Saturday 29 May 2010

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.

"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".

"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.

"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:

"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.

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:

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.

Saturday 22 May 2010

The Perfect Game

“But if you wish to remain slaves of bankers and pay the cost of your own slavery, let them create money and control credit.”

Josiah Stamp, Director, Bank of England, 1928

"Perfect Quarter’ at Four U.S. Banks Shows Fed-Fueled Revival"

This was expected given the Fed is depending now on banks to buy treasuries and borrowing at zero in the process. It is like shooting fish in a barrel.

"The gap between short-term interest rates, such as what banks may pay to borrow in interbank markets or on savings accounts, and longer-term rates, known as the yield curve, has been at record levels. The difference between yields on 2- and 10-year Treasuries yesterday touched 2.71 percentage points, near the all-time high of 2.94 percentage points set Feb. 18."

“The trading profits of the Street is just another way of measuring the subsidy the Fed is giving to the banks,” said Christopher Whalen, managing director of Torrance, California- based Institutional Risk Analytics. “It’s a transfer from savers to banks.”

The system is truly morally bankrupt because the losses are socialized.

"The notion that banks privatize profits and socialize losses dates at least to the 19th century, as in this 1834 quote of Andrew Jackson:

"I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the Bank. ... You are a den of vipers and thieves."

President Andrew Jackson, 1834, on closing the Second Bank of the United States;

"In 1835, Jackson managed to reduce the federal debt to only $33,733.05, the lowest it had been since the first fiscal year of 1791. President Jackson is the only president in United States history to have paid off the national debt. However, this accomplishment was short lived. A severe depression from 1837 to 1844 caused a tenfold increase in national debt within its first year."

"It was like a perfect storm for the fixed income market where you had very low volatility, tightening spreads and a buyer of last resort in the Federal Reserve,” said Paul Miller an analyst at FBR Capital Markets in Arlington, Virginia. “Even if a trade was going against you, you could just dump it on the Fed very quickly.”

The trading-powered gains may not last. At the end of March, the Fed wound up a program in which it had bought $1.25 trillion of Fannie Mae, Freddie Mac and Ginnie Mae home-loan securities. The purchases had helped drive debt buyers from U.S. mortgage bonds with government-supported guarantees and into riskier debt, helping banks that were holding or trading it."

There are more details on the perfect game in the below article from Seeking Alpha:

"Load up on the stuff you know the Fed is going to be buying, sit back, wait, collect coupons as the Treasury continues to funnel money into the bankrupt entities, and rack up trading gains as the Fed drives the prices higher. Bill Gross at PIMCO even gave us this playbook last year; he advised, "Shake hands with the Government.""

David Goldman in his excellent Inner Workings blog, sums it up nicely:

"The banks finance the governments, with money that they borrow from the governments. That’s why many banks showed a profit during every single trading day of the first quarter: with a steep yield curve and nearly zero-cost funding, you have to go out of your way to lose money."

The trend shows no sign of abating; when we get the Treasury TIC data for April at the end of this month, we will find out whether foreign banks continue to shovel money into the US Treasury market at the rate of $50 to $60 billion per month.

"This symbiosis means that the banking system is in effective government control. As my friend Michael Ledeen–an expert on Italian fascism among many other fields–this is “control without ownership,” or fascism, rather than socialism. Governments and banks will wrangle over the spoils. When the banks look fat the government will use them as a political whipping boy or milk them for taxes; when the banks’ holdings of government securities threaten to topple them, as in Europe last week, the governments will pledge a trillion dollars–and borrow it from the banks."

"Running a casino is like robbing a bank with no cops around." Ace Rothstein (Robert de Niro) in the movie Casino by Martin Scorsese

"Running an investment bank is like robbing a casino with no gaming regulators around."
Quote by Martin T

A double-dip is not that sweet...

