Rational Prosperity

2017 Update

2017-07-30T17:38:00.001+10:00

It's 2017 and I'm reading some of my old posts thinking, "I was way-off base with my predictions and beliefs."

One of the key concepts I've learned in the past 2 years is the futility of predictions. Nobody can predict with any accuracy more than a year into the future. The system is too complex (good YouTube series on complex systems here). I made a page about failed economist predictions that I haven't updated with the outcome but you can see for yourself what they were thinking and how wrong they were.

Rather than go into a long blog post about why and how predictions fail, I'll direct you to a book that summarises the evidence better than I can. That book is Superforecasting by Philip Tetlock and Dan Gardner. I encourage anyone who is interested in predictions to give it a read.

Another key understanding that has become stronger in the last few years is letting go of strong ideological beliefs and particularly beliefs that are part of your identity. These beliefs will make it very difficult to view evidence and information on its merits without confirmation bias coming into play. I wrote an article in late 2014 about this very concept and I think it is very beneficial to any critical thinkers.

The blog going forward

I don't intend to write detailed blog posts simply because most information is already out there on the internet and I would just be rehashing it with my own interpretation.

I will be posting random blog posts about things I want to document and share publicly for entertainment and general interest purposes. I think the next blog post will be a list of finance and trading movies that I've watched.

As always I can be contacted on twitter: @ShervinD

Abenomics

2015-08-23T22:23:00.001+10:00

This post will look at Japan's recent economic performance under the policy of Abenomics. Policy recommendations are made at the end.

Japan's Prime Minster, Shinzo Abe

In 2012 Japan's prime minister, Shinzo Abe, ushered in a new set of economic policies which have been termed Abenomics. The policy involves "three arrows": fiscal policy, monetary policy and structural reform.

For further in depth analysis and details on Abenomics please read: Abenomics and the Japanese Economy.

Japan's recent performance

The latest GDP print is disappointing; Japan's economy shrank 1,6% (annualised) in the last quarter. Exports where down 16.5% (annualised) highlighting the flaws the export reliant model. When global growth or export markets slow, the export economy suffers.¹

Private consumption fell 3% (annualised), which is significant given Japan's economy is 60% consumption. The falling Yen added to problems for the Japanese consumer with food prices rising.¹

The large drop in growth seen in 2014 (see above chart) was the result of an increase in the consumption tax from 5% to 8%.

Is Abenomics a success?

The rise in the consumption tax hurt consumer spending at at time the economy didn't need it. The result was a recession in late 2014 (two quarters of negative economic growth). Increasing government spending while increasing taxes is like having one foot on the accelerator and the other on the brake. The government must focus on generating growth today and address fiscal sustainability in a few years or expect the jittery economic growth to continue.

Raising domestic demand is paramount and the government should not only cancel future consumption tax increases but also reverse the previous increase. Additionally, the government could lower taxes for low-income earners to increase disposable income. It must be noted that Japan's income tax is very progressive.

Relying on a currency devaluation to boost exports is a less effective tool to boost growth. Firstly, the gains are marginal given the increasingly global supply chain. Secondly, it acts as a consumption tax on imports which reduces household real incomes. As mentioned above, rising food costs have become a problem for Japan.

The demographic challenge Japan faces must be addressed either through higher birth rates or net migration and getting more women into the workforce. This is one of the major aims of the structural reforms proposed under Abenomics.

Conclusion

The failure of Abenomics is political (not economic) with the deficit hawks continually demanding policies to reduce the deficit when the exact opposite is needed to propel Japan out of its protracted economic malaise. The more difficult task will be establishing the structural reforms which challenge the politically strong vested interests. If Japan can overcome these hurdles, they will be the shining example of an economy that escaped the debt deflation global epidemic.

References

Warnock, E. and Obe, M. (2015). Japan’s Economy Shrinks in Second Quarter. [online] WSJ. Available at: http://www.wsj.com/articles/japans-economy-shrinks-annualized-1-6-in-second-quarter-1439769883 [Accessed 23 Aug. 2015].

Austrian Malinvestment Theory

2015-08-16T18:50:00.001+10:00

A new train station in Wuhan (Central China) completed at the end of 2009

While a lot of what the Austrian School of Economics says is just political theory dressed up as economics, some of their theories may be sound in the real world. One such theory is the theory of malinvestment.

