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Italy and the Repricing of European Government Debt

  • The yield spread between 10yr BTPs and Bunds widened 114bp in May
  • Populist and anti-EU politics were the catalyst for this repricing of risk
  • Spain, Portugal and Greece all saw yields increase as Bund yields declined
  • The ECB policy of OMT should help to avoid a repeat of 2011/2012

I have never been a great advocate of long-term investment in fixed income securities, not in a world of artificially low official inflation indices and fiat currencies. Given the de minimis real rate of return I regard them as trading assets. I will freely admit that this has led me to make a number of investment mistakes, although these have generally been sins of omission rather than actual investment losses. The Italian political situation and the sharp rise in Italian bond yields it precipitated, last week, is, therefore, some justification for an investor like myself, one who has not held any fixed income securities since 2010.

An excellent overview of the Italian political situation is contained in the latest essay from John Mauldin of  Mauldin Economics – From the Front Line – The Italian Trigger:-

Italy had been without a government since its March 4 election, which yielded a hung parliament with no party or coalition holding a majority. The Five Star Movement and Lega Nord finally reached a deal, to most everyone’s surprise since those two parties, while both broadly populist, have some big differences. Nonetheless, they found enough common ground to propose a cabinet to President Sergio Mattarella.

Italian presidents are generally seen as rubberstamp figureheads. They really aren’t supposed to insert themselves into the process. Yet Mattarella unexpectedly rejected the coalition’s proposed finance minister, 81-year-old economist Paolo Savona, on the grounds Savona had previously opposed Italy’s eurozone membership. This enraged Five Star and Lega Nord, who then ended their plans to form a government and threatened to impeach Mattarella.

…click on the above link to read the rest of the article…

China is in Trouble

Before we discuss the economic situation of China, a few words about China’s strongman, Xi Jinping. The “new Chinese emperor” has engineered a meteoric rise. He started off as simple rural laborer but is now the most powerful Chinese president since Deng Xiaoping. Such a career path requires strength, tact, and probably a dash of unscrupulousness.

While the rulers of China have been able all along to hedge their plans over longer periods than their Western counterparts have, the new legal situation has extended this planning horizon even further.1 In comparison with those of Western economies, China’s countermeasures against the crisis in 2008 were significantly more drastic. While in the US the balance sheet total of the banking system increased by USD 4,000bn in the years after the global financial crisis, the balance sheet of the Chinese banking system expanded by USD 20,000bn in the same period. For reference: This is four times the Japanese GDP.

increm-China-1.png

The following chart shows the expansion of the bank balance sheet total as compared to economic output. Did the Chinese authorities assume excessive risks in fighting the crisis?

increm-China-2.png

Neither the fact that China’s bank balance sheets amount to more than 600% of GDP nor the fact that they have doubled in terms of percentage of GDP in the past several years suggests a healthy development. Our friends from Condor Capital expect NPL ratios51F to rise in China, which could translate into credit losses of USD 2,700 to 3,500bn for China’s banks, and this is under the assumption of no contagion (!). By comparison, the losses of the global banking system since the financial crisis have been almost moderate at USD 1,500bn

The most recent crisis does teach us, however, that the Chinese are prepared to take drastic measures if necessary. China fought the financial crisis by flooding the credit markets: 35% credit growth in one year on the basis of a classic Keynesian spending program is no small matter.

increm-China-3.png

…click on the above link to read the rest of the article…

James Madison’s Essay on Money

The following is by James Madison, the primary author of the US Constitution and fourth president.

For those who wish to get a further view on this, here is a paper from the Cleveland Fed on Madison’s essay: https://www.clevelandfed.org/newsroom-and-events/publications/discontinued-publications/economic-review/1998-economic-review/er-1998q1-james-madisons-monetary-economics.aspx

Money

Observations written posterior to the circular Address of Congress in Sept. 1779, and prior to their Act of March, 1780.

It has been taken for an axiom in all our reasonings on the subject of finance, that supposing the quantity and demand of things vendible in a country to remain the same, their price will vary according to the variation in the quantity of the circulating medium; in other words, that the value of money will be regulated by its quantity. I shall submit to the judgment of the public some considerations which determine mine to reject the proposition as founded in error. Should they be deemed not absolutely conclusive, they seem at least to shew that it is liable to too many exceptions and restrictions to be taken for granted as a fundamental truth.