You cannot bring about prosperity by discouraging thrift.
You cannot strengthen the weak by weakening the strong
You cannot help the poor man by destroying the rich.
You cannot further the brotherhood of man by inciting class hatred.
You cannot build character and courage by taking away man's initiative and independence.
You cannot help small men by tearing down big men.
You cannot lift the wage earner by pulling down the wage payer.
You cannot keep out of trouble by spending more than your income.
You cannot establish security on borrowed money.
You cannot help men permanently by doing for them what they will not do for themselves.

written in 1916 by the Rev. William J. H. Boetcker, a Presbyterian clergyman and pamphlet writer

It becomes clearer and clearer that a risk of a double-dip recession is alive and well.

Equities have continued the trend down and credit risk has risen as well, as reflected by the current CDS market spreads.

"The cost of protecting against default on high-yield and financial companies rose today, JPMorgan prices show. Contracts on the Markit iTraxx Crossover Index of 50 companies with mostly junk credit ratings increased 13.5 basis points to 619. The Markit iTraxx Financial Index of 25 banks and insurers rose 5 to 174 and the subordinated index rose 15 to 265."

The risk is being priced in the market. Most of the risk indicators, CDS, VIX, Ted Spread and Libor-Ois are on the rise.

According to Jeffrey Miron in Street Talk in Forbes, the sign is ominous:

"The news that claims for unemployment insurance rose unexpectedly last week - and by the largest amount in three months - will no doubt spark fears of a double-dip recession. Most economic indicators point to a consistent if perhaps lukewarm recovery, however, so is double-dip really a possibility?

Yes, because policymakers in the U.S. and Europe are likely to choose the wrong approaches in responding to their fiscal imbalances. The U.S. has been adding expenditure (Obamacare) and may soon consider a VAT; Europe appears ready to monetize its debt rather than curtail excessive spending. So fear of higher taxes and inflation may discourage new investment and hiring, allowing the U.S. and others to slide back into recession."

Unfortunately, recent events have shown we can expect indeed a double-dip because our politicians are most of the time making the wrong decisions.

Angela Merkel's knee jerk reaction triggered a panic in an already very dysfunctional and nervous market. It was a very bad decision. By banning short selling on financial companies in Germany, it is as if Merkel is telling the market that there are some major poblems with these companies. Rather than alleviating the market's concern, it has had the complete opposite effect and exacerbated the ongoing sell-off.

"It was especially strange that her government also banned naked short-selling of shares in Germany's largest banks, which are heavily exposed to Southern Europe's sovereign debt. That can only make investors more suspicious of those ostensibly sound institutions.

Ms. Merkel needs to remind herself that "markets" are mostly made up of money managers doing their best to protect pension funds and other savings of ordinary people. She says that she is trying to rescue the euro, but excessive rhetoric stimulates a flight by investors to other currencies. She says she is trying to save Europe, but erratic action feeds the impression of a continental political class that may be losing its nerve and its way."

This another fine example of why a double-dip can be expected because of the complete inability of our politicians to grasp the complexity of the problems at stake and the wilingness to tackle rapidly and decisevely the structural imbalances which have plagued Europe due to lack of fiscal discipline and public spending restraints.

This is not a time for haggling. It is decision time. A time for reform, a time for public spendings cuts and review, in most of the European countries.

Some countries have already started acting, Ireland, Spain, Portugal. But, some countries have not really started the process, like France. France is just starting to "think" about following the steps undertaken by Germany a few years ago in relation to introducing specific rules relating to budget deficit in its constitution. This fine line was drawn in order to protect its citizen from politians, who, as we all know from experience, tend to drift towards a spending spree when elected. The UK is a good ilustration of binge drinking, but also in binge spending. Under Labour, in ten years spending on the NHS increased from 53 billions GBP to a massive 120 billions GBP in the budget.

Here are the details relating to Germany's introduction of the stability law as detailed by Wolfgang Münchau in the Financial Times:

"From 2016, it will be illegal for the federal government to run a deficit of more than 0.35 per cent of gross domestic product. From 2020, the federal states will not be allowed to run any deficit at all."

"Anchoring the stability law at the level of the national constitution is an extreme measure – like locking the door, and throwing the keys away. It can only ever be undone with a two-thirds majority – and even a future Grand Coalition may not be able to deliver this as both of the large parties are in a process of secular decline. It means that future fiscal policy will be in the hands of the justices of Germany’s Constitutional Court."

