Posts Tagged ‘monetary inflation’

Should you be bullish on stocks?

Sunday, September 13th, 2009

Marc Faber is a well-known contrarian bear. He has such a pessimistic streak in his blood that he is given a nickname of “Dr. Doom.” But many people were surprised that this bear is actually quite ‘bullish’ on stocks. For example, even though he believes that stocks are going to face a major correction soon, he believes that the rally can still have more room to run.

How do you reconcile his bearish temperament and ‘bullishness?’

The trick is to understand that his reason for ‘optimism’ is different from the reason espoused by the “green-shoots-of-recovery” crowd. The basis of his ‘bullishness’ is based on a very pessimistic view of the economy. This Lateline interview sums up his view very well:

As we wrote before in Can we have a booming stock market with economic calamity?,

But as we stressed many times in this journal, it is possible to have economic calamity with booming asset prices, especially stock prices

Based on conventional economic theory, there is no explanation for such a stellar performance for the Zimbabwean stock market when the GDP was collapsing (see Zimbabwe: Best Performing Stock Market in 2007?). A stock analyst using conventional valuation analysis will hard pressed to justify the lofty heights of stock prices.

But followers of the Austrian School of economic thought have an explanation for this illogical phenomena. In a perfect world, every single cent of the printed money will go straight into repayment of debt and thus, wiping out debt obligations, introduce financial stability and not cause price inflation in one swoop. Unfortunately in the real world, the plans of the governments and central banks do not always work out perfectly. In a dysfunctional economy, the massive printing of money can lead to some of them being used for speculations of assets and commodities instead of de-leveraging. As what happened in 2008 (see Who is to blame for surging food and oil prices?), the speculation of the latter can lead to strong price inflation.

In the same way, the current bout of monetary inflation is the cause of the rally in the stock market. In fact, Marc Faber believes that this rally has more room to go beyond the current impending correction. It is possible that the coming correction may not come in the form of tumbling stock prices- stocks may stagnate sideways until the technical overbought condition deflate to a more balanced one.

Today, it is the stock market that gets artificially inflated. Tomorrow, it can be the commodity markets. Now, the question is, should you buy stocks to protect yourself against price inflation? We will look into it in the next article.

When will serious inflation catch up with us?

Thursday, July 31st, 2008

Recently, one of our readers asked us this question:

If, as you have reported, our money supply is still increasing at over 20% per annum, what is this likely to lead to in terms of price inflation in the years ahead? I suspect that it will somehow catch up with us one way or another, and the result will not be pretty. But this is just a generalised gut feeling, which is not as useful as a more particularised and detailed understanding would be for positioning oneself for the inevitable. Part of a clearer vision would be, of course, a better sense of the likely timeframes involved. How long before the ugly bits start to catch up with us, and how long will it be likely to last? What will be the signs of imminent danger? Or do we already have plenty of them now, as we speak?

First, for those who are new to this publication, we would highly recommend that you read Cause of inflation: Shanghai bubble case study before continuing reading the rest of this article. The reason is because mainstream economics and the Austrian School of economic thought have different definitions for inflation. To make our language more precise, we will refer to the former’s definition simply as price rise and the latter’s definition as monetary inflation. If you have time, you may want to read our guide, What is inflation and deflation?.

Next, the point of this article is about recognising the signs of inflation- we are not airing our opinion on what will happen in the future in this article. Our opinion for that can be found in Inflation or deflation first? instead.

Here are two considerations to think about when considering the future effects of monetary inflation:

  1. One troubling aspect when discussing the economic phenomenon of price rise is the indices used to measure it. As we argued before in How much can we trust the price indices (e.g. CPI)?, the whole idea of measuring general price levels is logically invalid. For instance, as we said in that article,

    … the world is experiencing unprecedented asset price inflation. In Australia, it is the housing price bubble. Since the Reserve Bank of Australia (RBA) does not have the mandate to prick asset price bubbles, then can we give them such a mandate by merely redefining houses as consumer durable goods and include them in the basket of goods in the price index calculation?

    That is, if we include houses as part of the basket of goods in the CPI, Australia will be suffering from severe inflation for the past 10 years! One way for governments to deny the severity of price rises is to fudge the figures and the composition of goods and services, which is what the US government is arguably doing right now.

