Posts Tagged ‘Wilhelm R?pk’

Are improving consumer sentiments ‘good’ news?

Wednesday, June 10th, 2009

In today’s 7:30 Report, Kerry O’Brien reported of a good news on the Australian economy. The good news, as it turned out to be, was a surprise jump in consumer sentiment as measured by the Westpac-Melbourne Institute index. It was the largest jump in 22 years. Words to describe this rebound include, “remarkable” and “surprise.”

What was the reason for the jump? According to Bill Evans, chief economist of Westpac, it was “very likely that the dominant factor behind this extraordinary rise was the release of the March quarter national accounts last Wednesday.” Other reasons include the lowering of interest rates, stock market rally and so on.

The fact that economists got excited over something so meaningless shows that shonky economics is practiced here in Australia.

As we quoted Wilhelm R?pk in his 1936 classic at Why is the market so easily tossed and turned by dribs and drabs of data?,

It was indeed an ingenious idea to apply the principle of nautical astronomy to economic forecasting, but there was one fatal flaw. For as long as we have not made a thorough investigation into the causal relationships between the time-series, the mere temporal sequence does not tell us any more than that something has happened in the past which might not happen in the future if some variables in the causal mechanism should change. But in investigating the causal relationships we are thrown back from statistical empiricism to ?theory? in the deductive and analytical sense.

By the statistical method, we ascertain facts, but we cannot explain them, i.e., bring them into logical order so that we ?understand? them. Only analytical theory can do that, and if there has been, in recent years, any furthering of our insight into the mechanism of crises and cycles, this has been the work of the theorists and not of the empiricists.

Where is the critical thinking by those mainstream economists?

It is very easy to understand why consumer sentiments improved. Today, many people’s ‘wealth’ are tied to the asset markets. Many have their retirement ‘savings’ invested in superannuation funds, which in turn pour the money into the stock market. Also, many have most of their ‘wealth’ tied to their primary asset, their home, which in turn depend on the property market. To put it simply, people’s sense of financial well-being are tied to asset prices. For those deep in debt, if their asset prices collapses, it’s curtains closed for them.

Naturally, if

  1. One’s sense of financial well-being depends on asset prices and
  2. Having read about “green shoots,” recovery ‘hopes,’ Chinese appetite for Aussie dirt, and sustained stock market rallies on the mainstream media daily and repeatedly,

… it is easy to feel optimistic as an indebted consumer. As the Nazi propaganda chief, Gobbels once remarked, if you repeat something long enough, eventually people will believe it as truth.

Allegedly, the stock market, in response, rallied hard upon this ‘good’ news. In some ways, this rally will feed back into consumer confidence. This reminds us of this story at Do sentiments make the economy or the economy makes the sentiments?,

It was autumn, and the Red Indians on the remote reservation asked their new chief if the winter was going to be cold or mild. Since he was a Red Indian chief in a modern society, he couldn?t tell what the weather was going to be. Nevertheless, to be on the safe side, he told his tribe that the winter was indeed going to be cold and that the members of the village should collect wood to be prepared.

But, being a practical leader, after several days he got an idea. He went to the phone booth, called the National Weather Service and asked, ?Is the coming winter going to be cold??

?It looks like this winter is going to be quite cold indeed,? the meteorologist at the weather service responded.

So the chief went back to his people and told them to collect even more wood. A week later, he called the National Weather Service again.

?Is it going to be a very cold winter??

?Yes,? the man at the National Weather Service again replied, ?It?s definitely going to be a very cold winter.?

The chief again went back to his people and ordered them to collect every scrap of wood they could find. Two weeks later, he called the National Weather Service again.

?Are you absolutely sure that the winter is going to be very cold??

?Absolutely,? the man replied.

?It?s going to be one of the coldest winters ever.?

?How can you be so sure?? the chief asked.

The weatherman replied, ?The Red Indians are collecting wood like crazy.?

This Westpac-Melbourne survey result is like the Weather Service man ‘predicting’ cold weather ahead by observing the Red Indians collecting firewood like crazy, who in turn did so on the Weather Service’s ‘prediction.’