"France has more or less followed Germany’s lead at every turn, but I suspect this may be a turn too far. Deficit reduction has not been, nor will it be, a priority for Nicolas Sarkozy, the French president."

The issue is that France doesn't have the luxury (apart from its industry...) to postpone anymore structural reforms similar to the ones undertaken by its closest business partner.

Unfortunately, the political system in France make the country very difficult to reform. Politicians are moving from one election to the next and cumulate various electoral mandates which means, that their interest is never aligned with the best common interest as they move to one election to the next, buying votes on unrealistic promises (35 hours week, etc.) by issuing more debt, and increasing in the process the already crippling burden of the debt.

The only way to reduce the debt levels is by starting first to balance the budget. It is a simple question of accounting principle but very unpopular with politicians.
Austerity is a foul word in France but it is has become critically urgent as well.

I agree with Wolfang Muchau relating to Sarkozy's lack of willingness in tackling deficits. Given Sarkozy is already thinking about the oncoming elections of 2012, you cannot expect decisive structural reforms to be undertaken. I expect a Socialist government will be elected in 2012, probably led by current IMF president Dominique Strauss-Kahn. It will be easier for a Socialist government in France to led the reforms, although to some it might appear completely counter-intuitive.

Where I completely disagree with Wolfgan Muchau is on the following:

"While the balanced budget law is economically illiterate, it is also universally popular. Average Germans do not primarily regard debt in terms of its economic meaning, but as a moral issue. Der Spiegel, the German news magazine, had an intriguing report last week on the country’s young generation. One of the protagonists in its story was a young woman who had borrowed a little money to set up her own company. The company turned out to be a success, and she had began to repay the loan. And yet she said she had not felt proud of having taken on debt.

This general level of debt-aversion is bizarre. Many ordinary Germans regard debt as morally objectionable, even if it is put to proper use. They see the financial crisis primarily as a moral crisis of Anglo-Saxon capitalism. The balanced budget constitutional law is therefore not about economics. It is a moral crusade, and it is the last thing, Germany, the eurozone and the world need right now."

Having a balanced budget dear Wolfgang is not economically illiterate, it is not only a moral issue but also it is the right thing to do for a government. It is a matter of responsibility for the government. Having a balanced budget reduces the risk of inflation and monetizing debt.

If the young generation of Germans regard debt as morally objectionable to some extent, there is hope. The protection given by the stability law is as well a deterrent to politicians tendency of spending more what a country can afford. Canada has had the right attitude in tackling its public spending and reducing its debt level very successfully. It can be done.

The most worrying part in today's turmoils is the current tussle between Germany's willingness to impose strict fiscal discipline in the Eurozone which does not coincide with France political agenda.

This creates a risk for a Euro break up. It is a fight between the disciplined members of the Eurozone and the lesser ones such as Greece, Italy and France.

As pointed by Professor Nouriel Roubini in Daily Finance, "Politics are now the main problem".

Tuesday 18 May 2010

Dear Chancellor...inflation is at 17months high in the UK...

Quantitative Easing is not making it easier for the Bank of England as I mentioned it back in April:

Inflation hit 3.7%

3% in March
3.5% in April reading
3.7% now...

Is the UK drifting to a 70s style Stagflation?

It all sounds like a remake. Hang parliament in 1974, IMF bailout in 1976...

This means, as I said before, tightening at some point is on the agenda in the near future, which increases severly the risks for a double dip recession in the UK.

Also please note the following, taking into account the old inflation methodology, which was the RPI, the real measure of inflation would be now at 5.3%, not the highest in 17 months but the highest in nearly 20 years...

Don't believe the hype.

You can as well look at the link to the website Shadowstats:

Inflation is higher than what it seems. Pure and simple.

The story is still very clear to me, deflation now then inflation. It was already highlighted in an article in Seeking Alpha in October 2008.

Deflation then inflation as illustrated by The Market Oracle:

QE is not working, because the money is not redirected to the real economy by helping banks to rebuild their balance sheets by locking in a nice spread, borrowing near zero and being net buyers of Government debt. This is the game being played.

