had grown beyond its original supporting role of efficiently and flexibly allocating capital for the real-side of the economy, to the point of playing one of the primary roles in the economy. In any case, both sides are interlocked hand-in-hand with each other, which means any shocks to the financial system will affect the real economy and vice versa. To illustrate this point, take the case of Australia. With the vast majority of working Australians parking their retirement savings through the superannuation system, which in turn distributes the savings into financial products (e.g. managed funds), which in turn further distribute these savings into the financial asset markets (e.g. stock market). Furthermore, even ownership of physical assets (e.g. property) requires credit, which in turn is sourced from the financial system. And when it comes to credit, developed Western economies like Australia have been gorging on them to fund anything from credit card debts, personal loans, car loans, stock investment through margin lending, store cards, etc. Therefore, you can see that any breakdown in the financial system will have serious and dire consequences on the rest of the real economy.

For Australia, it seems to be at a sweet spot. The voracious Chinese demand for commodities have been a windfall for Australia, which has vast reserves of resources to supply the Chinese economy. That, along with a highly advanced financial system helps spread the prosperity to the rest of the nation to some degree. But the dark side of this prosperity is the build up of leverage (debts) to a dangerously high level (see Aussie household debt not as bad as it seems? and Australia has no sub-prime debt? Think again!).

Now, there are dark clouds in the horizon. The global financial system had never been as interconnected as before in the history of capitalism. You can be sure that any trouble that begins in the US financial system will spread to the rest of the world. As of today, there are murmurs about the credit crunch being the most serious crisis since the Great Depression. As the financial system rot in the US economy spreads into its real side, you can be sure that Australia’s financial system will be severely affected as well. The Australian economy (along with other Western economies with advanced financial system like the US and UK economies) are highly leveraged (i.e. burdened with far too high levels of debt) both at the retail household level and at the institutional level. Already, we are hearing about bankruptcies, blow-ups and traumatic losses in the global corporate sector (e.g. Allco, MFS, Fincorp, Centro, Basis Capital, ABC Learning Centre, Tricom, Opes, Bear Stearns, UBS, Citigroup and too many more to list). The Australian household sector is feeling the debt stress (e.g. mortgage stress, housing affordability and rental crisis, soaring personal debt levels, etc). As we said before in Rising price of money through the demise of ?shadow? banking system),

Australians love their debt too much. From the large current account deficit (see Understanding the Balance of Payments), much of Australia?s debts are sourced from overseas. With the demise of the global ?shadow? banking system, the price of money in Australia has to rise too.

A highly indebted nation cannot afford to have the price of its credit rise without acute consequences. Thus, University of Western Sydney (UWS) Professor Steve Keen believes that a severe recession induced by debt deflation will arrive at Australia within 2 years.

The question is, will China save Australia from this?

For one, the rot in the global financial system may not affect the real side of the Chinese economy directly. This is because the Chinese financial system is still rather primitive compared to the advanced Wester economies. For example, there are still hundreds of millions of peasants toiling in the countryside. Those who migrated to the cities to toil under the factories are still not plugged into the developing Chinese financial system. Therefore, unlike the Western world, a bearish Chinese stock market does not necessarily forecast doom for the wider Chinese economy. As a result, the credit crunch that started in the US will have a limited impact on the real side of the Chinese economy. So far, this is good news for Australia (but Australia is not out of the woods yet).

Therefore, our opinion is that when the inevitable severe recession hits the Australian economy soon, the Australian mining (and related) sector will probably be the only bright spot in the darkness. In fact, we can argue that a recession may perhaps even be beneficial for the mining sector as much of the idle resources (caused by the recession) in the economy can be re-allocated to the mining sector (see How is Australia?s mining boom sucking resources out of the economy?).

But here comes the bad news.

Firstly, in a hard landing of the US economy, the real side of their economy will be crunched as well. Our theory is that this may lead to a more than proportionate contraction in the investment activities that dominates the Chinese economy, which will trigger a hard landing in the Chinese economy. Even if this theory turns out unfounded, there is another worry- the Chinese economy may not have enough resources supplied to it fast enough to maintain the trajectory of its economic growth. When that happens, the risk is that the trajectory may be shot down, resulting in the forced liquidation of all these mal-investments. The outcome is a big Chinese bust. Our article, Can China really ?de-couple? from a US recession? has the full explanation of our theory. When that happens, the last leg supporting the Australian economy will be kicked off. This is the worst-case scenario for the global economy (and by extension, Australia). Our feeling is that the coming Chinese bust may come with a time-lag after the US hard landing. If our theory about the more than proportionate contraction in Chinese investment holds true, then the time-lag may be shorter.

But yet again, this may not be all bad news in the longer run. If China’s rise is a secular event (see Example of a secular trend- commodities and the upcoming rise of a potential superpower) of the 21st century, then Australia can still climb out of this worst-case scenario.

Please note that we are not making any predictions here. Our vision is very far out into the future. Generally, the further one ventures into the future, the more likely unforeseen Black Swans will sneak in to turn one’s vision into fantasy. But as the old adage says, prepare for the worst but hope for the best.

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Posted in Looking Forward | 4 Comments »

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

Tuesday, March 4th, 2008

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

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

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

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

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

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

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

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

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Example of mal-investments?dot-com bubble

Wednesday, February 14th, 2007

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

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

This is an example of a mal-investment.

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

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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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