Malinvestment is a mistaken investment in the wrong line of production, which inevitably leads to wasted capital and economic loss, subsequently requiring a reallocation of resources to more productive uses.¹

The theory of malinvestment is a critical part of the business cycle according to the Austrian school. They blame the government either through its spending decisions or through the central bank for causing these market distortions resulting in misallocation of resources and the malinvestments which inevitably have to be liquidated.

To the neutral observer, one may be quick to dismiss this as the standard Libertarian anti-government rhetoric. However, it is widely accepted that poor central planning can lead to massive investments that are proven to be unproductive and misaligned with consumer demand.

This blog post follows the post on Minsky's Financial Instability Hyporthesis and tries to explain the business cycle phenomenon. The question is whether the government, the central bank and the fractional reserve system are the cause of the bad investments or is it more along the lines of Minsky's FIH - that the boom-busy process is inherent to a capitalist economy. I believe that both can be correct. The private and public sector are prone to making bad decisions. The government's decisions have greater economic impact but the private sector can also generate asset bubbles that can have greater consequences than any government decision ever could.

Krugman's Criticisms of Malinvestment Theory

Paul Krugman describes this as "Hangover Theory". He first states that investment cycles should not be assumed to correlate with the economic cycle. He makes the point that any reduction of investment will result in an increase in consumption because someone's spending is another's income. He also points out that every industry feels the pain, not just the investment sector.²

Krugman then states "A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time." He then suggests an increase in the money supply after the private sector writes off its bad investments because after the write off, there is only idle productive capacity left.²

Krugman attributes the appeal of "Hangover Theory" to counter the perceived statist implications of Keynesianism and describes the theory as "intellectually incoherent."²

Examples of malinvestment

The clearest examples of malinvestment are those government projects that cost billions and eventually prove to be white elephants because the economic and social benefits are tiny compared to the cost of the project. However, the worst malinvestments occur when the private sector AND the government work together to create gargantuan investment and asset bubbles.

A great example is the property and construction boom in China. After 2008, the Chinese government instructed its banks to lend and finance the construction sector. We saw the creation of ghost cities and the demand for iron ore (used to create the steel needed to build) sky-rocket. The Austrians would describe this as a false price signal, which caused iron ore miners around the world to increase their production capacity. Australia was one of the chief beneficiaries with mining investment driving much of the economic growth seen post-2008. In the last year or two, we have seen the Chinese economy roll over and with that the price of all commodities. The demand for steel has plummeted and the iron ore price has crashed. Just a few days ago BHP announced its third round of job cuts which reflects the adjustment to the overcapacity now laid bare in the mining sector.

Other examples from history include the US housing bubble. Interest rates reached 1% in 2002-2003 before slowly rising. Government policies encouraged and supported lending to sub-prime individuals through mandates and GSEs like Fannie Mae and Freddie Mac. Of course there was also widespread fraud on the part of the private sector. But the question remains, if interest rates bottomed at 2% instead of 1%, would the fallout have been far more limited?

Conclusion

One should be cautious when reading anything from the Austrian school, simply because of the political bias that is the foundation of their economic thought process. If an objective observer sees government intervention in an economy leading to investment booms and later a bust, it would be apt to fault the original government decision. It must be said that the government is not the only one making bad investment decisions. The private sector does it all the time and as Minksy's theory postulates, it may be inherent to a capitalist economy. Both theories importantly point out that the private sector makes mistakes, which many mainstream economic models seem to ignore.

References

Wiki.mises.org, (2015). Malinvestment - Mises Wiki, the global repository of classical-liberal thought. [online] Available at: https://wiki.mises.org/wiki/Malinvestment [Accessed 16 Aug. 2015].
Krugman, P. (2015). The Hangover Theory. [online] Slate Magazine. Available at: http://www.slate.com/articles/business/the_dismal_science/1998/12/the_hangover_theory.single.html [Accessed 16 Aug. 2015].

Minsky's Financial Instability Hypothesis

2015-05-25T21:35:00.000+10:00

Ponzi finance is like an unstable house of cards

The boom-bust cycle in economics is one which has many explanations. The Austrians blame malinvestments caused by central banks setting interest rates too low, Keynes blamed animal spirits and Marx warned it was falling profits that caused the bust. An increasingly popular explanation for the boom-bust cycle is the Financial Instability Hypothesis proposed by Hyman Minsky. The theory suggests that the rising proportion of debt relative to cash flow causes financial instability. This phenomena is inherent to a market economy and it is often summarised as "stability breeding instability."

I think there are some similarities with the Austrian malinvestment theory which I'll be covering in a future blog post.

This blog post is mostly a summary of journal articles from the Levy institute which are references at the end.