The effect of QE is that the currency is being debased, therefore mechanically Gold prices are going up against various currencies (GBP, USD, EUR, all having adopted the nuclear option of QE).

This is the main reason why I recently said that Gold can only go up. QE is not going to end, at least in the UK for the moment, the budget deficit is just too big to stop the printing press.

Saturday 15 May 2010

Anterograde Amnesia or Retrograde Amnesia? Or both?


Anterograde amnesia refers to the inability to remember recent events in the aftermath of a trauma, but recollection of events in the distant past in unaltered.

Retrograde amnesia is the inability to remember events preceding a trauma, but recall of events afterwards is possible.

"To slightly modify Alexis de Tocqueville: Events can move from the impossible to the inevitable without ever stopping at the probable."

David Einhorn, President of Greenlight Capital, in John Mauldin' "Outside the box" on the 26th of October 2009

The market moved dramatically tighter following the announcement of the 750 billion euros package and bank share rallied massively in double digits on the Monday.

"Monday, in fact, saw the biggest one-day change in the history of the Markit iTraxx Europe index – tightening from 142bp to 102bp."

Well, the euphoria did not last very long...

Itraxx Main CDS 5 year has move again at around 110 bps. Corporate default risk as measured by the Itraxx index is on the rise again after a strong respite:

"The Markit iTraxx Financial Index of swaps on the senior debt of 25 banks and insurers jumped 15 basis points to 147 and the subordinated index rose 19 to 215, JPMorgan prices show."

It is very interesting to see that the Itraxx Financial index senior is trading wider than the Itraxx Main Europe as historically, it should trade tighter. Corparate debt is seen safer than bank debt for the time being.

You just can't get rid of a problem by throwing money at it and Deutsche Bank chief Josef Ackermann did not help our politicians by raising doubt on Greek debts currently being snapped up on the secondary markets by European Central banks in a concerted effort.
As a result the Euro currency took another massive beating Rocky Balboa style and broke through a very important support at 1.2450 against USD from March 09 lows:

Euro did fell to lowest level since Lehman Brothers collapse as finally people envisage the probability of a Euro break up:

Sounds familiar does it? Be nice, please rewind...

I discussed this exact subject on the 9th of December last year in my post The importance of being earnest, about the Eurozone in general and the Euro in particular.

I stated at the time:

"The virtues of joining a single currency doesn't coincide with the vices of some European governments, who issued more debt and ran larger and larger budget deficits. It is a game you cannot play forever unless you can devalue and make your own citizens poorer in the process, which used to be a regular tool used by Italy before joining the Euro."

Looks like Volcker shares my views...

“You have the great problem of a potential disintegration of the euro,” former Federal Reserve Chairman Paul Volcker, 82, said yesterday in London. “The essential element of discipline in economic policy and in fiscal policy that was hoped for” has “so far not been rewarded in some countries.”

Quizz time:
In the above quote, Paul Volcker was thinking about which country?
A. Greece
B. France
C. Spain
D. Portugal
E. Italy
F. All of the above

In this previous post as well I indicated the possibility of a Euro break up. You will find the links to the analysis which had already been made by Nouriel Roubini and Macro Research house Gavekal.

But back to this week price action.

By tearing up the sacred rule book and resorting to the Nuclear Option of Quantitative Easing (the politically correct definition for what really means "screwing your currency"), the Euro could only go down from there. There was the same result for the GBP when the Bank of England resorted to "Quantitative Easing" (I hate these two words).

VIX is now much higher than in my previous post on the 10th of April:

And Gold? New record high as well. The only way is up now that the US, UK and now Europe are all equal in the "Debasing Currency Club".

On the employment front in the US you have the following:


"There are a total of 10 million claimants receiving some type of unemployment benefits. Furthermore, there are a growing number of individuals (referred to as ‘99ers” in some circles) who have exhausted all 99 weeks of benefits and are waiting for tier 5."

290,000 increase in NFP (Non Farm Payrolls) for April.

But unemployment is still rising and you have, as Creditsights mentioned a growing number of 99ers.

Clearly deleveraging is still in full play which means further headwinds for employment levels in the near future in the US

So much for the "anticipated" V recovery...

