Credit - The Cantillon Effects

"Labour was the first price, the original purchase - money that was paid for all things. It was not by gold or by silver, but by labour, that all wealth of the world was originally purchased."- Adam Smith 

Last week, we concluded our post by indicating of one of our "outside the box indicator" namely Sotheby's stock price versus world PMIs since 2007 - graph source Bloomberg:

We argued that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months.

Of course, our reference to this "outside the box" relationship was by no mean "innocent". In fact it was the perfect way for us to justify this week's chosen title given that "Cantillon effects" describe increasing asset prices (asset bubbles) coinciding with an increasing "exogenous" (central bank) money supply.

So why choosing art as a reference market in describing Cantillon effects and asset bubbles you might rightly ask? 

Well, as posited by a very interesting study by Cameron Weber, a PhD Student in Economics and Historical Studies at the New School for Social Research, NY, in his presentation entitled "Cantillon effects in the market for art":

"The use of fine art might be an effective means to measure Cantillon Effects as art is removed from the capital structure of the economy, so we might be able to measure “pure” Cantillon Effects.

In other words, the “Q” value in the classical equation of exchange is missing all together for the causal chain, thus an increase in the money supply might be seen to directly affect the price of art.

Economic theory is that as money supply increases, the “time-preferences” of art investors decreases (art becomes cheaper relative to consumption goods) and/or inflationary expectations mean that art investors see price signals (“easy money”) encouraging investment in art." - Cameron Weber, PHD Student.

Nota bene: Classical equation of exchange, MV = PQ, also known as the quantity theory of money. Quick refresher: PQ = nominal GDP, Q = real GDP, P = inflation/deflation, M = money supply, and V = velocity of money.

-Endogenous money, PQ => MV (Hume, Wicksell, Marx)

-Exogenous money, MV => PQ (Keynes, Monetarist)

In our Cantillon Effects, we get:

Δ M  => Δ Asset Prices

Our friend Cullen Roche recently argued that the "Austrian Business Cycle Theory is inherently flawed and built on misunderstandings about the way the modern monetary system actually works.":

"Austrian Business Cycle Theory Misunderstands Endogenous Money.  Like many other economic schools of thought, Austrian economics is predicated on a loanable funds model with a world view designed to demonize just about everything the central bank does.  As I’ve explained before, the primary purpose of the central bank is not a conspiratorial attempt to enrich bankers, but to help oversee and regulate the smooth functioning of the payments system." - Cullen Roche

As far as we are concerned, if economy is a "religion" then we are agnostic, but, we do believe that, there are some points which are valid in some theories, Austrians included.

By no mean, we would like to enter into endless economic arguments. We have no point to prove, just common sense to display. 

Our objective in this week's conversation, is rather to expand our vision (and maybe yours) to our understanding of "Cantillon effects", asset prices bubbles and "mis-behaviors" of markets (in true Mandelbrot fashion that is...).

"Cantillon effects" in the market for art:

"Money supply is “M1” based on methodology used by Bessler 1984 and Devadoss  & Meyers 1987, in order to compare results of Cantillon Effects versus money supply effects on output prices.

Art data based on 1,336 repeated sales from 1830 – 2007 on the London market. 

Data provided by Goetzmann et al 2010, data commonly used by cultural economists to measure returns to art versus other assets, updated by Goetzmann et al for error correction, contemporary art (1960s onward) and a more recent method for inflation indexing.

We find two distinct periods of monetary history, leading to the need for data bifurcation between the pre-war Classical Gold Standard (1830 – 1913) and the post-war central-banking era (1946 - 2007)."

 - source Cameron Weber, PhD Student in Economics and Historical Studies.

From the same study from Cameron Weber we learn the following interesting point:

"Bessler 1984 and Devadoss & Meyers 1987 use a VAR log likelihood model to estimate the most likely lagtimes between a monetary change and effects on output prices.  They find (using monthly data) that the most likely lagtime is 13 and 14 months with a rapidly dissipation of the price increase immediately following the most likely effect.

Using the same methodology we find that the most likely effect of a money supply change on art prices is also between the 13th and 23rd month (e.g., during the 2nd year using yearly data).

However, unlike the earlier work on output prices, we find that the effect on art prices does not decay rapidly after the monetary increase, showing perhaps that money changes are cumulative (and/or have momentum) and could lead to an ‘asset bubble’."  - source Cameron Weber, PhD Student in Economics and Historical Studies.

The most interesting part of using the art market as a "proxy" for asset bubbles is indeed that money changes (namely the monetary base) leads to the creation of "asset bubbles".

Back in December 2010, in relation to the launch of QE2, in our conversation "Inception - Bernanke's QE2 Experiment" we argued:
"Like in the movie Inception, the Fed is trying to plant an idea into people's mind. Bernanke idea's with QE2 is to create a wealth impression which would increase consumption and economic growth, with the help of rising assets prices. We had the Greenspan put and the Bernanke put, we also now have to contend with the same bubble creation plan which was initially followed by Alan Greenspan.
We all know now the results of creating asset bubbles and the consequences.

It is a very dangerous game." - source Macronomics.

And as we posited in our January conversation "If at first you don't succeed...": 

"Arguably the strategy of our "Sorcerer's apprentice" has been to try to induce a rise in velocity, but, we have shown in our post "Zemblanity" that the "relationship" between US Velocity M2 index and US labor participation rate over the years is clearly indicative of the failure of the theories of Friedman and Keynes because central banks have not kept an eye on asset bubbles and the growth of credit and do not seem to fully grasp the core concept of "stocks" versus "flows." - source Macronomics

Another illustration of the cumulative effect in the change of money leading to asset bubble has been clearly illustrated by the housing bubble leading to the financial crisis given we are now at the 5 year anniversary mark. 

Once again "Cantillon effects" were at play as clearly demonstrated by Cameron M Weber, Cameron Weber, a PhD Student in Economics and Historical Studies, in the following abstract - "The Economic History of the Recent Financial Crisis Using Cantillon and Intervention Effects as a Basis for Explanation":

"This research uses Cantillon effects and institutional, policy, incentives created in the market for home purchases in the US to show correlation and causation between an increase in the quantity of money and an increase in home prices during the housing “boom” and the subsequent financial collapse based on the “bust” of the housing boom. Initial results show that the FHA policy initiated in 1998 to encourage 0% down-payment mortgages for housing triggered a relationship between an exponential growth in housing prices with that of an exponential increase in the money supply. Initial results also show that this structural relationship ended in May 2006 when the SEC declared “accounting irregularities” at Fannie Mae, which also coincides with the downturn in housing prices." - source Cameron Weber.

When it comes to the current market conditions and "Cantillon Effects", and asset bubbles, as well as other valid economic theories, Keynes coined the term "Animal spirits" in his 1936 book "The General Theory of Employment, Interest and Money" to describe the instincts, proclivities and emotions that influence human behavior, consumer confidence, as well as speculation:

"Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." - John Maynard Keynes, The General Theory of Employment, Interest and Money, 1936.