If the circulating medium be of universal value as specie, a local increase or decrease of its quantity, will not, whilst a communication subsists with other countries, produce a correspondent rise or fall in its value. The reason is obvious. When a redundancy of universal money prevails in any one country, the holders of it know their interest too well to waste it in extravagant prices, when it would be worth so much more to them elsewhere. When a deficiency happens, those who hold commodities, rather than part with them at an undervalue in one country, would carry them to another. The variation of prices in these cases, cannot therefore exceed the expence and insurance of transportation.

…click on the above link to read the rest of the article…

Central Banking: It’s Alive!!

In his recent posting on Linked In, entitled, ‘The death of macro-prudential’, Stuart Trow of the EBRD delivered a well-aimed broadside at the pitiable conduct of the Bank of England and elaborated on some of the malign consequences of its catalogue of errors. Without wishing to single him out unduly for criticism for a piece with whose broad outlines I concur,  I see it as a prime example of where even those who are not wholly in thrall to the cult of ‘Whatever it Takes’ often miss the critical features of that cult’s essential evil. Left unaddressed, therefore, I fear this lack can only leave the intellectual soil fertile for a continued harvest of malign outcomes on the part of our clay-footed idols in the central banks.

Where better to start than with the following bold assertion of the author, viz., that ‘…if only policymakers had been allowed to exercise their judgement, crises could have been anticipated and avoided…’?

In my eyes, that heroic presumption of policymakers’ qualities of ‘judgement’ almost vitiates the argument from the off. Irrespective of whether one can be persuaded that Mario Draghi, Jerome Powell, Divus Marcus Carney and the like are the most intelligent, most far-sighted – most impartially Olympian – beings on the planet, the reality is that neither their fervid number-crunching of rows of abstracted, statistical time-series nor the GIGO output of their horribly over-specified macroeconomic ‘models’ can possibly substitute for the particular judgement and uniquely individual preferences of untold millions of men and women interacting, every minute of every day, every where in the market.

No, the best the central bankers can hope to achieve – in finest Hippocratic fashion – is that their own meddling does not send too any wrong signals, conjure up too many wrong incentives, or encourage too many, ultimately self-defeating behaviours among the innocent millions over whom they have been almost divinely-appointed to hold sway and over whom they hold seemingly limitless power.

…click on the above link to read the rest of the article…

The Role of Shadow Banking in the Business Cycle

1The process of lending and the uninterrupted flow of credit to the real economy no longer rely only on banks, but on a process that spans a network of banks, broker-dealers, asset managers, and shadow banks funded through wholesale funding and capital markets globally. – Pozsaret et al., 2013, p. 10

I. Introduction

According to the standard version of the Austrian business cycle theory (e.g., Mises, 1949), the business cycle is caused by credit expansion conducted by commercial banks operating on the basis of fractional reserve.2Although true, this view may be too narrow or outdated, because other financial institutions can also expand credit.3

First, commercial banks are not the only type of depository institutions. This category includes, in the United States, savings banks, thrift institutions, and credit unions, which also keep fractional reserves and conduct credit expansion (Feinman, 1993, p. 570).4

Second, some financial institutions offer instruments that mask their nature as demand deposits (Huerta de Soto, 2006, pp. 155–165 and 584–600). The best example may be money market funds.5 These were created as a substitute for bank accounts, because Regulation Q prohibited banks from paying interest on demand deposits (Pozsar, 2011, p. 18 n22). Importantly, money market funds commit to maintaining a stable net asset value of their shares that are redeemable at will. This is why money market funds resemble banks in mutual-fund clothing (Tucker, 2012, p. 4), and, in consequence, they face the same maturity mismatching as do banks, which can also entail runs.6

Many economists point out that repurchase agreements (repos) also resemble demand deposits. They are short term and can be withdrawn at any time, like demand deposits. According to Gorton and Metrick (2009), the financial crisis of 2007–2008 was in essence a banking panic in the repo market (‘run on repo’).

…click on the above link to read the rest of the article…

 

Should the Fed Print Money to Accommodate Demand for Money?

For most economists and commentators the main role of the Fed is to keep the supply and demand for money in equilibrium. Whenever an increase in the demand for money occurs, to maintain the state of equilibrium the accommodation of the demand for money by the Fed is considered as a necessary action in order to keep the economy on a path of economic and price stability.

The accommodation of the increase in the demand for money is not considered as money printing and therefore not harmful to the economy i.e. setting in motion the boom-bust cycle as long as the growth rate of money supply does not exceed the growth rate in the demand for money.

Note that on this way of thinking since the growth rate in the demand for money is offset by the growth rate of the supply of money then no effective increase in the supply of money occurs. From this perspective, no harm is inflicted on the economy.

Why accommodating demand for money always harmful

What do we mean by demand for money? In addition, how does this demand differs from the demand for goods and services?