Update on the bond vigilantes: FLIGHT TO QUALITY (at least perceived quality...)

"U.S. two-year notes had their first three-week winning streak since January as demand for the safest assets rose on speculation Europe’s sovereign-debt crisis will damp growth and lead to disintegration of the euro."

10-Year UK 108.13 3.75 yield
10-Year German 101.20 2.86 yield
10-Year French 103.23 3.12 yield
10-Year Italian 101.12 3.90 yield

Bund is the safe haven in Europe.

Spreads of German 10 year Bund versus other European countries 10 years government bonds is on the rise:

Spread BUND VS French OAT 10 year (Bloomberg):

Spread BUND VS Italian BTP 10 year (Bloomberg):

Spread BUND VS Spain 10 year (Bloomberg):

Spread BUND VS Greek 10 year (Bloomberg):

And good old TED spread is moving up as well:

"The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt. The TED spread is an indicator of perceived credit risk in the general economy."
When the TED spread increases, it is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. Interbank lenders therefore demand a higher rate of interest, or accept lower returns on safe investments such as T-bills."

No need to panic yet given long term average of TED is around 30 bps but definitely something to watch.

The theme is still the same deflation then inflation down the road as we are still ongoing the painful deleveraging process which goes with the reduction of public spending and tackling the debt burden. GDP growth will be slow, and slightly positive to negative in some European countries.

Thursday 13 May 2010

Canada, a great example of successful structural reforms and efficient banking regulation

When United States economy tanked, everyone was expecting the Canadian economy to follow the same fate given how connected both economies are.

It was not the case.

Jim Flaherty, Canadian's finance minister attributed the resilience of the Canadian economy to its "boring" financial system, rock solid and heavily regulated.
Leverage for banks was capped to around 20 times.

Maybe Canadians are strict followers of Austrian economics and have learnt more about the importance of a sound financial system?

Truth is Canadians are much more conservative than their American neighbors when it comes to lending. But the main difference as well compared to the US is that the government did not interfere in the way the housing market was financed: No Fannie Mae or Freddie Mac (we know the story on how well these two ex "private" companies are doing at the moment, losing billions after billions of dollars but that's another story to come in my blog).

Also Canadian banks have truly been much better than their US counterpats in managing risk and cutting risk when needed.

This is a link to a very good article from the Wall Street Journal regarding the Canadian Banks.

"Start with the housing sector. Canadian banks are not compelled by laws such as our Community Reinvestment Act to lend to less creditworthy borrowers. Nor does Canada have agencies like Fannie Mae and Freddie Mac promoting "affordable housing" through guarantees or purchases of high-risk and securitized loans. With fewer incentives to sell off their mortgage loans, Canadian banks held a larger share of them on their balance sheets. Bank-held mortgages tend to perform more soundly than securitized ones.

In the U.S., Federal Housing Administration programs allowed mortgages with only a 3% down payment, while the Federal Home Loan Bank provided multiple subsidies to finance borrowing. In Canada, if a down payment is less than 20% of the value of a home, the mortgage holder must purchase mortgage insurance. Mortgage interest is not tax deductible.

The differences do not end there. A homeowner in the U.S. can simply walk away from his loan if the balance on his mortgage exceeds the value of his house. The lender has no recourse except to take the house in satisfaction of the debt. Canadian mortgage holders are held strictly responsible for their home loans and banks can launch claims against their other assets.

And yet Canada's homeownership rate equals that in the U.S. (Both fluctuate, in the mid to high 60% range.)"

Yes that's the way it should be done! Banks like individuals have skin in the game, simple as that, and they are accountable for it.

As a fact reminder, in the US, one quarter of US household are in negative equity territory.

Update from Reuters on the trend in the US Housing:

"The percentage of American single-family homes with mortgages in negative equity rose to 23.3 percent in the first quarter from 21.4 percent in the fourth quarter, according to the Zillow Real Estate Market Reports."

It doesn't bode well for the American banks balance sheet...

Although during the recession the Bank of Canada reduced its benchmark interest rate to 0.25% and injected liquidity, given the latest price action in the housing market, the authorities are already moving to prevent the bubble to grow and a rate hike is expected in June.