It doesn’t take a genius to deduce that another panic in the stock market will cause consumer sentiment to tumble again.

Are governments mad with ‘stimulating?’

Thursday, March 26th, 2009

In the 1990s, when the Japanese bubble economy burst and fell into debt deflation, its banks were crippled with bad debts. In the ensuing decade, the Japanese government embarked on massive government stimulus programs. Roads to nowhere were built and there were even comments about resorting to military spending (which of course was dismissed later as mere rhetoric because of neighbouring countries’ sensitivities to Japan’s wartime past). When the first stimulus programs proved to have failed in its objective, a second and bigger one was announced. When that failed too, a third and bigger one was announced. Altogether, the Japanese government had embarked on 10 stimulus programs totalling 30 trillion yen. Today, the Japanese government’s debt is greater in size than the entire GDP!

Fast forward to today. The Global Financial Crisis (GFC) had prompted many countries to embark on major stimulus programs. This time round, most of the largest economies are doing the ‘stimulating’- US, UK, Japan (again) and China. The Europeans, on the other hand, are shying away from that. Here, in Australia, our government is also doing the ‘stimulating.’

One of the Einstein’s definition of madness is: continuing to do the same thing, hoping for a different outcome. So, it is pretty clear to us that madness is prevailing.

The root reason why all these stimulation will not work is that we have a structural problem in the global economy. Stimulus spending will not solve the structural problem. As long as the structural problems are not dealt with, the economic slump will not end. As we quoted Wilhelm R?pk’s 1936 economic classic at Overproduction or mis-configuration of production? in January 2008,

It is an indisputable fact that a general slump, which does not permit of the scale of production reached in the boom being maintained, sets in during the crisis, and it is equally indisputable that this general slump is the result of the total demand suddenly falling behind the total supply. But let us make sure what this means and what it does not mean. Under no circumstances can it mean that the cause of the general slump is to be sought in the fact that production has outstripped consumption and that too many of all goods at once are being produced.

Today, governments see the same thing and simplistically believe that aggregate demand is less than aggregate supply. Therefore, the solution, as they understand the crisis to be, is to ‘stimulate’ the economy in order to boost aggregate demand. But as we explained before in Overproduction or mis-configuration of production?, this idea is fallacious.

The whole point of an economic crisis is to correct the structural flaws in the global economy and clean out the wasteful mal-investments. But government bailouts and stimulus are interfering with the correction process. Therefore, this global economic malaise will be prolonged much longer than necessary. If governments go over the top with ‘stimulation’ that don’t work, the outcome will be hyper-inflation (see Supplying never-ending drugs till stagflation).

For our newer readers, we recommend that you read our guide, What causes economic booms and busts?.

Hedging against deflation

Monday, October 6th, 2008

The recent nationalisations, collapses and runs on banks in the US and Europe brings a new dimension of economic uncertainty to many people. The last time such things occur in the developed Western world was during the Great Depression in the 1930s. For this current generation of economists, financial analysts and money managers, a credit crisis is something that is supposed to occur only in textbook studies of the past. But recent financial market events brought such abstract history into real life. Suddenly, the idea that cash is no longer safe is a rude surprise for many. If cash is no longer safe, then where else can you hide?

This is what is technically called “deflation.” Deflation is not as simple as just falling prices. It is, as we explained in Will deflation win?,

A falling money supply is the definition of deflation, for which the symptoms will be falling asset prices, which if prolonged enough, will lead to falling consumer prices. But before we go off to celebrate falling prices, remember that this is an evil type of deflation because it is the type that is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on.

We recommend that you read our guide, What is inflation and deflation? for more information about this topic.

So, if you are particularly concerned about deflation, how should you protect yourself? As we said before in Should you hold gold or cash in times of deflation?,

You see, the ?cash? that you had deposited in a bank is an asset to you but a liability to the bank. In times of severe economic conditions (e.g. during the Great Depression), can your bank honour its liabilities? If it can?t, then your ?cash? is in grave danger.