The demand for a good does not reflect the demand for a particular good as such but the demand for the services that the good offers. For instance, an individual demands food because this provides the necessary elements that sustain his life and wellbeing. Demand here means that people want to consume the food in order to secure the necessary elements that sustain their life and wellbeing.

The demand for money arises because of the services that money provides. However, instead of consuming money people demand money in order to exchange it for goods and services.

…click on the above link to read the rest of the article…

The Myth That Central Banks Assure Economic Stability

The world has been plagued with periodic bouts of the economic rollercoaster of booms and busts, inflations and recessions, especially during the last one hundred years. The main culprits responsible for these destabilizing and disruptive episodes have been governments and their central banks. They have monopolized the control of their respective nation’s monetary and banking systems, and mismanaged them. There is really nowhere else to point other than in their direction.

Yet, to listen to some prominent and respected writers on these matters, government has been the stabilizer and free markets have been the disturber of economic order. A recent instance of this line of reasoning is a short article by Robert Skidelsky on “Why Reinvent the Monetary Wheel?” Dr. Skidelsky is the noted author of a three-volume biography of John Maynard Keynes and a leading voice on public policy issues in Great Britain.

Skidelsky: Central Banking Equals Stable Prices and Markets

He argues against those who wish to denationalize and privatize money and the monetary system. That is, he criticizes those who want to take control of money and monetary affairs out of the hands of the government, and, instead, put money and the monetary order back into the competitive, private market. He opposes those who wish to separate money from the State.

Skidelsky sees the proponents of Bitcoin and other “cryptocurrences” as “quacks and cranks.” He says that behind any privatization of the monetary system reflected in these potential forms of electronic money may be seen “the more sordid motives” of “Friedrich Hayek’s dream of a free market in money.”

…click on the above link to read the rest of the article…

Does Subjective Valuation Mean Arbitrary Valuation?

Why do individuals pay much higher prices for some goods versus other goods? The common reply to this is the law of supply and demand.

However, what is behind this law? To provide an answer to this question economists refer to the law of diminishing marginal utility.

Mainstream economics explains the law of diminishing marginal utility in terms of the satisfaction that one derives from consuming a particular good.

For instance, an individual may derive vast satisfaction from consuming one cone of ice cream.

However, the satisfaction he will derive from consuming a second cone might also be big but not as big as the satisfaction derived from the first cone.

The satisfaction from the consumption of a third cone is likely to diminish further, and so on.[1]

From this, mainstream economics concludes that the more of any good we consume in a given period, the less satisfaction, or utility, we derive out of each additional, or marginal, unit.

It is also established that because the marginal utility of a good declines as we consume more and more of it, the price that we are willing to pay per unit of the good also declines.

Utility in this way of thinking is presented as a certain quantity that increases at a diminishing rate as one consumes more of a particular good. Utility is regarded as a feeling of satisfaction or enjoyment derived from buying or using goods and services.

According to the mainstream way of thinking, an individual’s utility scale is wired in his head. This scale determines for the individual whether he will purchase a particular good. The valuation scale is given and there is no explanation on how it was established.

…click on the above link to read the rest of the article…

The Relevance of Hayek’s Triangle Today

Most of us are aware of the inflationary pressures in the major economies, that so far are proving somewhat latent in the non-financial sector. But some central banks are on the alert as well, notably the Federal Reserve Board, which has taken the lead in trying to normalise interest rates. Others, such as the European Central Bank, the Bank of Japan and the Bank of England are yet to be convinced that price inflation is a potential problem.

Virtually no one in the central banks, government treasury departments, or independent analysts see the real inflationary danger. There is a lone exception perhaps in Dr Zhang Weiying, the top economist at Beijing University and formally in charge of China’s economic policy, who quoted Hayek’s business cycle theory to point out the dangers of excessive deficits.[i] Whether he is listened to by his colleagues, we shall doubtless find out in due course. Otherwise, a sudden acceleration of price inflation will come as a complete surprise to our financially sophisticated markets.

This article explains why the danger lies in the structure of production, which in the West at least is seriously out of whack. The follies of post-crisis central bank monetary reflation are likely to drive us rapidly into the next credit crisis as a consequence. To understand why this is so requires us to revisit the 1930s writings of an Austrian-born economist, who was tasked by the London School of Economics with explaining to advanced students the disruption to the production process from changes in consumer demand.

Friedrich von Hayek was famously reported as the economic guru of both Margaret Thatcher and Ronald Reagan. This distinction owes its origin to his market-based approach to economics, which was in stark contrast with the statist approach that was predominant in political circles at that time, and still is today. It was simple shorthand for the media writing for a mass audience.