In similar fashion to the Cantillon Effects, which led to the Austrian Business Cycle Theory and the role of "exogenous" money, Keynes held the view that "animal spirits" lead to damaging speculation and he was a proponent for government restrictions on investment to avoid the formation of "asset bubbles".

But, the "behavioral psychologist" in us would argue that large speculative episodes throughout histories are not engendered solely by human nature. Multiple examples of boom, and bust cycles have shown that the "Cantillon Effects" leading to the formation of asset bubbles shared common trait of "stimulation". For instance the housing bubble in the US was clearly the result of government policy in conjunction with increases in the money of supply with incorrect interest rate levels leading to speculation and "mis-allocation" of capital.

In similar fashion, as we argued recently, the effect of the last few years of ZIRP has led to speculative inflows in Emerging Markets. Current outflows are due to "flows" issues rather than "stocks" issues (debt levels in many Emerging Markets remain well below Developed Markets), confirming therefore our "reverse osmosis" theory.

We did give an early warning on the risk for Emerging Markets on the 14th of April in our conversation "The Night of the Yield Hunter" though:

"The risk of a deflationary bust validates our negative stance towards commodities and emerging markets as indicated last week for the second quarter.

In similar fashion UBS in their March 2012 note entitled "The Ides of March" made an interesting point which could validate the on-going weakness in both commodities and Emerging Markets:

"The end of Federal Reserve and European Central Bank (ECB) stimuli will cause an acceleration of capital flows out of emerging markets, hitting commodity demand."  - source UBS

The work done by Didier Sornette's team relating to the prediction of the formation of asset bubbles as indicated on the "Financial Crisis Observatory" site clearly illustrates the "Cantillon Effects" at play.

For instance their recent study of the "behavior" and bubble formation for Tesla's share price is also illustrative of "bubble formation" and "animal spirits" or when "our positive activities depend on spontaneous optimism rather than mathematical expectations", to quote Keynes:

"Inflated high-tech stocks like Tesla (or LinkedIn) are particularly vulnerable during a global correction in stock markets.

Without judging the value of Tesla’s technology, innovation and management, it is a textbook example of a bubble.

See this paragraph from our recent article D. Sornette and P. Cauwels The Illusion of the Perpetual Money Machine, Notenstein Academy White Paper Series (Dec. 2012)

(http://arxiv.org/abs/1212.2833 and http://ssrn.com/abstract=2191509)

(https://www.notenstein.ch/sites/default/files/publications/notenstein_white_paper_series_041212.pdf)

“First, a novel opportunity arises. This can be a ground-breaking technology or the access to a new market. An initial strong demand from first-mover smart money leads to a first price appreciation. This often goes together with an expansion of credit, which further pushes prices up. Attracted by the prospect of higher returns, less sophisticated investors then enter the market. At that point, the demand goes up as the price increases, and the price goes up as the demand increases. This is the hallmark of a positive feedback mechanism. The behavior of the market no longer reflects any real underlying value and a bubble is born. The price increases faster and faster in a vicious circle with spells of short-lived panics until, at some point, investors start realizing that the process is not sustainable and the market collapses in a synchronization of sale orders. The crash occurs because the market has entered an unstable phase. Like a ruler held up vertically on your finger, any small disturbance could have triggered the fall.” 

It is also important to stress that in the same manner Tesla is the textbook example of the importance of bubbles in innovation and technological revolutions, as explained within our "social bubble'" hypothesis [1-4].

If you look at the income statement of Tesla you see that the company has been losing money consequently. This is no surprise for such a high-tech startup.

If investors would only focus on fundamental value, Tesla would not be able to raise money through the stock-market. However, because of the anticipations, hence, the bubble effect on the price, investors are nevertheless attracted by expected profits. This would not be possible if the price would be fully fundamentally driven." - source ETH, Financial Crisis Observatory.

Tesla Market value exceeded $20 billion on the 26th of August - graph source Bloomberg:

There you go, "spontaneous optimism rather than mathematical expectations" to paraphrase Keynes.

The Log-Periodic Power Law Oscillations (LPPL), is part of the methodology used by Professor Sornette  to ascertain the "bubble" level (here comes the notion of fractals and our prior reference to Mandelbrot and his book The (Mis)Behaviors of Markets).

Of course, another illustration of "Cantillon Effects", credit creation and "bubbles", as we have long ascertained, has been in the shipping industry as illustrated by the "boom" and "bust" of the Baltic Dry Index.

The Baltic Dry Index aggregates the costs of moving freight via 23 seaborne shipping routes. It covers the movement of dry-bulk commodities, such as iron ore, coal, grain, bauxite and alumina.

In similar fashion the burst of the credit bubble had a dramatic impact on housing, shipping was as well not spared as cheap credit did indeed fuel a bubble of epic proportion - graph source Bloomberg:

"The dry-bulk market, which accounts for about 50% of shipped freight, is driven by steel demand, as iron ore and coking coal make up about 40% of volumes. Utility coal, grain, bauxite-alumina and phosphate are also major dry-bulk commodities. The Baltic Dry Index, a major barometer for the industry, has more than doubled ytd."  - source Bloomberg.

The deflationary environment, and "Schumpeter" like creative destruction has enabled innovation, in the container shipping space benefiting, the fittest to survive such as Danish Maersk currently busy upgrading massively its container fleet. Maersk remains our favorite, when it comes to identifying the survivors in this game of "survival of the fittest" but we digress.

As we indicated in our January conversation entitled "The link between consumer spending, housing, credit growth and shipping - A follow up":

"If there is a genuine recovery in housing driven by consumer confidence leading to consumer spending, one would expect a significant rebound in the Baltic Dry Index given that containerized traffic is dominated by the shipping of consumer products."

We have indeed seen such a rebound in the Baltic Dry Index - graph source Bloomberg:

"Containerized traffic is dominated by the shipment of consumer products, and a resurgence in international volumes is dependent on the housing market. Furniture and appliances are some of the top freight categories imported into the U.S. and euro zone from Asia. Furniture demand has been picking up, after bottoming in 2009 following the collapse of the housing market." - source Bloomberg.

As far as the Baltic Dry Index is concerned, while US Family Housing Starts looks fairly flat, US Furniture sales have indeed been very strong explaining therefore the pick-up in the aformentioned Baltic Dry Index:

Since 2006:

- in yellow the Baltic Dry Index, 

- in orange US Family Housing Starts 

- in white US Furnitures Sales.

The "Cantillon Effects" of cheap credit led to an inflation of both the housing bubble and the baltic dry bubble. The increase of US demand led to an increase in Chinese production, and a rise in commodities prices. 

In similar fashion, we indicated the "Cantillon Effects" of QE2 has been exporting inflation in our conversation "Misstra Know-it-all":

"The Fed tried to increase jobs by lowering interest rates, weakening the dollar in the process, boosting exports but exporting inflation on a global scale, particularly in the commodities space, leading to political instability in the process with QE 2. The effect QE 2 has had on the commodity sphere has been well described in a Bank of Japan research paper entitled "What Has Caused the Surge in Global Commodity Prices and Strengthened Cross-Market Linkage?", published in 2011.