Furthermore, Canada has been hugely successful in reducing its debt burden since 1995.
Canada's debt-to-GDP ratio is now around 53%.
Canada's debt burden has dropped by more than 50 percentage points from its peak in 1995. At that time it was the second-highest in the G8: from 68% in 1995 to about 29% in 2008.

Canada's debt chart 1979 to 2008:

How was this achieved?

By a radical 20% cut in spending imposed by the federal government in the 1990s which led to a cut of 47,000 civil servants jobs.

Canada was at the time close to the brink.

Here are the details of the cuts they proceeded with and what the government of Prime Minister Jean Chretien targeted, as per the following link from an article of The Times from Alexander Frean, Ottawa :

"There were big cuts in fisheries (22 per cent), defence (more than 15 per cent), transport (50 per cent) and international aid (20 per cent) departments but benefits for the elderly increased by 15 per cent over six years and spending on aboriginal peoples and children rose by around 10 per cent."

"They believe that other countries have something to learn from their country’s experience. One said: “Some nations think you cannot just eliminate the public debt. But we have shown that it is possible.” "

It was brutal but it did put the country back in the right direction.

This is what Europe needs to adress in relation to its public finances issues. They need to follow Canada and cut agressively. Spain and Portugal as well as Greece should apply the Canadian recipe. The UK as well would be wise to follow a similar path and the task is truly daunting for the new coalition government.
Ireland, Spain and Portugal are on the right track, Greece is in a difficult position due to a very lax fiscal system and general widespread corruption.
France has hardly started reducing public spending and it is a concern given the last balanced budget was in 1980 and budget surplus was 1976.

The projections for the Canadian Economy going forward are very good as per below's link:

"In 1994, when Canada's deficit peaked before federal spending cuts, including to provincial transfers, started the road to surplus, the only industrialized nation in the world with a worse fiscal picture than Canada was Italy. Canada's debt-to-GDP ratio was over 70 per cent.

In 2009-10, when the deficit hit a record $53.8 billion, Canada had the best record of any nation in the G7 on most economic indicators, including debt-to-GDP ratio.

In 2008-09, the debt-to-GDP ratio was 29 per cent, the lowest in 29 years. It will peak at 35.4 per cent in 2010-11 and then begin dropping again slowly hitting 31.9 per cent in 2014-15."

Monday 10 May 2010

The 750 billion Euros Poker hand: All in !

The G20 and the ECB finally caved in to the Markets and the Nuclear option plan, Quantitative Easing. Central bank have been instructed to buy Government bonds (Greek debt as well...) on the secondary market.

Again, we are pointing towards the same road, deflation then inflation.

As I said it before, the game is to debase the currency and generate inflation down the line, the EU follows the path of the US and the UK, as Japan did previously, and failed.

This is why Gold has not retraced significantly.

Gold is now a one way market, the only way is up, as Yazz sung back in 1988:

"We been broken down
the lowest turn
and been on the bottom line
sure ain't no fun
but if we should be evicted from our homes
we'll just move somewere else
and still carry on
Hold on, Hold on, Hold on

The only way is up, baby
For you and me, baby
The only way is up
For you and me"

The G20 governments are basically postponing the day of reckoning and delaying the bond vigilantes. The structural issues have not been adressed yet. Also who is going ultimately to pay for this?

For the time being the bond vigilantes have been kept at bay, but should financial and fiscal discipline not materialise in the near future, you can expect them to be back with a vengeance.

The massive rally we have seen from CDS indices moving dramatically tighter to bank shares massive double digits equity moves, it really points to short covering, particularly in respect to the EUR/USD.

The big challenge is still very real. Following the financial crisis, banks have been busy repairing their balance sheets, credit has not flown dramatically back into the economy and banks have been net buyers of treasuries, borrowing at zero and locking a nice spread in the process.
Now countries are facing a similar music. Most European countries need to repair their public finances. For some, like the UK it will be easier as the UK control its currency.