The key thing to remember is that as long as your asset is a liability of someone else (e.g. bank), you have a counter-party risk. If your counter-party defaults, your asset is gone. In this evil kind of deflation, counter-party default is the greatest risk to your wealth. Therefore, there is only two ways to protect yourself:

  1. Choose your counter-party wisely.
  2. Keep your wealth in a physical form such that it is nobody else’s liability.

We will first explain point (1). Basically, the only supposedly risk-free counter-party is the government because it has the executive power to tax and print money (note that we used the word “supposedly”- the Russian government defaulted on its bonds in 1998). If you store your wealth in the form of government debt (e.g. Treasury bonds), you will be guaranteed a periodic payment from the government. As we explained before in Measuring the value of an investment,

For example, if you pay $100 for a newly issued 10-year government bond that pays 6% per annum, you are sacrificing $100 of today?s consumption in order to receive $6 per year for the next 10 years. That 6% is your rate of return on your investment. Now, let?s say you decide to sell your government bond to Tom at $90. The rate of return for Tom is 6/90 = 6.67%. Let?s say Tom sells the bond to Dick at $110, the rate of return for him will be 6/110 = 5.45%. Thus, the rate of return of the bond is inverse to the price paid for it.

In times of deflation, government bonds will be so highly sought after that its free market value will rise. Consequently, its yield (rate of return) will fall. On the flip side, government bonds are completely useless during inflation. In times of hyper-inflation, government bonds are as good as toilet paper.

Now, point (2) is already explained in Should you hold gold or cash in times of deflation?. But we would like to add a few more points:

  1. Gold was an excellent hedge during the days of the Great Depression because the US was still under a gold standard. The government would print a specific amount of US dollars to buy the gold that you presented to them. As we quoted Wilhelm R?pk in Which industry?s profitability grew as the Great Depression progressed?, the gold mining industry prospered during the Great Depression because

    So long as there exists at least one country [the US] on a full gold standard, an essential condition of which is freedom to buy gold from or sell gold to the central institution at a fixed price, there is literally an unlimited demand for the commodity at that price. In other words, not only is a minimum price for the product of the industry guaranteed, but there is, besides, no limit to the amount the market will take.

  2. The case for physical gold as a deflation hedge is weakened if the government insures bank deposits. In the US, the FDIC insures up to $100,000 of bank deposits. In Australia, there is NO government deposit insurance.
  3. But if for whatever reason, you (1) distrust the government’s deposit insurance, (2) have more than the amount that is insured by the government, (3) believes that the government will print lots of physical cash to provide for cash withdrawals in a bank run, (4) put a freeze on cash withdrawals to prevent bank runs, (5) government does not insure bank deposits (e.g. Australia), (6) can only trust storing your wealth in tangible form (6) etc, there is still arguably a case for holding gold as a hedge against deflation.
  4. The US government outlawed gold ownership during the Great Depression. It may happen again this time.

Does correlation implies causality?

Wednesday, July 9th, 2008

In July this year, Australia’s consumer confidence fell into a 16-year low (see Economic gloom deepens). In today’s Alan Kohler’s financial news report on ABC 7pm News, he plotted a graph of petrol prices and consumer confidence survey readings. You could see that there was an inverse correlation between petrol price and consumer confidence. Alan Kohler said that this graph was to “show you” where the fall in consumer confidence came from.

For us, we are not so sure about that.

Here, we are not making any judgement on this implied assertion. But we would like to point out a potential mental pitfall: does correlation necessarily implies causality? That is, does the inverse correlation between petrol price and consumer confidence necessarily imply that the downward trend of the latter is caused by the upward trend of the former? Could the reason for the correlation be due to both having the same underlying cause?

This is one thing that investors must always be on the look out for. Using statistics, we can calculate the correlation factor between two time series. It is one thing to find out that both of them turn out to have a strong correlation (or inverse correlation) relationship with each other. It is another thing to interpret the meaning of this finding. As we quoted Wilhelm R?pk in Why is the market so easily tossed and turned by dribs and drabs of data?,

By the statistical method, we ascertain facts, but we cannot explain them, i.e., bring them into logical order so that we ?understand? them.

Beware of analysts, especially the ones who are quoted on the media, who are very loose with the interpretation!