  2. Also, as we said before in Introduction to the famous Quantity Theory of Money, according to the Austrian School of economic thought,

    Monetary inflation (or ?printing? money or increasing the money supply) results in the distortion of the relative price levels. That is, when money is ?printed,? prices will be affected in varying degrees for different things with different time lags (see How to secretly rob the people with monetary inflation?).

    Monetary inflation takes time to work itself out to the rest of the economy. Sometimes, the effect is not immediate. For example, for the past 10 years, monetary inflation did not result in visible price rises. In fact, thanks to the rise of Chinese manufacturing, we have price falls of manufactured goods, while at the same time, the price of houses sky-rockted (see The Bubble Economy). But lately, we see the rise in the prices of commodities, food and oil. To add to the difficulty, the effect affects prices of different things with different time-lags. Some goods and services are are susceptible to monetary inflation than others.

    Next, monetary inflation may not affect the price levels of of everything to the same degree. For example, the past rise in house prices was probably not going to be accompanied by as great rises in the price of funeral services.

In view of these two considerations, you can see why it is not easy to give a straight answer to our reader’s question. But before hyperinflation can develop, there will be plenty of warning signs. An exponential increase in the supply of money is one sign. The conditions that we described in What is a crack-up boom? is another. Governments turning towards populism and fiddling with the laws is another (see Recipe for hyperinflation). In other words, while you cannot know the precise time-frames of such development, you will have plenty of time to prepare for it as long as you keep your eyes and ears wide open. In addition, the initial stages of inflationĀ are akin to a silent killer that is slowly doing its destructive work. But as it move towards the finale (i.e. hyperinflation), you will see the acceleration of developments.

Thus, we would encourage you to acquaint yourself with history in order to help you recognize the signs. We will be watching and listening too. You will get to see what we see and hear what we hear both in this publication and on our sister site: Contrarian Investors’ News.

Who is to blame for surging food and oil prices?

Thursday, May 22nd, 2008

Imagine you are standing in a typical petrol station in 1974 on a typical day (there was an oil shock in 1973). This is what you may see back then:

Cars queued for hours to get petrol in 1974

Now, imagine you get sucked into a time warp and time-travelled to today on 2008. This is what you may see:

A typical petrol station in 2008

So, let’s say a passer-by told you that petrol price had doubled more than 2 Ā½ times over the past 2 years, would you laugh at the passer-by? “Yeah right!” you may say. “Where’s the queue and rationing?”

Indeed, this is what has happened. As we said before in The Problem that can throw us back into the age of horse-drawn carriages, there are good reasons why the oil price rose over the past decade. In fact, this is true for commodities in general (e.g. base metals, food). As we explained before in Why are the poor suffering from food shortages? and Example of a secular trend- commodities and the upcoming rise of a potential superpower, there are good reasons for this. Already, we are hearing of food riots in the Middle East and Asia.

Yet, strangely, these upward price movements seem unreal. Where’s the queues and rationing? How do we explain this?

Two days ago, in the U.S. Senate Committee on Homeland Security and Governmental Affairs hearing, this question was put forth: Financial Speculation in Commodity Markets: Are Institutional Investors and Hedge Funds Contributing to Food and Energy Price Inflation? Here, we must give special thanks to one of our readers, Zoo for highlighting this piece of information at Picture of a fiat money.

Here, let us zoom into the testimony of Michael Masters, who is the Managing Member and Portfolio Manager, Masters Capital Management, LLC. As our reader Zoo said, “It seems it is the testimony of Michael Masters, a hedge fund manager, which made all the Senators sit up and take notice (sic).” This is Michael Masters’ introduction in his testimony:

Good morning and thank you, Mr. Chairman and Members of the Committee, for the invitation to speak to you today. This is a topic that I care deeply about, and I appreciate the chance to share what I have discovered.

I have been successfully managing a long-short equity hedge fund for over 12 years and I have extensive contacts on Wall Street and within the hedge fund community. It’s important that you know that I am not currently involved in trading the commodities futures markets. I am not representing any corporate, financial, or lobby organizations. I am speaking with you today as a concerned citizen whose professional background has given me insight into a situation that I believe is negatively affecting the U.S. economy. While some in my profession might be disappointed that I am presenting this testimony to Congress, I feel that it is the right thing to do.

You have asked the question ?Are Institutional Investors contributing to food and energy price inflation?? And my unequivocal answer is ?YES.?