What is the Financial Instability Hypothesis?

The hypothesis refers to phases in which economic units go through as the economic cycle develops.

There are three phases that economic units can involve themselves in:

Hedge financing occurs when units can fulfil all of their contractual payment obligations by their cash flows. The more equity in the liability structure, the more likely they are a hedge financing unit.
Speculative finance units can meet their payment commitments on their liabilities, even though they cannot pay back principal from income cash flows. Such units will "roll over" their liabilities.
Ponzi finance units' cash flow from operations are not sufficient to fulfil either the repayment of principal or interest on outstanding debts. Such units can sell assets or borrow. Borrowing to pay interest lowers their equity. A unit that Ponzi finances, lowers the margin of safety that it offers the holders of its debt.

If hedge financing dominates, the economy is stable. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood the economy is in a deviation amplifying system (simply put, a big boom or bust).

Financial Instability Hypothesis Theorems

The first theorem of the Financial Instability Hyphothesis (FIH), the economy has financing regimes under which it is stable and regimes in which it is unstable.
The second theorem is that over long periods of prosperity, the economy transitions from a stable financial system to an unstable system. Capitalist economies transit from hedge financing units to a structure in which there is a large weight of speculative and Ponzi finance.

If the economy is in an inflationary state and monetary policy tightens, speculative finance units will become Ponzi finance units and previously Ponzi finance units will see their net worth decline. These units will have to sell assets and thus asset values decline.

The FIH model does not rely on exogenous shocks to generate business cycles of various severity. The hypothesis holds that the business cycles of history are compounded by internal dynamics of a capitalist economy and the system of interventions and regulations that are designed to keep the economy operating within a reasonable bound.

Link to behavioural economics?

The paradigm shift away from assuming we are rational economic units to accepting the real world proof of the opposite, is a recent occurrence. Minksy refers to the "euphoric economy" which can be linked to biases such as the overconfidence bias and the herd mentality. There is no doubt that these traits exacerbate the bubbles and provide a fertile ground for speculative and Ponzi finance to emerge.

Other important notes from Tymoigne (2010)

Government deficits directly improve the financial strength of the private sector.
Government deficit may be a problem if there's a stringent exchange rate regime (e.g. Greece - monetary sovereignty surrendered to the Eurozone) or if debt is issued in foreign currency (e.g. Argentina)
Financial fragility is not a measure of the size of the leverage but the quality
Bell (2009) found good indicators of banking crises include rapid loan growth, slow output growth, and rising real interest rates.
Speculative and Ponzi finance haver a higher mismatch between assets and liabilities, which most of the time means that there is a high proportion of short-term debts and low liquidity buffers.
Under Ponzi finance, it is expected that net worth and liquidity will decrease given asset values. This decline in net worth and liquidity will not be recorded in data until defensive position-making needs actually occur. If assets are valued on a market basis, and if their prices grow fast enough to compensate for higher debt or lower liquid assets, the decline in net worth can be avoided (Minksy 1964: 213ff.) In that case, the growing solvency of economy unit involved in a Ponzi process depends highly on the continuation of rising assets, rather than on the capacity to generate an income from the ownership of the asset. In fact, an economic unit involved in Ponzi finance is guaranteed to record very high short-term profits and so a very high increase in net worth for a short period.

Where are we now?

A few examples in recent weeks of Ponzi finance come from the China/commodity boom.

The most obvious economy in the Ponzi finance phase is China. Just read this: (oringal here: http://english.caixin.com/2015-03-11/100790192.html)

"In years past, Rongsheng found it easy to get bank support for building orders. But according to a ship financing expert, banks changed their tune after Rongsheng started having trouble repaying loans. The repayment woes surfaced after the company apparently overstretched its order books to the point where it couldn't deliver vessels on time.

Rongsheng's weak financial position was highlighted by a third-quarter 2014 financial report in which the company posted a net loss of 2.4 billion yuan. It also reported 31.3 billion yuan in liabilities, including 7.6 billion yuan worth of outstanding short-term debt.

A source close to the company said Rongsheng's capital crunch has worsened since February 2014, when the CDB demanded more collateral after the company failed to make a scheduled payment on a 710 million yuan loan. When Rongsheng refused, the CDB called the loan. Other banks that issued loans to the shipbuilder have taken similar steps, said the source."