Like we said about "positive correlations", "Misstra Know-it'all" has indeed played a quick hand, lifting stock prices, playing on the wealth effect game and exporting "hot money" flows in Emerging Markets."

When it comes to inflation, the "Cantillon Effects" are another way of looking at inflationary pressures, but of different nature. Inflationary pressures are not always strictly tied up to consumer prices, but, can be transmitted first in asset prices. While inflation in the US peaked at 5.6% in August 2008 prior to the stock market crash of October, the "Cantillon Effects" witnessed in the surge of assets prices were largely ignored by the US central bank - graph source Trading Economics:

As far as markets are concerned and in respect to the current level of prices, whereas market's performance in the 5 years that followed the demise of Lehman Brothers has been stellar, we agree with Bank of America Merrill Lynch's recent note entitled "Tinker, Taper, Told Ya, Buy" from the 12th of September, the next 5 years will probably be more "problematic"

"Asset markets will not do as well in the next 5 years, no matter what “nouveau bulls” say. Central banks will be less generous, corporations less selfish. And should excess liquidity be quickly removed markets will get “CRASHy”." - source Bank of America Merrill Lynch

Truth is the big beneficiary of the "Cantillon Effects" in the reflation game played out by the Fed has indeed been Wall Street versus Main street as indicated by Bank of America Merrill Lynch in the same note:

"After Lehman…

An unprecedented financial and economic crisis, crystallized by the September 15th 2008 bankruptcy of Lehman Brothers, was followed by an unprecedented monetary policy response, which in turn has been followed by unprecedented bull markets in bonds, stocks and now real estate. Wall Street has soared, but Main Street has soured (Chart 2). The exceptional “sweet spot” engendered by generous central banks and selfish corporations has been great for owners of capital, but bad for labor.

The "race to reflate" in the developed world and faltering Chinese macro leadership dictated the winners & losers of the past 5 years: Gold, High Yield, EM debt & Asian equities have been big winners; Commodities, Government Bonds & Japanese equities have been the big losers (see Table 1 on front page).

QE was the prime driver of the ‘09 trough in stocks & the ‘11 trough in real estate, and liquidity withdrawal has driven the jump in global interest rates in 2013. A further rapid, jump in rates would destabilize asset markets, but this threat remains low in coming quarters. The 100 basis point summer surge in the 30-year Treasury yield has tethered the S&P500 index to a tight 1600-1700 range and traumatized many fixed income & emerging markets." - source Bank of America Merrill Lynch

So if markets, does indeed become crashy in the next five years, we suggest you check, once in a while the   bubble index blog:

LPPL Market Watch

On a final note, if indeed rates are for "normalization", in similar effect, the world is "normalizing" as well given the Syrian crisis has seen the return of the Russia to world center stage, making us believe into a new era of "bipolarization". Market wise, we believe as well the Russian ruble is poised for a rebound as indicated by Bloomberg Chart of the Day:

"The ruble is poised to rebound from a four-year low as oil’s climb to the highest since February lures investors who fled during an emerging-market selloff after the Federal Reserve said it would taper economic stimulus.

The CHART OF THE DAY shows the currency of Russia, the world’s biggest oil producer, tumbling to its weakest since August 2009 against the central bank’s dollar-euro basket, even as Brent crude futures rallied to $117.34 a barrel last month. Previously the ruble had largely kept pace with changes in the price of crude, the country’s main export earner.

About $24 billion has been taken from emerging-market bond funds since the end of May, OAO Gazprombank and Morgan Stanley said, citing EPFR Global data. That’s the same month Fed Chairman Ben S. Bernanke first said U.S. policy makers were contemplating reducing quantitative easing.

“For the past few months, the market has been fixated on the Fed,” said Dmitry Dorofeev, a trader and strategist at BCS Financial Group in Moscow. “The ruble’s relationship with oil should re-establish itself once the initial taper is out of the way, and we should get a nice bounce.”

The ruble also may recover as energy exports climb from seasonal lows and local demand for foreign currency declines after annual dividend payments by large Russian companies and the peak of the tourist season, Dorofeev said. Russia is the world’s biggest supplier of natural gas and the No. 2 oil exporter, according to the International Energy Agency. The ruble has dropped 7 percent against the dollar and 7.8 percent against the euro this year, on track for its worst annual performance since the 2008 financial crisis." - source Bloomberg

"If liberty means anything at all, it means the right to tell people what they do not want to hear." - George Orwell 

Stay tuned!

Ben Bernanke - The illusionist and the year of the rabbit - The illusion of wealth

The illusion of Wealth:

We all know what happened during the financial crisis, a lot of Americans used their house as an ATM. Today the ATM is broken, following the dramatic impact of the crisis on households balance sheet and the collapse of the housing market. Thanks to QE2 and the rise in all asset prices, Ben Bernanke seems to be succeeding in creating the illusion of wealth. It is indeed the year of the rabbit and the magician is clearly Bernanke, pulling the wealth rabbit out of a hat.

http://www.quebecoislibre.org/05/050415-9.htm
THE ILLUSION OF HOUSEHOLD WEALTH - 15th April 2005 - Chris Leithner

"By borrowing against a home whose price is rising, sometimes substantially, households have been able to "extract equity" and consume the proceeds; and the growing magnitude of extraction has enabled them to increase their consumption at a rate that has greatly exceeded the increase of household income. But all financial transactions incur risk, and the most immediate risk of this behaviour is the sturdiness of the assumption that the prices of households' assets, particularly houses, can continue to rise much more quickly than income. A less immediate but ultimately much more significant risk is the weakening of the capital structure. A weaker structure today implies sluggishly growing or stagnant or even falling living standards in the future."

In this excellent article Chris also adds the following:

"Using American data from 1952 to 2003, Kasriel has charted the relative importance of savings and capital gains as components of households' net worth. In the mid-1990s, the impact of capital gains began to outstrip savings by a wide margin. From 1995 to 1999, a steady increase in the prices of the household's portfolio of stocks drove the increase of its net worth; and since 2000, increases in the market price of the family home have done so. During the period 1952-1994, capital gains on stocks or real estate were, on average, 1.7 times greater than household saving; and from 1995 to 2003 these gains averaged 4.4 times household saving. Consumers, cheered by politicians, concluded that capital gains are – and that savings are not – the route to higher net worth."

The Concept of Capital:
In his contribution, Chris Leithner discusses the critical concept of capital, quoting Peter Kasriel, chief economist at Northern Trust.

"Far better than most contemporary economists, who seem to comprehend it not at all, Kasriel understands the concept of capital. He notes that capital stock is conventionally defined as the sum of business assets, private residential housing, consumer durables and government property. Although he does not explicitly say so, he seems to recognise that residential real estate, consumer durables and government property are not capital goods – and therefore that they should not be regarded as components of the capital stock."