That’s a strong categorical statement. Unlike many mainstream financial commentators, Michael Masters did not fluffed around with the “on-the-other-hand” and “having-said-that” types of answer. It is as clear as you can get, backed up by evidence, charts and numbers.

So, how do we explain such a spectacular rise in commodity prices without the queues and rationing? Michael Masters answered,

What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets

Just who is this “new category” of market participants? Is it China and India? No! The rising demand of these two giant nations had been gradually brewing and simmering over the past decade and will continue to the next decade and beyond. Their demand are hardly a shock. Michael Masters pointed the finger at:

Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.

To give you a sense of scale of their share on the commodities futures contracts, Michael Masters gave an example:

According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. Over the same five-year period, Index Speculators’ [institutional investors’] demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!

There are a few more examples given by Michael Masters in his testimony. What happened was that these institutional investors hoarded commodities through the futures market, affecting futures price, which in turn affected the spot prices (i.e. the real world market price). The spot prices are the prices that we all face in our daily life.

In additional, these institutional investors (which Michael Masters called “Index Speculators” are a completely different breed from the traditional speculators. The latter were relatively small fries who (1) had limited supply of money, (2) specialised in certain commodities and (3) price conscious (i.e. they are careful with what price they pay for). The Index Speculators are poles apart. They have vast amount of money (fiat money in US dollars) to be distributed among “key commodities futures according to the popular indices” and are not conscious about the price they pay. They think in terms of portfolio asset allocation, which means that if they decide to allocate, say 2% of their assets into a specific commodity, they will “buy as many futures contracts as they need, at whatever price is necessary, until all of their money has been ‘put to work.’ ” Unlike the traditional speculators who buys and sells, Index Speculators never sell because they treat commodities as some kind of quasi-assets. You can expect such behaviour to have colossal impact on commodity prices.

How did all these Index Speculators came about? Michael Masters explained,

In the early part of this decade, some institutional investors who suffered as a result of the severe equity bear market of 2000-2002, began to look to the commodity futures market as a potential new ?asset class? suitable for institutional investment. While the commodities markets have always had some speculators, never before had major investment institutions seriously considered the commodities futures markets as viable for larger scale investment programs. Commodities looked attractive because they have historically been ?uncorrelated,? meaning they trade inversely to fixed income and equity portfolios. Mainline financial industry consultants, who advised large institutions on portfolio allocations, suggested for the first time that investors could ?buy and hold? commodities futures, just like investors previously had done with stocks and bonds.

The value of assets devoted to commodities by these Index Speculators grew from just US$13 billion in 2003 to US$260 billion as of March 2008. Over these 5 years, the prices of commodities grew by an average of 183%. In 2003, they were small fries in the commodities futures market. Today, they are the largest force in the market.

Why is it that no one seems to know about this phenomenon? Michael Masters believes that (emphasis in the original testimony):

The huge growth in their demand has gone virtually undetected by classically-trained economists who almost never analyze demand in futures markets.

To compound the effect of Index Speculators on commodity prices, it must be noted that the commodity futures markets are much smaller than the capital markets. For example, it is 240 times smaller than the global equity market. Thus, every dollar on commodity futures has a much greater impact on prices than the same dollar on equities. To compound the problem even further, it was observed that their demand increases prices, which in turn increases demand even more. That is, hoarding begets more hoarding.

So, let’s return to the petrol problem. Let’s say OPEC increases production in an attempt to help bring down the price of oil. Or the world decides to to embark on an oil fast. Will that work? You can see that these Index Speculators can easily pour more money into the oil futures sink hole.

Sad to say, through a loophole, the US Commodities Futures Trading Commission (CFTC) allows such speculators “unlimited access to the commodities futures markets.” As Michael Masters explained,

The really shocking thing about the Swaps Loophole is that Speculators of all stripes can use it to access the futures markets. So if a hedge fund wants a $500 million position in Wheat, which is way beyond position limits, they can enter into swap with a Wall Street bank and then the bank buys $500 million worth of Wheat futures.

In the CFTC?s classification scheme all Speculators accessing the futures markets through the Swaps Loophole are categorized as ?Commercial? rather than ?Non-Commercial.? The result is a gross distortion in data that effectively hides the full impact of Index Speculation.

So, whose fault is this? We can blame these Index Speculators. But 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.

Is it surprising to see the arrival of the Index Speculators?