…click on the above link to read the rest of the article…

MAY DAY

“Japan was the dress rehearsal; the rest of the world will be the main event.”

  • Investor in Japanese stocks, known to this correspondent, circa 2001.

“Twitter has taught me a couple of things. 1: there are some incredibly brilliant people in the world. 2: they are vastly outnumbered.”

  • Tweet by @jrsalzman.

There are weeks when decades happen, and this past week feels like one of them. While US inflation expectations touched a four-year high and 10-year US Treasury yields reached seven-year highs, the voters of Italy – or rather its anti-establishment Five Star Movement and its far-right League – delivered a resounding raspberry to the EU and any lingering hopes for faster and smoother European integration. Two years ago, in this commentary, we were conveying our relief that the UK had finally elected to sever its political ties with a failing totalitarian socialist economic bloc. Now, displaying – if possible – even more political incoherence, the Italians are having a go. You can see below, courtesy of the Daily Telegraph, why they might have a point:

What follows is what we wrote in the giddy days of June 2016:

The euro zone is a latter-day gold standard. Because its member countries have no control over their own monetary policy, they must accept a one-size-fits-all model. But what is appropriate today for an economy like Germany’s is unlikely to be appropriate for an economy like that of Greece. (Which should never have been allowed to join in the first place – but then institutionalised corruption is another of the euro zone’s fatal flaws. Are the EU’s accounts and payments “free from material error” ? On this basis they haven’t been signed off by the EU’s own Court of Auditors for over 20 years.)

…click on the above link to read the rest of the article…

Does it Matter Whether Assumptions in Economics are Arbitrary?

Various assumptions employed by mainstream economists appear to be of an arbitrary nature. The assumptions seem to be detached from the real world.

For example, in order to explain the economic crisis in Japan, the famous mainstream economist Paul Krugman employed a model that assumes that people are identical and live forever and that output is given. Whilst admitting that these assumptions are not realistic, Krugman nonetheless argued that somehow his model can be useful in offering solutions to the economic crisis in Japan.[1]

The employment of assumptions that are detached from the facts of reality originates from the writings of Milton Friedman. According to Friedman, since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a model are. In fact anything goes, as long as the model can yield good predictions. According to Friedman,

The ultimate goal of a positive science is the development of a theory or hypothesis that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed…. The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximation for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.[2]

Observe that on this way of thinking, the formation of the view regarding the real world is arbitrary – in fact, anything goes as long as the model could generate accurate forecasts.

In his Philosophical Origins of Austrian Economics (Mises Institute Daily Articles June 17 2006), David Gordon wrote that Bohm Bawerk maintained that concepts employed in economics must originate from the facts of reality – they need to be traced to their ultimate source. If one cannot trace it the concept should be rejected as meaningless.

…click on the above link to read the rest of the article…

Wealth-Destroying Zombies

The hot topic in monetary economics today (hah, if it’s not an oxymoron to say these terms together!) is whither interest rates. The Fed in its recent statement said the risk is balanced (the debunked notion of a tradeoff between unemployment and rising consumer prices should have been tossed on the ash heap of history in the 1970’s). The gold community certainly expects rapidly rising prices, and hence gold to go up, of course.

Will interest rates rise? We don’t think it’s so obvious. Before we discuss this, we want to make a few observations. Rates have been falling for well over three decades. During that time, there have been many corrections (i.e. countertrend moves, where rates rose a bit before falling even further). Each of those corrections was viewed by many at the time as a trend change.

They had good reason to think so (if the mainstream theory can be called good reasoning). Armed with the Quantity Theory of Money, they thought that rising quantity of dollars causes rising prices. And as all know, rising prices cause rising inflation expectations. And if people expect inflation to rise, they will demand higher interest rates to compensate them for it.

The quantity of dollars certainly rose during all those years (with some little dips along the way). Yet the rate of increase of prices slowed. Nowadays, the Fed is struggling to get a 2% increase and that’s with all the “help” they get from tax and regulatory policies, which drive up costs to consumers but has nothing to do with monetary policy. Nevertheless interest rates fell. And fell and fell.

Why Have Interest Rates Been Falling?

It seems obvious that if one wishes to say that a trend has changed, after enduring for well over three decades, one needs to explain why.

…click on the above link to read the rest of the article…

Expectations and the Austrian Business Cycle Theory

According to the Austrian Business Cycle Theory (ABCT) the artificial lowering of interest rates by the central bank leads to a misallocation of resources because businesses undertake various capital projects that prior to the lowering of interest rates weren’t considered as viable. This misallocation of resources is commonly described as an economic boom.