This is probably one of the most important concept to understand. To some extent, it explains why there was a huge misallocation of capital during the financial crisis which validates the Austrian Business Cycle Theory.

Here is a reminder of the Austrian Business Cycle Theory:

"According to the theory, the business cycle unfolds in the following way: Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable credit-sourced boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This credit-sourced boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if the money supply remained stable."

Chris goes on an quotes Kesriel:
"Just because an existing house goes up in [price] does not necessarily mean that the more expensive house 'produces' more actual housing services. Does a rise in the price of the house enable more people to live in it? Does the increase in the price of an existing drill press necessarily mean that the drill press is now capable of drilling more holes in an hour?
The economic wealth of a nation is related to an increase in the number of drill presses, not the nominal value of the existing stock of drill presses. The more drill presses an economy has, the more holes can be drilled in the production of other goods. The greater the capital stock of an economy, the more productive is its labour force. In short, the greater the capital stock of an economy, the more goods and services that economy is likely to be able to produce".

The relationship between capital stock and household net worth is a very important one: the more households save the faster the capital stock subsequently grows:
"Two critical insights into the nature and causes of the growth of wealth. The first is that it owes much more to savings than to capital gains. The second insight is that wealth also depends heavily upon the composition of capital stock."

Chris concluded:
"Policies that encourage saving and investment – and do not sanctify spending and consumption – are required. But to expect politicians to change their profligate spots is to suppose that leopards will become vegetarians. As a result, potentially severe disorders have been bequeathed to the future."
This what Chris Leithner had to say in April 2005.

But back to today's macro environment.
In relation to the latest quarterly publication of the US GDP, it transpires that the reason why Personal Consumer Expenditure (PCE) rose Month to Month 0.7% in December, was because savings rate fell:
In the final quarter of last year, consumers spent more and saved less. Americans saved 5.4 percent of their disposable income, compared with 5.9 percent in the third quarter.

Truth is, continuous fall in home prices in the US will hurt both consumers and banks, counteracting the wealth effect generated by QE2 and the rise of assets prices.

Banks still face unexpected losses from their on-balance sheet mortgages, from commercial and residential mortgages. A slower growth in the US combined with a stable unemployment level could entice the FED to go for QE3.

Although western Central banks, namely the FED, Bank of England and the ECB will remain accomodative in 2011, you can expect further tightening in the emerging market space, due to inflationary pressures growing relentlessly on their economies.

"I promise to pay the bearer on demand..." - Panics and Populism.

From the Bank of England's website:

http://www.bankofengland.co.uk/banknotes/about/faqs.htm#2

"The words "I promise to pay the bearer on demand the sum of five [ten/twenty/fifty] pounds" date from long ago when our notes represented deposits of gold. At that time, a member of the public could exchange one of our banknotes for gold to the same value. For example, a £5 note could be exchanged for five gold coins, called sovereigns. But the value of the pound has not been linked to gold for many years, so the meaning of the promise to pay has changed. Exchange into gold is no longer possible and Bank of England notes can only be exchanged for other Bank of England notes of the same face value. Public trust in the pound is now maintained by the operation of monetary policy, the objective of which is price stability."

Indeed in a deleveraging and restructuring world, the promise to pay the bearer has changed.

Public trust has been seriously impaired in the latest financial crisis, in both the financial sector as well as in trust in elected governments in general and politicians in particular.

The difficulties of imposing drastic austerity measures in numerous European countries are indeed endangering democracies. General strikes are on the rise in many European countries, France, Greece, Spain, etc.

The rise of populism is a stark reminder of the impact of economic crisis on fragile democracies as seen in the 30's in numerous European countries which led to the Second World War.

Populism in Latin America has had important impacts.

Populism has been fiscally supported in Latin America during periods of growth such as the 1950s and 1960s as well as during commodity price booms such as in oil and precious metals, which also explains today how Chavez in Venezuela is able to maintain his grip of the country. The fate of Chavez is intimately linked to the price of Oil.

Highly unequal societies leads to a rise in populism.

It is a global trend.

From Latin America, to Europe and the US, populism is dangerously rising.

Populism movements are deeply correlated to Panics and Depression throughout human history.

The emergence of the Tea Party movement in the US in 2009 is reminescent of the rise of the Greenback Party, which was active between 1874 and 1884, following the US civil war.

The Greenback Party was born because of the Great Depression of 1873:

http://en.wikipedia.org/wiki/Panic_of_1873

"The Panic of 1873 or Depression of 1873 marked a severe international economic depression in Europe and United States that lasted until 1879, and even longer in some countries. It began with financial failures in Vienna (capital of Austria–Hungary then) that spread to most of Europe and overextended American banking in late 1873. It was one of a series of economic crises in the 19th and early 20th centuries. In Britain, the result was two decades of stagnation known as the "Long Depression", during which Britain lost its world economic leadership. In U.S. literature this global event is usually known as "Panic of 1873", while in Europe it is known as Long Depression or Great Depression."

Effects in the U.S.
The failure of the Jay Cooke bank, followed quickly by that of Henry Clews, set off a chain reaction of bank failures and temporarily closed the New York stock market. Factories began to lay off workers as the United States slipped into depression. The effects of the panic were quickly felt in New York, more slowly in Chicago, Virginia City, Nevada and San Francisco.

The New York Stock Exchange closed for ten days starting September 20. Of the country's 364 railroads, 89 went bankrupt. A total of 18,000 businesses failed between 1873 and 1875. Unemployment reached 14% by 1876. Construction work halted, wages were cut, real estate values fell and corporate profits vanished."

Sounds eerily familiar doesn't it?

From the same Wikipedia document we learn about the impact this crisis had in both Germany and Austria.

Germany and Austria:
A similar process of overexpansion was going on in Germany and Austria, where the period from German unification in 1870-71 to the crash in 1873 came to be called the Gründerjahre or "founders' years". A liberalized incorporation law in Germany led to the founding of new enterprises, such as the Deutsche Bank, as well as the incorporation of established ones. Euphoria over the military victory against France in 1871, combined with the influx of capital from the payment by France of war reparations, encouraged stock market speculation in railways, factories, docks, steamships - in short, the same areas of overexpansion as in the United States. It was in the immediate aftermath of Bismarck's victory against France that he began the process of silver demonetization. The process began on 23 November 1871 and cumulated in the introduction of the gold mark on 9 July 1873 as the currency for the new united reich to replace the silver coins of all the constituent parts. Germany was now on the gold standard. Demonetization of silver was therefore a common element in the crises on both sides of the Atlantic Ocean.

On May 9, 1873, the Vienna Stock Exchange crashed, no longer able to sustain false expansion, insolvency, and dishonest manipulations. A series of Viennese bank failures resulted, causing a contraction of the money available for business lending. In Berlin, the railway empire of Bethel Henry Strousberg crashed, bursting the speculation bubble there. The contraction of the German economy was exacerbated by the conclusion of war reparations payments to Germany by France in September 1873. Coming two years after the founding of the German Empire, the panic became known as the Gründerkrach or "founders' crash".