Just the other day another example of Ponzi finance came to light when Fortescue (ASX: FMG) tried to refinance their debt only to change the structure and then cancel the transaction. (original here: http://www.abc.net.au/news/2015-03-18/fortescue-debt-debacle-highlights-perilous-position/6328668 )

That initial deal was for a $US2.5 billion syndicated loan. It was scrapped yesterday in favour of the "Senior Secured Note Offering" which also has been junked in what can only be interpreted as a worrying development for the nation's third biggest iron ore exporter.

This sums up the situation well:

Imagine having nearly 9 billion of debt maturing in next 2-5 yrs & you sell one product.....at a loss.
— Greg (@macromusing) March 18, 2015

It is clear that FMG can no longer payback the principal and is in the speculative finance stage. As the price of iron ore falls below the cost of production, Fortescue is no longer profitable. At this stage paying interest becomes a problem as cash reserves drain and Fortescue enters the Ponzi finance stage. As long as iron ore prices continue to fall, Fortescue is guaranteed to become a Ponzi finance unit.

I have been a China bear for a few years now (see last year's detailed post here) and it looks like the wheels are finally coming off.

Conclusion

Minsky's FIH is an important theory for understanding how an economy can become unstable due to the debt financing decisions of economic units. It is a theory that should stand the test of time as most recessions and financial crises involve economic units that end up financing low quality investments. Recessions could be mitigated if policy makers monitor the quality of investments and take action before the financial system becomes extremely fragile.

References:

Minksy, Hyman P. 1992. Financial Instability Hypothesis. http://www.levyinstitute.org/pubs/wp74.pdf

Tymoigne, Eric. 2010. Detecting Ponzi Finance: An Evolutionary Approach to the Measure of Financial Fragility http://www.levyinstitute.org/pubs/wp_605.pdf

Economics and Politics

2014-12-04T21:53:00.000+11:00

Source: Lena Groeger

One of the most important fields to emerge in the past three decades is the field of cognitive and behavioural bias. Countless experiments prove that we are all heavily biased decision makers and not the rational homo economicus purported by academic theories. Because economics is not a natural science like physics, conducting experiments to prove theories is not possible. Despite this, economists have tried to use maths (see econometrics) to prove various theories. The problem with constructing mathematical models is the reliance on assumptions and because there are so many moving parts in the economy, even a complex model will be inaccurate.

The lack of clear evidence results in multiple theories that are difficult to disprove. Usually supporters of a particular economic theory will find it magically aligns with their political bias. Obviously this is no surprise because confirmation bias is one of the most common biases we all exhibit.

For economics to really become practical and more scientific, biases must be eradicated when conducting economic analysis. When biases are mitigated, you don't get flawed predictions like "QE will result in hyperinflation" or "the budget sequester will cause the economy to go into recession."

For economics to be scientific and void of bias, it must be apolitical. I can only hope that one day economics will be apolitical. What will this day look like? It will occur when the vast majority of the economists agree on theories and predictions.

This is exactly why I support Money Realism because it tries to keep the politics out of economics. Cullen explains this in his summary of MR eliminating politics from economics:

"We probably can’t completely eliminate politics from economics, but MR is based on attempting to understand the monetary system and the economy at its operational level as opposed to focusing on providing policy solutions like so many other economic schools. So we focus on things that are verifiable. For instance, how certain institutions are structured in specific monetary systems, how modern banking works, etc. It’s all based on the view that a superior understanding of the money system comes from building an understanding of how the monetary “machine” works from the ground up.

We try, as best we can, not to provide prescriptive ideas and instead try to provide a set of understandings so that users of MR’s understandings can then decide on their own how best to implement policy. We are not Keynesians, Monetarists, Austrians or any specific school at all. MR is simply a set of understandings designed to describe the money system.

Economics tends to focus on how certain policies can solve problems. I believe economists should adhere to a Da Vinci method. That is, when Da Vinci studied the human body he did not focus so much on how to fix the body, but how it worked. Economists focus too much time trying to fix the economy and not enough time building a set of principles that define how it works. If more economists adhered to a Da Vinci method I think better solutions would necessarily arrive.

This is the primary strength of MR. We don’t treat economics like it’s a religion. Instead, we treat it like an evolving and changing science that requires flexibility and an open-minded approach. As far as I know, there are few if any approaches to economics that provide this sort of approach."

Examples of biased economists

Some prominent economists that come to mind are Paul Krugman who has a blog titled "Conscience of a liberal". Just in case you did not know which political ideology he subscribes to. It is also clear that the Nobel Prize winner in economics, still does not understand how the banking system works when he claims that banks are not lending out reserves!:

"Banks are holding almost $2.7 trillion in excess reserves — funds they could lend out, but choose instead to leave idle."