In relation to the latest bail out:

David Goldman in his excellent blog Inner Workings sum it up nicely:

"The banking system really was about to come down. The reason is that sovereign debt is a bigger problem than subprime mortgages ever were. We know from available data that two-thirds of the US deficit, according to available numbers, has been financed by domestic as well as foreign banks during the last quarter of 2009 and the first quarter of 2010. This is clear from the Treasury’s data on international capital flows, which shows $50 to $60 billion a month worth of purchases of US Treasury securities from abroad, almost all of it from London or the Caribbean, that is, offshore banking centers. US banks meanwhile are adding Treasuries to their portfolios as fast as they shed commercial and industrial loans. Detailed data is not available on international banks’ holdings of Greek, Spanish, Portuguese or Italian bonds, but we know from anecdotal evidence that the weak sisters of southern Europe have been financed by bank treasuries just as the United States has.

It’s all been done by smoke and mirrors. The governments bailed out the banks in September 2008, and again in various increments through the Spring of 2009. The great Keynesian stimulus that was supposed to guarantee recovery left most industrial countries with government deficits in excess of 10% of GDP. How does the US finance a deficit equal to 12% of GDP with a savings rate of 2.5%? By bank leverage. The banks, once bailed out by the governments, in turn bail the governments out. And when the weaker governments threaten to go belly up, the banking system freezes up."

This is why a decisive action had to be taken, the system was freezing up again, the signs were very clear in the credit markets, looking at the TED spread as well as the OIS-Libor rate. The interbank market was drifting towards a Lehman style freeze.

Since the near collapse of the financial system, the patient who already had one cardiac arrest had to be resuscitated. Following TARP, this is the second defibrillator attempt.

Saturday 8 May 2010

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."

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."

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!

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.

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:

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."

Thursday 6 May 2010

Sell in May and go away...

Very big day today on the credit markets as fear lead to some very significant widening in major credit indices.

Itraxx Main 5 year is now around 120 basis points, up from 85 bps a month ago, but up by around 20 bps just today!
Itraxx Crossover 5 year CDS widened by 70 bps in a single day as well.

Sovereigns CDS took some additional hits:

As well, all Senior Banks CDS are wider.

Banks are leveraged play on the economy as I keep repeating on this blog.

“The risk is for the banking sector because they’re the ones that own most of the government bonds and in cases of extreme crisis banks rely on governments to bail them out,” said Juan Esteban Valencia, a London-based credit strategist at Societe Generale SA. “If governments can’t issue at relatively normal levels, it’s going to be very difficult to bail out banks and that means banks are getting hammered.”

What has been worrying today is that Senior CDS widened more relatively to Sub CDS. This is concerning because it highlights liquidity strain in the system (TED spread widening). Senior debt is much larger than sub in terms of issued debt.

About the TED spread:

Equities are also feeling the pain and bank stocks have been heavily sold.

The second phase of the crisis is being played, after the financial crisis, we are experiencing a sovereign crisis and very severe crisis of confidence in the Eurozone which is reflected by the massive sell-off of the Euro we have seen in the last few days.

Tuesday 4 May 2010

Remembering Angus Maddison

Sadly after my last post relating to Angus Maddison, I discovered he had passed away on the 24th of April.

How ironic?

Please find enclosed a link to The Economist review on Angus Maddison's contribution to Macro Economy.

In my last post I mentioned at length's Angus work from his excellent book Contours of the World Economy.
I mentioned that as per Angus view, China's growth is a simple reversion to the mean as he recently highlighted as per below's quote from the Economist article.

"Ten days before his death he was cited in a speech by Robert Zoellick, president of the World Bank, declaring the end of the “third world”. Maddison’s figures show that Asia accounted for more than half of world output for 18 of the last 20 centuries. Its growing clout in the world economy is, therefore, a “restoration” not a revolution."

Macro Economy doesn't repeat itself but does rhyme...

Saturday 1 May 2010

Long term Macro views - as per Angus Maddison

To begin with, I highly recommend reading Angus Maddison's book Contours of the World Economy, 1-2030 AD, Essays in Macro-Economic History.

In most of my previous posts, I have been focusing on the risks of a double dip recession and the outstanding structural issues faced by most of the developed countries.

In all that doom and gloom Marc Faber's style, there are some bright spots of development in the world and in this post I will try to highlight the incredible tectonic shift we have been witnessing in the World Economy.