Britain
In Britain the long depression resulted in bankruptcies, escalating unemployment, a halt in public works, and a major trade slump that lasted until 1897.

The Austrian Business Cycle Theory I reviewed in a previous post is a very good explaination of the recent crisis as well as the previous ones:

http://macronomy.blogspot.com/2010_05_01_archive.html

The over expansion of credit and loosening of credit standards seem to always led us to economic crisis.

The panic of 1873 was followed by a similar panic in 1893 in the US.

Similar to 1873, the crisis was caused by railroad overbuilding and unsound railroad financing which led to a series of bank failures. Compounding market overbuilding and a railroad bubble was a run on the gold supply and a policy of using both gold and silver metals as a peg for the US Dollar value. Until the Great Depression, the Panic of '93 was the worst depression the United States had ever experienced.

http://en.wikipedia.org/wiki/Panic_of_1893

"The 1880s had been a period of remarkable economic expansion in the United States. In time, the expansion became driven by speculation, much like the tech bubble of the late 1990s and the housing bubble of the early 21st century, except that the associated industry was railroads."

And the panic of 1893 was followed this time by another panic in 1907.

http://en.wikipedia.org/wiki/Panic_of_1907

"The Panic of 1907, also known as the 1907 Bankers' Panic, was a financial crisis that occurred in the United States when the New York Stock Exchange fell close to 50% from its peak the previous year. Panic occurred, as this was during a time of economic recession, and there were numerous runs on banks and trust companies. The 1907 panic eventually spread throughout the nation when many state and local banks and businesses entered into bankruptcy. Primary causes of the run include a retraction of market liquidity by a number of New York City banks and a loss of confidence among depositors, exacerbated by unregulated side bets at bucket shops."

The panic of 1907 led to the creation of the FED in 1913, the financial system was shored up in 1907 by the intervention of J.P. Morgan and other bankers.

The market overbuilding and the the real estate bubble led to the financial crisis of 2007 which started with subprime.

The Greenback Party:

http://en.wikipedia.org/wiki/United_States_Greenback_Party

"The Greenback Party (also known as the Independent Party, the National Party, and the Greenback-Labor Party) was an American political party with an antimonopoly ideology that was active between 1874 and 1884. Its name referred to paper money, or "greenbacks," that had been issued during the American Civil War and afterward. The party opposed the shift from paper money back to a bullion coin-based monetary system because it believed that privately owned banks and corporations would then reacquire the power to define the value of products and labor. It also condemned the use of militias and private police against union strikes. Conversely, they believed that government control of the monetary system would allow it to keep more currency in circulation, as it had in the war. This would better foster business and assist farmers by raising prices and making debts easier to pay. It was established as a political party whose members were primarily farmers financially hurt by the Panic of 1873.

The Gilded Age was an era of political ferment and conflict over the proper uses of governmental activity. The Greenback movement began as a protest against the national system of money and banking that had emerged by the mid-1870s. In particular, Greenbackers condemned the National Banking System, created by the National Banking Act of 1863, the harmonization of the silver dollar (Coinage Act of 1873 was in fact the "Crime of '73" to Greenback), and the Resumption Act of 1875, which mandated that the U.S. Treasury issue specie (coinage or "hard" currency) in exchange for greenback currency upon its presentation for redemption beginning on 1 January 1879, thus returning the nation to the gold standard. Together, these measures created an inflexible currency controlled by banks rather than the federal government. Greenbacks contended that such a system favored creditors and industry to the detriment of farmers and laborers.

In 1880 the Greenback Party broadened its platform to include support for an income tax, an eight hour day, and allowing women the right to vote. Ideological similarities also existed between the Grange (The National Grange of the Order of Patrons of Husbandry) and the Greenback movement. For example, both the Grange and the GAP favored a national graduated income tax and proposed that public lands be given to settlers rather than sold to land speculators. The town of Greenback, Tennessee was named after the Greenback Party about 1884."

In the US the Tea Party movement has been building up following the massive economic recession:
On June 8, 2010, in the Super Tuesday primary election, several tea party backed candidates have won.

http://en.wikipedia.org/wiki/Tea_Party_movement

"According to president of the American Enterprise Institute, Arthur C. Brooks, America is locked in a culture war in which either America will continue to be an exceptional nation organized around the principles of free enterprise, limited government, a reliance on entrepreneurship and rewards determined by market forces, or America will move toward European-style statism grounded in expanding bureaucracies, a managed economy and large-scale income redistribution. Brooks states that while some have tried to dismiss the "tea party" demonstrations and the town hall protests as the work of extremists, ignorant backwoodsmen or agents of the health-care industry, this movement reveals much about the culture war that is underway, and it is not at all clear which side will prevail."



Untermyer: Is not commercial credit based primarily upon money or property?

Morgan: No, sir. The first thing is character.

Untermyer: Before money or property?

Morgan: Before money or anything else. Money cannot buy it ... a man I do not trust could not get money from me on all the bonds in Christendom

J.P. Morgan testifying before the Pujo Committee

The inflation debate or why you can have inflation in a deflationary environment

From one article to the next, one site to another, the inflation debate is raging.

On the website Pragmatic Capitalist, the author of the blog TPC is arguing that the "inflationistas" are wrong in relation to the risk of inflation down the line due to the massive money printing exercise we have been witnessing.

It is indeed a very complex debate and in this post, I will try to add my contribution on the subject. The discussions surrounding the inflation debate will lead us to question the definition of inflation and inherently the definition of sound money.

To summarise the ongoing debate, is the massive liquidity injections we have witnessed in the world inflationary or not?

For TPC on its blog, it is not inflationary at least in the US do to the ability of the US to print money at will, same apply to the UK.

http://pragcap.com/talking-ourselves-off-the-edge-of-the-cliff

"First, the government doesn’t actually print money (at least not in terms of money creation). They simply press a button on a computer that changes accounts up and down. It’s not like they find a gold miner and print up a note and “monetize” anything. Most importantly though the government never actually has nor doesn’t have dollars. They simply change accounts up and down as they tax and spend. So what does the Fed do? They target the Fed Funds Rate via monetary operations with the belief that they are the grand wizard behind the whole operation. The Fed’s interest rate mandate or target of “price stability” actually means they can’t monetize the debt."

"Now, this is generally the point in the conversation where the inflationistas begin talking about the “effective default” of the USA via dollar devaluation. The problem is, each time the crisis flares up the price action in markets makes it abundantly clear that there is no inflation, but rather continuing deflationary fears. Einhorn’s comments regarding inflation are no different than the other inflationistas who continue to scream “fire” in a crowded theater despite no signs of fire. Of course, there has been no inflation because there is none. The inflationistas have made the same error that Mr. Bernanke made when he supposedly “saved the world” in 2008. Mr. Bernanke assumed that banks were reserve constrained while Mr. Einhorn assumes that adding to reserves is inherently inflationary. But as we see very low levels of borrowing (due to the private sector’s lack of debt demand – caused by the continuing balance sheet recession and de-leveraging) we see zero signs of inflation."