Does monetary inflation increase the rich-poor divide?

Monday, February 26th, 2007

Much of the latest economic boom that we see in Australia, United States and Britain are based on asset-driven growth (see Myth of asset-driven growth), which comes about through monetary inflation (aka ?printing? of money). Back in December last year, in How to secretly rob the people with monetary inflation?, we explained that whenever government ?print? money, there will be an unfair redistribution of wealth. As such, usually the common people on fixed salaries and who do not own any ?assets? will have to bear the brunt of price inflation.

As such, we are hardly surprised to see this article in the mainstream press.

Example of inevitable effect of monetary inflation

Wednesday, February 21st, 2007

Back in Cause of inflation: Shanghai bubble case study, we said that:

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.

Today, we look at an example of how monetary inflation leads to price inflation. As explained in this article in the Sydney Morning Herald, the current rental crisis in Sydney is an ?inevitable consequence of the housing boom and bust we’re experiencing.? The housing ?boom,? (as we had explained in The Bubble Economy) is the effect of monetary inflation.

As of right now, global liquidity is still expanding. So far, price inflation, as claimed by the US Federal Reserve, is ?under control.? Rest assured, it will only be a matter of time before price inflation creeps in again. Humanity has yet to find a way to repeal the fundamental laws of supply and demand.

One funny effect of monetary inflation: ?New rules outlaw melting pennies, nickels for profit?

Thursday, December 14th, 2006

Today, this article filled our day with laughter: New rules outlaw melting pennies, nickels for profit.

Monetary inflation has now come to the point that the price of the metal in coins far exceeds the face value of the coin itself. Pathetically, the government then has to make up new rules in order to intervene into the free market. The justification for this new rule is:

?The nation needs its coinage for commerce,? U.S. Mint director Ed Moy said in a statement. ?We don’t want to see our pennies and nickels melted down so a few individuals can take advantage of the American taxpayer. Replacing these coins would be an enormous cost to taxpayers.?

Against this excuse, we would like to point out what Murray Rothbard had to say in What Has Government Done to Our Money?:

On the free market, money can be acquired by producing and selling goods and services that people want, or by mining (a business no more profitable, in the long run, than any other). But if government can find ways to engage in counterfeiting, the creation of new money out of thin air, it can quickly produce its own money without taking the trouble to sell services or mine gold. It can then appropriate resources slyly and almost unnoticed, without rousing the hostility touched off by taxation. In fact, counterfeiting can create in its very victims the blissful illusion of unparalleled prosperity. Counterfeiting is evidently but another name for inflation, both creating new “money” that is not standard gold or silver, and both function similarly. And now we see why governments are inherently inflationary: because inflation is a powerful and subtle means for government acquisition of the public’s resources, a painless and all the more dangerous form of taxation.

What can we expect in a US dollar decline?

Wednesday, December 13th, 2006

Yesterday, we mentioned about the possible scenario of a decline (or collapse) of the US dollar in Will the US dollar collapse?. Today, we will look at the consequences of such an eventuality.

As we explained in The Bubble Economy, the reason why monetary inflation had not led to severe price inflation is because of the disinflation effect of cheap Chinese imports. Thus, goods that can be imported from China have their prices being suppressed from inflating. However, goods and services that cannot be imported will suffer price inflation, most notably housing and health care. Thus, the US had been printing money and buying goods overseas with their printed money. Simultaneously, the excess printed money went into assets (housing) to cause price bubbles.

Now, as the US dollar decline, that will result in imported goods getting more expensive for American consumers. Since the US import far more than they export, the outcome will be price inflation for those imported goods. When that happens, the Federal Reserve will be forced to raise interest rates to curb inflation. If the Federal Reserve does that, Wall Street will take a big hit, perhaps triggering a sell-off in the stock market since they are expecting the Federal Reserve to cut interest rates in 2007. We guess Ben Bernanke must be in a dilemma and losing sleep over this scenario. If the Fed raises interest rate, it will probably push the already weak US economy into recession. If it does not, the result will be inflation, which if left unchecked, will lead to hyperinflation. That could be the reason why the Fed had been exasperatedly warning about inflation (i.e. interest rates could still rise) in an apparent attempt to shake off the market?s expectation of an interest rate cut next year.