As a rule businessmen discover their error once the central bank—that was instrumental in the artificial lowering of interest rates—reverses its stance, which in turn brings to a halt capital expansion and an ensuing economic bust. From the ABCT one can infer that the artificial lowering of interest rates sets a trap for businessmen by luring them into unsustainable business activities that are only exposed once the central bank tightens its interest rate stance.

Critics of the ABCT maintain that there is no reason why businessmen should fall prey again and again to an artificial lowering of interest rates. Businessmen are likely to learn from experience, the critics argue, and not fall into the trap produced by an artificial lowering of interest rates. Correct expectations will undo or neutralise the whole process of the boom-bust cycle that is set in motion by the artificial lowering of interest rates. Hence, it is held, the ABCT is not a serious contender in the explanation of modern business cycle phenomena.

According to a prominent critic of the ABCT, Gordon Tullock,

One would think that business people might be misled in the first couple of runs of the Rothbard cycle and not anticipate that the low interest rate will later be raised. That they would continue to be unable to figure this out, however, seems unlikely. Normally, Rothbard and other Austrians argue that entrepreneurs are well informed and make correct judgments. At the very least, one would assume that a well-informed businessperson interested in important matters concerned with the business would read Mises and Rothbard and, hence, anticipate the government action.[1]

…click on the above link to read the rest of the article…

Is the US Exporting a Recession?

  • The Federal Reserve continue to raise rates as S&P earnings beat estimates
  • The ECB and BoJ maintain QE
  • Globally, corporations rely on US$ financing, nonetheless
  • Signs of a slowdown in growth are clearer outside the US

After last week’s ECB meeting, Mario Draghi gave the usual press conference. He confirmed the continuance of stimulus and mentioned the moderation in the rate of growth and below-target inflation. He also referred to the steady expansion in money supply. When it came to the Q&A he revealed rather more:-

It’s quite clear that since our last meeting, broadly all countries experienced, to different extents of course, some moderation in growth or some loss of momentum. When we look at the indicators that showed significant, sharp declines, we see that, first of all, the fact that all countries reported means that this loss of momentum is pretty broad across countries.

It’s also broad across sectors because when we look at the indicators, it’s both hard and soft survey-based indicators. Sharp declines were experienced by PMI, almost all sectors, in retail, sales, manufacturing, services, in construction. Then we had declines in industrial production, in capital goods production. The PMI in exports orders also declined. Also we had declines in national business and confidence indicators.

I quote this passage out of context because the entire answer was more nuanced. My reason? To highlight the difference between the situation in the EU and the US. In Europe, money supply (M3) is growing at 4.3% yet inflation (HICP) is a mere 1.3%. Meanwhile in the US, inflation (CPI) is running at 2.4% and money supply (M2) is hovering a fraction above 2%. Here is a chart of Eurozone M3 since 1999:-

EU M3 Money Supply

Source: Eurostat

The recent weakening of momentum is a concern, but the absolute level is consistent with a continued expansion.

…click on the above link to read the rest of the article…

Inflation or Employment

  • Inflationary fears are growing and US rates continue to rise
  • Employment has become more flexible since the crisis of 2008/2009
  • Commodity prices have risen but from multi-year lows
  • During the next recession job losses will rapidly temper inflationary pressures

Given the official policy response to the Great Financial Recession – a mixture of central bank balance sheet expansion, lower for longer interest rates and a general lack of fiscal rectitude on the part of developed nation governments – I believe there are two factors which are key for stock markets over the next few years, inflation and employment. The fact that these also happen to be the two mandated targets of the Federal Reserve – full employment and price stability – is more than coincidental. My struggle is in attempting to decide whether demand-pull inflation can survive the impact of a rapid rise in unemployment come the next recession.

Inflation and the Central Bankers response is clearly the new narrative of the financial markets. In his latest essay, Ben Hunt of Salient Partners makes some fascinating observations – Epsilon Theory: The Narrative Giveth and The Narrative Taketh Away:-

This market, like all markets, cares about two things and two things only — the price of money and the real return on invested capital. Or, as they are typically represented in cartoon form, interest rates and growth.

…This market, like all markets, needs a positive narrative on risk (the price of money) or reward (the real return on capital) to go up. Any narrative will do! But when neither risk nor reward is represented with a positive narrative, this market, like all markets, will go down. And that’s where we are today. 

…click on the above link to read the rest of the article…

Olduvai II: Exodus
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Olduvai
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Olduvai II: Exodus
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Olduvai III: Cataclysm
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