In this lenghty article TPC replies to the comments made by David Einhorn from Greenlight Capital.

TPC also add the following comment:

"In terms of government spending (or blanket Keynesianism as most doubters prefer to call it) it’s largely an accounting identity. Private sector deficit is public sector surplus. If government never spends private sector funds are slowly drained. Just imagine a one time 100% asset tax. What would happen to the economy? It would die of course. Contrary to popular opinion, government must spend before it can tax. Not vice versa. Therefore, a certain level of government spending is necessary. The recent CBO findings show that government spending was the primary reason why the economy didn’t sink into a black hole over the last year. We also know from borrowing data and bank conditions that monetary policy has failed entirely. Of course, I have argued that the government spending has been very poorly targeted and resulted in more malinvestment and ineffective output than should have been the case, but that shouldn’t surprise anyone when you allow the bank lobbyists to control legislation. Spending is not the answer, but we must understand that spending at the government level also isn’t the enemy. Regardless, these blanket statements that government spending is always bad is flat out wrong."

The issue and I agree with TPC in relation to Government spending is the quality of the spending. Government spending can be necessary provided it is acting as an investment such as infrastructure spending. In many countries, UK, France, Greece, the US, there is a lot of waste in goverment spending which have to be addressed.

We previously looked at what Canada did in the 90's in a previous post which lead to a decrease in the debt levels to GDP and boosted the economy. Of course there were short term massive pains but it generated long term gains.

The debate about inflation as highlighted by the response of TPC to David Einhorn's comments, is as well a debate between the Austrian School of Economy versus Keynesians believers.

I was recently given to read an article relating to the monetary situation of Europe following the First World War up to the Second World War and beyond. This article was written by Jacques Rueff, French Economist, Memories and Reflections on the age of inflation, 1956.

Jacques Rueff was very conscious about the risk the dollar faith economy would lead to.

In this article of the Daily Reckoning, published by Bill Bonner, Bill Bonner highlights the insight Jacques Rueff had in 1976, warning of the risk of a "faith dollar based economy".

http://www.dailyreckoning.com.au/jacques-rueff/2008/08/11/

"Since 1911, there existed in England a system of unemployment insurance that gave an indemnity to jobless workers, known as the "dole." The consequence of this regime was to establish a minimum salary level, at which workers would prefer to ask for the dole rather than work for less. It appears that in the beginning of 1923 salaries, which had been declining with other prices in England, suddenly hit this new minimum. There, they stopped falling, and since then, they practically ceased to move."

That's why France runs such high unemployment rates today; its dole is bountiful. When you add up the costs of "charges sociales," paperwork, and the minimum wage, more than one in ten potential workers is not worth the money. But no right thinking politician is about to suggest the obvious solution: get rid of the dole. So, Keynes came up with a subterfuge. The central bank should cause price inflation during a slump, he proposed. Rising prices for 'things' meant that salaries - in real terms - would go down. That was the greasy scam behind Keynes' General Theory of Employment, Interest and Money: inflation robbed the working class of their wages without them realizing it. The poor schmucks even thank the politicians for picking their pockets: "salary cuts without tears," Rueff called them.

"Full employment" was soon no longer a wish, but an obligation.

"No religion spread as fast as the belief in full employment," wrote Rueff. "...and in this roundabout way, allowed governments that had exhausted their tax and borrowing resources to ressort to the phony delights of monetary inflation. "

At the moment, TPC is right in relation to the deflation environmnent we are experiencing.

Jacques Rueff commented previously that the additional increase in money generates inflation when people receiving additional receipts, prefer to keep these receipts in their till or wallet, which means that these additional receipts of money, which are not desired, creates an excess demand, which then affect price levels.

"Au contraire, l'émission de suppléments de monnaie engendre un phénomène inflationniste si elle a lieu sans que les personnes qui reçoivent les encaisses supplémentaires désirent les garder dans leurs tiroirs-caisses ou dans leurs portefeuilles, c'est-à-dire lorsque ces suppléments de monnaie, n'étant pas désirés, suscitent une demande excédentaire, qui alors agit sur les prix."

This explains why excess credit in the US, which lead to an increase in house prices, was inflationary on many assets prices.
I strongly believe that the Austrian School Business cycle theory is the best explaination of the financial crisis which started in 2007.
Both Ludwig von Mises and Friedrich Hayek correctly warned of a major economic crisis before the Great Depression.
Hayek made his prediction of a coming business crisis in February 1929. He warned that a financial crisis was an unavoidable consequence of reckless monetary expansion.

http://en.wikipedia.org/wiki/Austrian_business_cycle_theory

"Austrian economists assert that inherently damaging and ineffective central bank policies are the predominant cause of most business cycles, as they tend to set "artificial" interest rates too low for too long, resulting in excessive credit creation, speculative "bubbles" and "artificially" low savings.

According to the Austrian School business cycle theory, the business cycle unfolds in the following way. Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable "credit-fuelled boom" during which the "artificially stimulated" borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable. Economist Steve H. Hanke identifies the financial crisis of 2007–2010 as the direct outcome of the Federal Reserve Bank's interest rate policies as is predicted by Austrian school economic theory."

In addition to the Autrian Business Cycle Theory, it is important to take into account Irving Fisher's contribution with his debt-deflation theory:

http://en.wikipedia.org/wiki/Debt-deflation

"In Fisher's formulation of debt deflation, when the debt bubble bursts the following sequence of events occurs:

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links:

1.Debt liquidation leads to distress selling and to
2.Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
3.A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
4.A still greater fall in the net worths of business, precipitating bankruptcies and
5.A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make
6.A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to
7.pessimism and loss of confidence, which in turn lead to
8.Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause
9.Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest."

Therefore a perceived inflation can happen in a deflationary environment, it can co-exist. We are witnessing it, in fact in the UK where recently inflation rose to 3.7% on an annualised basis while the UK is still entrenched in a very difficult deleveraging process.

The definition of inflation is as well a matter of intense discussion.

For the Austrian School and Ludwig Von Mises in particular, inflation is measured by the true growth of money supply.

http://en.wikipedia.org/wiki/Austrian_School#Inflation

This is what Ludwig Von Mises defined as inflation:

"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."

A lot of people argue around the current level of gold prices as a sign of incoming inflation, the truth is that we are still deeply in a deflationary environment, but inflation will be increasing at some point, when and only when the deleveraging process will be over.
The issue at hand is can the liquidity be withdrawn from the system at the moment? Probably not. The fear of deflation is very real and clear, hence the requirement of quantitative easing to avoid a deflation trap.

Inflation might have receded but cannot disappear given the current fractional banking system we are living in.

Alan Greenspan, former chairman of the Federal Reserve said the following at the start of his career:

"In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves. This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard."


The discussion around inflation is central as it leads to the understanding of sound money.

