Saturday 14 September 2013

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

"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)
( and
“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:
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!

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