Another biased economist that comes to mind is Stephen Koukoulas who frequently lambasts conservative politicians. He was an advisor to the former Prime Minister and leader of the Australian Labor party, Julia Gillard. Unfortunately his otherwise good economic analysis is tainted by his political bias.

On the other side of the political divide there are people like Peter Schiff and Robert Murphy from the Austrian school and a whole host of neoclassical economists like Arthur Laffer who will preach the virtues of a free market and that more government action will lead to adverse outcomes.

I would suggest you ignore the above economists who closely align themselves with one side of politics. Look out for those who are objective and apolitical, which is important in almost any field that relies on discovering knowledge.

But what about my political ideology? If I had to describe my own political bias then it would be Libertarian. Unfortunately, identifying with a particular ideology leads to many biases that result in a distorted view of reality. Thus I will now address eradicating political bias from your identity.

The most important reason to get rid of politics from your identity

The simple answer is politics makes you stupid. How you ask? When we adopt a political ideology as part of our identity, we perceive value from having correct beliefs. But what happens when these beliefs are wrong? You start to question your own self-worth and become reluctant to change these beliefs/identity, which makes "changing your identity a psychologically brutal process."

"The most important psychological imperative most of us have in a given day is protecting our idea of who we are and our relationships with the people we trust and love." These quotes are from the article by Ezra Klein - How politics makes us stupid, which is highly recommended reading. This is the reason I am abandoning my Libertarian beliefs or any political belief/ideology for that matter. I don't want to be stupid and I guess you don't want to be either!

Same Foundations, Different Perspectives

2014-10-30T20:10:00.000+11:00

If you have been reading my blog recently then you know my economic view of the world is based on Money Realism. While this provides a good foundation for understanding the monetary system, predictions may vary among its adherents. Simply put, I am slightly more bearish on the US economy than Cullen is.

Cullen points to three improving macro indicators: retail sales, initial jobless claims and manufacturing production. The problem with looking at these indicators is that they are all lagging and only offer the historical trend. One must look at forward looking markets or leading indicators. I asked Cullen if he looks at forward indicators and if they are showing any divergence from the lagging indicators to which he responded:

"My general view is that the macro picture in the USA has not changed in recent weeks and that Mister Market was just having an Ebola and Europe scare…"

It appears Cullen has a sanguine outlook for the US economy but let me tell you what I am seeing...

The bond market is one forward looking indicator and it is predicting low inflation. Lower inflation usually means a lack of demand in the economy and entails an extension of the accommodative monetary policy set by the Fed. In other words this lowers the probability of interest rate increases in the future.

Note the sharp drop in the back end of the US inflation curve over recent months

Another forward looking indicator is US residential construction investment which is slowing:

dynamics in housing not posive, in UK as well as in US ...hope for the best, but https://t.co/GYvmQXlxaV pic.twitter.com/OcWNIDndvf
— Aurelija Augulyte (@auaurelija) October 8, 2014

Finally, the collapse in oil prices is telling you that the global economy is stagnating and that inflation is not likely to be a concern in the short to medium term (lower inflation = economy not operating at full capacity):

The other reason the US economy will slow in the short-medium term is that a significant part of the US economic recovery has been driven by fixed capital investment in the oil and gas industry. With oil prices falling, we are likely to see less investment activity. It depends how much further oil prices fall, but WTI would need to fall below $80 before we start seeing projects suspended.

Of course falling oil prices are also beneficial to US consumers who will be paying less to fill up their cars. It is often remarked that a falling oil price is like a tax cut for consumers who will now have higher discretionary incomes. The falling oil price is a mixed bag for growth but inflation is definitely less of a problem in the short-term.

There are other macro risks including geopolitics and further strength in the USD, which would slow down the US recovery. Until those risk scenarios materialise, the US economy should continue to heal albeit at a slower pace. The Fed is unlikely to increase rates until wages begin to rise and inflation becomes a clear problem. Given the perception of a fragile recovery, the Fed will be reluctant to raise the Fed Funds Rate/IOER early. I do not see the Fed increasing interest rates in the first half of 2015 and are now less likely to hike rates in the second half of 2015.

To summarise:

Forward looking indicators are warning that the US economy's momentum is slowing along with the global economy
Inflation less of a concern given market expectations and falling oil prices
Deflationary forces will prevent the Fed from increasing interest rates in the first half of 2015

EDIT: In April 2015, Cullen Roche agrees that the US economy "appears to be softening" and it "would be wise to wait on rate increases".