Ludwig Von Mises said the following in relation to money:

"It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights. The demand for constitutional guarantees and for bills of rights was a reaction against arbitrary rule and the nonobservance of old customs by kings."

In addition to the above and to open the discussion on the solution to the current environment, I would like to highlight Irving Fisher's proposed solution to the issue of deflation and his critics:

"Fisher viewed the solution to debt deflation as reflation – returning the price level to the level it was prior to deflation – followed by price stability, which would break the "vicious spiral" of debt deflation. In the absence of reflation, he predicted an end only after "needless and cruel bankruptcy, unemployment, and starvation", followed by "an new boom-depression sequence":

Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebted-ness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so-called "natural" way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.
On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged."

Reflation is currently what our governments are trying to achieve via massive liquidity injection and quantitative easing, and mind-blowing money supply increase as well as.

Remember Fisher's equation:
MV = PT where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place

QE in the UK, as I said in March is not working:

http://macronomy.blogspot.com/2010_03_01_archive.html

MV=PT as per Irving Fisher's equation. The Bank of England bought 200 Billions worth of long dated Gilts with QE. The BOE by pumping M (M4) is expecting T to rise and it is not really happening...
As a reminder: MV = PT. M is the stock of money in the economy,V is the velocity of circulation or the speed at which money flows around the economy. P is the price level and T the value of transactions, or gross domestic product (GDP). Hence by
increasing ‘M’, QE aims to increase ‘T’.

The initial MV = PT equation means that a rise in ‘M’ leads in reality to a fall in ‘V’ leaving no net benefit.

The solution of reflation is not working unfortunately. Debt-deflation, which is currently what is being tested, will fail.

To conclude on this post, relating to the deflation-inflation debate is that we are currently in a deflationary environment which poses no short term threat of massive inflation, but creates a risk of high inflation, if there is no debt restructuring at some point, as well as some profound structural reforms in public finances in the very near future, which will push us towards a double dip recession. It is unavoidable.

Creative destruction and the Minsky moment

“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works” - John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867

In this post I will review the consequences of this week price action.

I will also point out the current Minsky moment and theory as well as reviewing the Austrian Business Cycle Theory which if applied could have prevented much of the current mess we are in.
I will also underline again the incredibly accurate analysis and forecast made by Joseph Schumpeter in his book Capitalism, Socialism and Democracy.

From Wikipedia:

"A Minsky moment is the point in a credit cycle or business cycle when investors have cash flow problems due to spiraling debt they have incurred in order to finance speculative investments. At this point, a major selloff begins due to the fact that no counterparty can be found to bid at the high asking prices previously quoted, leading to a sudden and precipitous collapse in market clearing asset prices and a sharp drop in market liquidity."

http://en.wikipedia.org/wiki/Minsky_moment

The Minsky Theory:

"Hyman Minsky has proposed a post-Keynesian explanation that is most applicable to a closed economy. He theorized that financial fragility is a typical feature of any capitalist economy. High fragility leads to a higher risk of a financial crisis. To facilitate his analysis, Minsky defines three approaches to financing firms may choose, according to their tolerance of risk. They are hedge finance, speculative finance, and Ponzi finance. Ponzi finance leads to the most fragility.

-for hedge finance, income flows are expected to meet financial obligations in every period, including both the principal and the interest on loans.

-for speculative finance, a firm must roll over debt because income flows are expected to only cover interest costs. None of the principal is paid off.

-for Ponzi finance, expected income flows will not even cover interest cost, so the firm must borrow more or sell off assets simply to service its debt. The hope is that either the market value of assets or income will rise enough to pay off interest and principal.

Financial fragility levels move together with the business cycle. After a recession, firms have lost much financing and choose only hedge, the safest. As the economy grows and expected profits rise, firms tend to believe that they can allow themselves to take on speculative financing. In this case, they know that profits will not cover all the interest all the time. Firms, however, believe that profits will rise and the loans will eventually be repaid without much trouble. More loans lead to more investment, and the economy grows further. Then lenders also start believing that they will get back all the money they lend. Therefore, they are ready to lend to firms without full guarantees of success. Lenders know that such firms will have problems repaying. Still, they believe these firms will refinance from elsewhere as their expected profits rise. This is Ponzi financing. In this way, the economy has taken on much risky credit. Now it is only a question of time before some big firm actually defaults. Lenders understand the actual risks in the economy and stop giving credit so easily. Refinancing becomes impossible for many, and more firms default. If no new money comes into the economy to allow the refinancing process, a real economic crisis begins. During the recession, firms start to hedge again, and the cycle is closed."

http://en.wikipedia.org/wiki/Financial_crisis#Minsky.27s_theory


We have reached this moment this week. CDS prices are rising fast and furiously (Itraxx Main 5 year is now around 140 Bps an Itraxx Crossover 5 year is at 605 bps). I have witnessed similar price action in the credit market in August 2007 following the demise of the two highly leveraged Bear Stearns funds that collapse which triggered the subprime debacle. Some so called experts where at the time telling everyone that subprime was a small problem that could be contained. Same is happening today, some experts are telling us Greece is a small problem that can be contained. We are all witnessing the contagion in the market hence the Minsky moment we are in!

http://www.businessweek.com/news/2010-05-07/bank-risk-soars-to-record-default-swaps-overtake-lehman-crisis.html

TED spread is widening and this is clearly a sign of liquidity strain in the system as well as the widening in the OIS-Libor spread.

As per the Wall Street Journal on Friday, Short term lending is rising which is a sign of rising liquidity concern and counterparty risk aversion in the financial markets. This explains why there is 40 bps difference between the Itraxx Main 5 year CDS and the Itraxx Senior Financial Index 5 year CDS.

In normal markets Itraxx Financials index trades below Itraxx Main Europe as per below graph:



"The three-month dollar-lending rates among banks, the London interbank offered rate, or Libor, rose Friday, to 0.42813% from Thursday's 0.37359%, the highest since August, as risk-wary banks became more reluctant to lend to each other. Dollar Libor, which peaked in July 2009, has been mostly stable since the fall of 2009, but started to pick up again this past March.

Short-term funding markets already had shown signs of liquidity strains Thursday amid worries about counterparty risk with European banks."





Source Bloomberg

Fear gauges in the government bond market was higher Friday. The TED spread, measures the gap between the "risk free" rate three-month Treasury bills and the London interbank offer rate on three-month dollars, reached 30 bps, setting up a new high for the year so far...

Another indicator I mentioned previously as an indicator of risk spiking up is the VIX (on the 10th of April I argued that market were too complacent and the VIX was too low and VIX was at a very good entry point):


Source Bloomberg

The higher the VIX, the higher the fear and panic in the market.

We have witnessed all of the above towards the previous catastrophic Lehman collapse.