I will focus on this post on looking at historical trends and I will try to highlight what to expect in the coming decades in relation to Macro Economic growth in the World.

Let's start first by reviewing the evolution of the share of World GDP from 1-2003 AD (percent of world total) as per Angus Maddison's book (page 381):

According to Angus Maddison, the share of the World GDP for Western Europe has dropped between 1973 to 2003 from 22.8 % to 16.5 %.
Between 1870 and 1913, Western Europe'share of Global GDP was around 30.5 % during the industrial revolution, although it was only 20.5% in 1820.

For the USA the peak share of World GDP was 1950 at 27.3 %. Since then their share of World GDP has dropped to 22.1 % in 1973 and to 20.6 % in 2003.

The interesting part is relating to the share of World GDP for China, the peak was around 1820 at 32.9% according to Angus Maddison. It dropped to 17.9% in 1870 which is explained by the industrial revolution experienced by Western Europe at the same time. In 1950 and 1973, China's share of World GDP was 4.6 %. In 2003, China's share of World GDP came back close to 1870's level at around 15.1 % of World GDP.

This it where it is becoming interesting, according to Angus Maddison's projection for 2030(page 340 in his book), you can expect the following:
Western Europe share of GDP will drop to 13% in 2030 from 19.2% in 2003.
Asia (including Japan) shares of World GDP will power ahead from 40.5 % in 2003 to 53.3% in 2030.
In 1820 Asia's share was 59.4 % with a low point of 18.6 % in 1950.

Asia will therefore become the largest driving force in world trade. China will again become the world's biggest economy by 2018 according to Angus Maddison, with USA at number two and India at number three!

Western European countries faces the following massive headwinds:
Ageing population for a start.
Very high debt to GDP ratios which will weight very severly on maximum GDP growth attainable. Given current budget deficits, private growth will be hindered by higher taxation and larger weight of the public sector on the GDP.

When the average debt to GDP in percentage will be around 100% in 2014 in Europe, Emerging markets average debt to GDP will be in the region of 35 % in 2014.

This graph comes from the following interesting research document published by Deutsche Bank which can be obtained using the link provided below:

The authors of this very good research document conclude with the following statement:

"Should consolidation fail, policymakers in DMs and some EMs may be tempted to look for other ways to fix the fiscal damage. Either they could tolerate a substantial acceleration in CPI inflation to inflate public debt and/or they risk severe adjustments in the real effective exchange rate. Such adverse scenarios should not be
disregarded. The assumption that major macro issues cannot go wrong in the DM world (including EMU) has to be scrapped in the aftermath of the global crisis while this time EM, not DM, economies are the ones in the lead to keep public indebtedness sustainable.
Welcome to a new world!"

Emerging markets Debt is therefore the new investment grade and Western Europe Debt looks more and more like the new High Yield (or junk already for some countries...).
While most of western developed countries are busy trying to debase their currencies to generate inflation, Asian currencies will continue to outperform due to the very good situation of their economy, enjoying both trade balance surpluses and manageable debt to GDP levels.

In relation to Commodities and Gold in particular, I expect them to continue to rise in the near future. As I mentioned previously in this blog, this is the reason why so many hedge fund managers are heavily exposed to Gold (Paulson, Moore, Soros, etc). This is part of their macro strategy following the ongoing rebalancing of the World Economy we are experiencing. They are simply betting that our politicians will try to inflate their way out of the debt problem we are facing.

In terms of macro investments, Asian currencies will rise against the Euro, USD and GBP. Fixed Income Emerging Markets funds will do very well in this new environment given their lower probability of defaults depending on the country they are exposed to (South Korea, Singapore, Taiwan, Maylasia, Indonesia are attractive).

According to the Deutsche Bank research, we are in a new world, I will conclude this post, that it is more a return to the mean, as Angus Maddison is clearly illustrating in his research. Asian countries are returning to the level of world GDP shares they had 200 years ago and before.

Like Mark Twain said "History doesn't repeat itself, but it does rhyme."

Same apply to Macro Economy, it doesn't repeat itself but it eventually does rhyme.
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