Review of Past Predictions

2014-10-22T20:32:00.000+11:00

In my previous post, Mea Cupla, I discussed my new economic framework built on Money Realism with influences of Behavioural Economics, Post-Keynesian economics, some Austrian Economics (malinvestments) and a few others. Now it is time to review ALL my past prediction and make forecasts on what lies ahead using my new economic framework.

Anyway let's go back and review my posts:

First we have "Downfall of the US Empire". In this post I rebuke the debt incurred by the US in addition to "printing money" and QE. The error made in this post was to only focus only on the liability side of the US balance sheet and not the asset side. The US is the most productive and innovative economy in the world. Additionally, the US government has trillions of dollars worth of land and natural resource assets. When this is considered, the debt can easily be repaid. On a more technical note, the US government can avoid bankruptcy or default by monetising its debt. Therefore the debt is not a problem and neither is QE. The main limitation on endless government borrowing is inflation not the debt itself.

The next economic article I wrote was one entitled "Asset Bubbles" in February 2010. I recognised that asset bubbles are driven by irrationality, which aligns well with my current view of understanding behavioural biases when analysing the economy. I then write about property bubbles and predict Sydney's property market will crash. While I still think the Australian property market is prone to a correction. I no longer think a crash is likely given the government imposed supply constraints and because the RBA can still cut interest rates or even purchase RMBS to ease the supply of credit for mortgages. But what is the difference between a correction and a crash? I'm going to use the same loose definitions of both as they apply to the stock market. A correction is a decline of 10% and a crash is a rapid decline in a short period of time. Let's say a crash is 20% or more.

I then go on to identify China as a bubble, which I still think is true given the enormous expansion of credit used to fund unproductive investments. The main lesson to learn from this post is that when price deviates from its long-term average, it cannot be said that there is a bubble. There may be legitimate fundamental factors driving prices and as long as that does not change, prices will remain elevated. This is not true for China because even though they will be a powerhouse economy of the future, no economy is immune to a bust following a massive credit boom. You can read about my dire predictions on the Chinese economy here.

2012 Articles

The next post I wrote is in February 2012 on fiscal policy. I criticise government borrowing and cite a few reasons why. The primary claim I make is government borrowing crowds out private sector borrowing. This is only true when the economy is booming, bond yields are rising and inflation is a problem. More government borrowing in this scenario would put upward pressure on interest rates economy wide. My original claim was wrong in normal times but correct when inflation is high.

In July 2012, I wrote about why we want a stronger currency. Ultimately we should not want a strong or a weak currency but one that reflects the fundamentals. Now obviously that is as ambiguous as it comes in economics. But the main point is that a strong currency will hurt domestic exporters while consumers will benefit from cheaper imports. Conversely, a weak currency will boost exports but foreign imports will be expensive. Central banks are conflicted on this topic because a strong currency will reduce imported inflation while reducing employment in export industries and vice-versa with a weak currency. Trying to stimulate the economy by purposely weakening the currency is ineffective as Japan has recently found out (research from GS).

In August 2012, I wrote about how banks feed off inflation. This is probably the best example of my incorrect understanding of the monetary system. I explicitly reference the money multiplier when talking about fractional reserve banking. What's funny is that the conclusions about banks needing inflation to generate increasing profits are correct. If the money supply contracts because people are repaying loans, then the interest income banks receive decline, which will impact their profits. The main point is that we have a credit based monetary system that requires inflation or else the system implodes in a deflationary spiral. Hence why central banks are terrified by the prospect of deflation.

2013 Articles

Moving along to March 2013 when I wrote an article gloomily entitled, "The Keynesian Endgame". But wait till you read the first sentence: "I absolutely despite the Keynesian school of economic thought." I can only shake my head at this ridiculous diatribe. Having actually read Keynes, he's not as bad as the Austrians portray him to be. While the vilification of Keynes was gratuitous, I still believe the crux of the article. The main message is - the current debt-laden world is unsustainable. I'll address this point in the months ahead.

In June 2013 I wrote an article provocatively titled, "Apocalypse Now", in which I outline the main risks I see for the Australian economy. This article was light on theory so there's not much revision here except for my comments on Japan. Obviously QE is not inflationary for the general price level in the economy. It could be said that QE results in asset price inflation but that's not inflation in the traditional sense of the word. I still retain my bearish bias on the Chinese economy which you can read about here. I later mention the main risks to the global economy which is still 100% valid today:

"There are also known unknowns (as Donald Rumsfeld likes to say), which include terrorism, global health pandemic (watch the movie Contagion), natural disasters, wars, government policies (QE, protectionist trade and capital policies)."