Now to the explaination of the Minsky moment, the Austrian Business Cycle Theory explains partly and the economic reasons behind our current financial crisis since 2007.

http://en.wikipedia.org/wiki/Austrian_business_cycle_theory

As per Wikipedia:

"The Austrian business cycle theory ("ABCT") is an explanation of the primary causes of business cycles held by the heterodox Austrian School of economics. The theory views business cycles (or, as some Austrians prefer, "credit cycles") as the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.

Austrians believe that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment. According to the theory, the business cycle unfolds in the following way: Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable credit-sourced boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This credit-sourced boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if the money supply remained stable. A correction or "credit crunch" – commonly called a "recession" or "bust" – occurs when exponential credit creation cannot be sustained. Then the money supply suddenly and sharply contracts when markets finally "clear", causing resources to be reallocated back towards more efficient uses.

Given these perceived damaging and disruptive effects caused by volatile and unsustainable growth in credit-sourced money, many Austrians (such as Murray Rothbard) advocate either heavy regulation of the banking system (strictly enforcing a policy full reserves on the banks) or, more often, free banking. The main proponents of the Austrian business cycle theory historically were Ludwig von Mises and Friedrich Hayek. Hayek won a Nobel Prize in economics in 1974 (shared with Gunnar Myrdal) in part for his work on this theory."


Alan Greenspan maintained interest rates too low for too long: 2000 to 2006 the creation of the bubble which led to the bust.

The Austrian Business Cycle Theory explains what happened very clearly:

"The boom then, is actually a period of wasteful malinvestment, a "false boom" where the particular kinds of investments undertaken during the period of fiat money expansion are revealed to lead nowhere but to insolvency and unsustainability. It is the time when errors are made, when speculative borrowing has driven up prices for assets and capital to unsustainable levels, due to low interest rates "artificially" increasing the money supply and triggering an unsustainable injection of fiat money "funds" available for investment into the system, thereby tampering with the complex pricing mechanism of the free market. "Real" savings would have required higher interest rates to encourage depositors to save their money in term deposits to invest in longer term projects under a stable money supply. The artificial stimulus caused by bank-created credit causes a generalized speculative investment bubble, not justified by the long-term structure of the market.

The "crisis" (or "credit crunch") arrives when the consumers come to reestablish their desired allocation of saving and consumption at prevailing interest rates. The "recession" or "depression" is actually the process by which the economy adjusts to the wastes and errors of the monetary boom, and reestablishes efficient service of sustainable consumer desires."

"The monetary boom ends when bank credit expansion finally stops - when no further investments can be found which provide adequate returns for speculative borrowers at prevailing interest rates. Evidently, the longer the "false" monetary boom goes on, the bigger and more speculative the borrowing, the more wasteful the errors committed and the longer and more severe will be the necessary bankruptcies, foreclosures and depression readjustment. There is also a notion of capital consumption contributing negatively to the readjustment period, which has been discussed in works such as Human Action."

Main critics of the Austrian Business Cycle theory such as Paul Krugman and Gordon Tullock argue the following:

"Mainstream economists argue that the theory requires bankers and investors to exhibit a kind of irrationality – that they be regularly fooled into making unprofitable investments by temporarily low interest rates."

Fabulous Fab Abacus CDO anyone?
Well guess what, bankers and investors exactly did that when they bought transactions similar to the Abacus CDO, and yes they were indeed fooled into making "unprofitable investments" enticed by the AAA provided by the complacent rating agencies which were being paid to issue the ratings by the very banks, issuing these structured credit transactions to these "sophisticated investors". This what some of the CDOs were all about (not all of them though as it depends what securities you include in the structure...).

The European govermnents are trying to postpone the day of reckoning for Greece and the markets are clearly showing they are not buying it.

The best for Europe would be a major debt restructuring for Greece, reducing the interest rate they have to pay, extending the maturity of the debt and the bondholders taking a haircut on their holdings.

The level of debt for Greece is clearly unsustainable and no matter how much money European countries will throw at it, it will not resolve the structural issues at the core which are widespread corruption in the Greek system, complete lack of fiscal discipline and fraud in the entire country.

To entice Greeks to accept the austerity measures, bond holders taking a haircut on their holdings would alleviate the pain and entice the Greek population to accept more willingly the austerity measures. The issues are that without being able to devaluate their currency, Europe is just trying to postpone the day of reckoning for Greece.

Creative Destruction and Schumpeter's contribution:

http://en.wikipedia.org/wiki/Joseph_Schumpeter

Schumpeter view on the demise of capitalism and "creative destruction":

"Schumpeter's theory is that the success of capitalism will lead to a form of corporatism and a fostering of values hostile to capitalism, especially among intellectuals. The intellectual and social climate needed to allow entrepreneurship to thrive will not exist in advanced capitalism; it will be replaced by socialism in some form. There will not be a revolution, but merely a trend in parliaments to elect social democratic parties of one stripe or another. He argued that capitalism's collapse from within will come about as democratic majorities vote for the creation of a welfare state and place restrictions upon entrepreneurship that will burden and destroy the capitalist structure. Schumpeter emphasizes throughout this book that he is analyzing trends, not engaging in political advocacy. In his vision, the intellectual class will play an important role in capitalism's demise. The term "intellectuals" denotes a class of persons in a position to develop critiques of societal matters for which they are not directly responsible and able to stand up for the interests of strata to which they themselves do not belong. One of the great advantages of capitalism, he argues, is that as compared with pre-capitalist periods, when education was a privilege of the few, more and more people acquire (higher) education. The availability of fulfilling work is however limited and this, coupled with the experience of unemployment, produces discontent. The intellectual class is then able to organise protest and develop critical ideas."

Schumpeter view on democracy:

"In the same book, Schumpeter expounded a theory of democracy which sought to challenge what he called the "classical doctrine". He disputed the idea that democracy was a process by which the electorate identified the common good, and politicians carried this out for them. He argued this was unrealistic, and that people's ignorance and superficiality meant that in fact they were largely manipulated by politicians, who set the agenda. This made a 'rule by the people' concept both unlikely and undesirable. Instead he advocated a minimalist model, much influenced by Max Weber, whereby democracy is the mechanism for competition between leaders, much like a market structure. Although periodic votes by the general public legitimize governments and keep them accountable, the policy program is very much seen as their own and not that of the people, and the participatory role for individuals is usually severely limited."


It is very important to review Schumpeter's view of democracy but also understanding the incredible fragility of democracy due to human nature and the role our policiticans have played, in today's major financial crisis.

The below quote is supposedly attributed to Alexander Fraser Tytler (1770), Cycle of Democracy but unverified. It makes never the less a very interesting point.

"A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse from the public treasury. From that moment on, the majority always votes for the candidates promising the most benefits the public treasury with the result that a democracy always collapses over lousy fiscal policy, always followed by a dictatorship. The average of the world’s great civilizations before they decline has been 200 years. These nations have progressed in this sequence: From bondage to spiritual faith; from faith to great courage; from courage to liberty; from liberty to abundance; from abundance to selfishness; from selfishness to Complacency; from complacency to apathy; from apathy to dependency; from dependency back again to bondage."