The ideal outcome will be for the US dollar to decline so gradually that the US economy will have plenty of time to wean itself from cheap Chinese imports. But if some financial accident occurs and the US dollar collapses, the outcome will be unthinkable.

How to secretly rob the people with monetary inflation?

Sunday, December 10th, 2006

Quite some time ago, we had learnt that Alan Greenspan, the former US head of the Federal Reserve, had a sign at his desk that said, ?The Buck Starts Here.? While we are not sure of the truth to this, we know that at the very least, the statement itself is true (and funny as well)?the Federal Reserve has the power to create US dollars out of thin air. Since the world is running on fiat currency system, this arrangement is an accepted order of things globally. While we are not pointing a finger at anyone, we cannot help but feel disturbed by the ethical implication of this arrangement.

Suppose someone of great counterfeiting skill forged a million dollars. Who is the first to benefit? Obviously the forger because he can now spend the fake money on whatever he likes. The shopkeeper who receives the forger?s fake money will benefit next as his income increases. As the fake money spread throughout the economy, the money will pass from hand to hand in the forms of incomes and expenditures, raising the prices of goods and services along the way. Who will suffer most? The last person who receives the fake money because by the time he does so, price would have already risen.

Now, let us look at the situation in Shanghai as an example?see our previous article, Cause of inflation: Shanghai bubble case study. (Please note that we are not pointing a finger at the Chinese authorities?this is a universal problem that applies to every country in the world.) Clearly, there are some people who unfairly benefit and some who loses out. When central banks print money, the commercial banks are usually the first in the queue to receive them. The next to receive the money will be the companies and businesses that receive the money in the form of loans through the fractional reserve banking system. As that money made its way into the various classes of assets (e.g. properties and stocks), there will be some who strike it ?rich? as they sell their assets at inflated prices. As we said before in Speculative fervour in the Chinese stock market, the proliferation of ?success? stories of those who achieve their wealth through their ?investment? is testament to this phenomenon. Those who ?made? money will no doubt spend them, thus adding to the aggregate demand of the economy and bidding up prices. The end result is price inflation. Who are the last ones who will receive the money? The common people on fixed salaries and who do not own any ?assets? will have to bear the brunt of price inflation. In Shanghai, the rural migrants are one of the most susceptible groups. What is the end result of this? A redistribution of wealth from the last ones in the queue to the first one in the queue! Usually, the latecomers are the most vulnerable members of society.

Thus, monetary inflation always brings about false illusions of prosperity in the beginning. In reality, if left unchecked and unrectified, will be harmful to society in the end.

Why is China printing so much money?

Thursday, December 7th, 2006

In our previous article, Cause of inflation: Shanghai bubble case study, we explained that the root cause of price inflation is monetary inflation. The Chinese economy is awash with growing liquidity (that is, the economy is soaked with ever-growing supply of money). The next question to ask is: why is money supply growing in China?

One of the culprits for this problem is the inflexible exchange rate of the Chinese currency (RMB). The RMB is not a freely floating currency?its exchange rate is still controlled by the Chinese central bank albeit having some semblance of flexibility. At the current rate of exchange, the RMB is undervalued. Since it is undervalued, foreign capital will want to enter China in the form of foreigners buying up the RMB. If the RMB is a freely floating currency, the demand for it by foreigners will bid up its price, which will reduce its demand as it becomes more expensive. Conversely, as its price rose, domestic sellers of RMB will sell down its price. Finally, a market equilibrium price will be reached where the quantity supplied will meet its quantity demanded. Since the RMB?s undervalued exchange rate is still barred by the Chinese central bank from rising, foreign demand will exceed its domestic supply. So, the question is: where is the RMB going to come from? In the absence of capital controls freedom, the only choice the Chinese central bank has is to print RMB to maintain the undervalued exchange rate. Now, with foreigners armed with freshly printed RMB, they bided up the prices of Chinese assets, including stocks and properties. In the case of Shanghai, real estate prices had reached dangerously bubbled prices. As those newly printed money permeate its way into the rest of the Chinese economy, the result is price inflation. We are hearing reports from the grassroots level that prices of many things (including everyday goods and foodstuffs) in Shanghai are increasing.

Lately (as we mentioned before in Are you being ripped off by fund managers?), we are not keen in handing our hard-earned wealth into the managed fund that is sinking more money into the massive pool of raging liquidity in the Chinese economy. There are better alternatives to take part in the growth of China than to join in the bubble.