This year we've seen the war in Ukraine and in Iraq with ISIS. Then there's the global health pandemic of 2014 - ebola. Thus far the markets seems to be shrugging off these risks. But it only takes a slight escalation in the spread of ebola for example, before the market rapidly reprices risk to the detriment of asset valuations. I still believe the following prediction made in June 2013 will eventuate:

"My predictions: base case rates go lower in Australia to 2% and in combination with the lower AUD (70c-80c) causes the economy to re-leverage. Worst case scenario is an implosion in Asia due to any of the factors mentioned above, will cause rates to go to zero in Australia and the AUD to go sub 50c as commodity prices collapse and the high unemployment prevents credit growth from occurring. It’s difficult to see any bullish scenario simply because “we’ve been there and done that” for a few years now."

The next post I want to look at is one entitled "Escape is Impossible" in December 2013. Back then I realised that QE from the Fed was largely ineffective, albeit for the wrong reasons. This is the post where I start getting more things right than wrong.

There you have it. A quick review of my past posts and what I missed or got right. It's difficult to believe that for years I had been operating under a flawed economic model, leading to erroneous conclusions. While I have updated my knowledge, most economists still don't understand the monetary system an in particular the concept of endogenous money. It will only be a matter of time before they change their views (I hope) because their predictions will be consistently wrong.

Updated Predictions and Forecasts

As promised, here is a summary of my updated forecasts and theories:

US does not have a debt crisis due to enormous asset side of balance sheet
Australian property market likely to fall at least 10% as economy enters recession by 2016 (same as before)
China will crash by 2016 (same as before)
Government borrowing does not reduce business borrowing (most of the time)
Engineering a weaker currency through monetary policy is not a path to sustainable economic growth
Keynesian policies such as deficit expanding tax cuts or infrastructure investments are beneficial during a recession
The reason why high inflation won't occur is because credit growth is demand driven (as MR states) and as we've seen over the years in the US, Europe and Japan, lower interest rates have not engendered credit growth
Basically more debt in the system results in less growth because interest must be paid from income (Post-Keynesian theory of financialisation of the economy), which means less disposable income
Deflation is occurring across the world but could be one or a combination of many reasons including: the accumulation of private sector debt, demographic trends, globalisation or income/wealth inequality (Post-Keynesian reason)

Mea Culpa

2014-10-17T19:50:00.001+11:00

"When the facts change, I change my mind. What do you do, sir?" - Unknown quote

Rebuilding the model

Part of the learning process is acknowledging the limitations of your understandings and when a better theory or model of the world is developed then one must reject any contradictory models or theories. I say this because a year ago you could have described my economics views as Austrian, with little tolerance for government intervention. Whether it be regulations, taxes or spending - the less the better.

That changed towards the end of 2013 after I learned that the Austrian model of banking and money is inaccurate when applied to the current monetary system (it may have been accurate decades ago). Further doubts arose as I learned more about cognitive bias and behavioural economics/finance. These realisations invalidated my economic view of the world and I began to question everything including: if free markets were really the best way to allocate resources? and does government have a role to play during recessions? But I first had to address how I came to be so wrong in the first place.

I looked at my economic education sources: Mises.org, ZeroHedge, Peter Schiff etc. What do they all have in common? All have a strong libertarian political bias and hence also share a pro-free market or Austrian economic view. I couldn't believe it, I had fallen for confirmation bias. My own libertarian political bias had guided me to embrace an economic school of thought which supported absolutely free markets with little room for government intervention. I knew that any cognitive bias distorts one's perception of reality and if I wanted to know how the economy really operates, I would need to research other economic theories and schools of thoughts objectively.

Like a phoenix rising from the ashes, a new model is born.

I started my post-Austrian economic journey when I discovered Modern Monetary Theory (MMT) and Money Realism (MR). At first their theories sounded heretical. They were saying things like the government can never default and that bank loans create bank deposits. Like any objective critical thinker, I learned more about it and found their monetary model to be a more accurate portrayal of the current monetary and banking system than any Austrian model.

Earlier this year, the Bank of England released a paper (highly recommended reading to understand money creation and QE) explaining the monetary system, which matched the model portrayed in MMT and MR. It also means that it punches holes in Austrian theory with conclusions such as:

Banks don't rely on deposits to create loans
Savings that are deposited in a bank do nothing for the economy. Hence savings deposited at a bank or what Keynes described as "liquid assets", results in less economic activity
A central bank conducting QE is not the same as the "money printing" in Zimbabwe or Weimar Germany

I still think the Austrians have a lot right about high levels of government intervention harming the economy and their theory of malinvestment has some merit. But their monetary model (loanable funds model) needs to be discarded to reflect the current reality. In response to these claims, Austrians retort that they describe the real economy and not the fiat/nominal/accounting economy. This may be true, but at least acknowledge that the loanable funds model (people save and then banks lend those savings out) embedded in Austrian Capital Theory is utterly wrong.

So what are my general beliefs and views now? After being intellectually burned on Austrian theory, I've become a strong proponent of objectivity and observation rather than developing a theory and then imposing it on the world. In Nassim Taleb's book Antifragile, he discusses this thought process and classifies it as phenomenology. Simply put: don't worry about the theory, just know what works.

Much of mainstream economics is influenced by political bias and therefore any accurate economic school of thought must be apolitical. Given this premise, I was forced to reject MMT because they are tainted by a strong left-wing political ideology which favours pervasive government intervention. This leaves MR which explicitly states its focus on the "operational realities of the current monetary system". Political decisions are left to others and have no place in MR. As nerdy as this sounds, I fell in love with this principle.

You can learn about Money Realism at pragcap.com run by the wonderful and erudite Cullen Roche.

What are my current economic thoughts?

I think everything that MR claims is true when compared to all other economic schools of thought. Cullen does a fantastic job of comparing the other economic schools here and here.

One of the important tenets of MR is that we are all irrational and thus, markets are not as efficient as we believe (you probably already knew that). This does not imply free market capitalism should be rejected. It just means pure capitalism is not the ideal outcome for the economy.

Government intervention can be a net benefit to the economy in a recession if done correctly. There is a fine line between allowing an unsustainable boom or bubble to deflate and preventing a potential depression. Policy makers must not prop up inefficient businesses if they are the by-product of poor decisions by investors (similar to the Austrian malinvestment theory).

I also place a lot of value on cognitive bias and behavioural economics/finance. It explains everything from booms/busts (herd mentality and loss aversion) to people claiming the data is manipulated to show no inflation (confirmation bias and just batshit crazy).

I also have incorporated the main idea of Antifragile by Nassim Taleb, describing things that become stronger (antifragile) not weaker (fragile) after being temporarily exposed to a stressor.

Cannot recommend this book highly enough!

An economy is just the aggregate of people's spending decisions and because of behavioural biases like overconfidence and the herd mentality, excesses can accumulate in the system. Without the full impact of a recession, risk taking will become irrational as investors expect fiscal and monetary stimulus to limit their losses (moral hazard). This is similar to Minsky's Financial Instability Hypothesis which states stability creates instability. In layman's terms, the more stable the economy, the more risk taking which results in future instability. Again you can see the influences of behavioural economics with overconfidence etc.

This is the main reason I strongly believe a recession should be allowed to run its course. After a recession, the system becomes stronger as the weakest businesses are liquidated and the factors of production that were previously used inefficiently are now reallocated to the strongest and more efficient businesses. The government can support unemployed people through welfare and can stimulate economic activity but cutting taxes and allowing the deficit to increase. These measures must be taken ONLY after the unsustainable excesses and malinvestments of the boom are liquidated.

What lies ahead...

Now that I have a better understanding of the reality of the banking system, it's time to update my predictions. My own view is that all developed economies are sinking into Japanese style debt deflation. The conventional monetary policy is that lowering interest rates encourages more borrowing which is then spent on investment by businesses and consumption by households. Implicit in this theory is that we can reduce the severity of recessions and the economy will grow forever. Is that possible? Can we just always lower interest rates and the economy keeps on chugging along to new heights? Remember that old phrase when someone tries to convince you that some form of government intervention makes everyone a winner, there's no free lunch in economics. There are other confounding factors such as demographic trends, inequality and technological progress fuelling the deflationary trend which I will discuss in future posts.

But that's it for now. In the next post I will be reviewing my past predictions and updating my forecasts for the future using my current and more accurate understanding of economics and finance.

Mining Subsidies - Analysis of Ross Gittens's "Mining boom policies dig a hole for economy" - SMH 24/6/14

2014-06-25T21:53:00.000+10:00

Are we subsidising the mining industry too much? Yes is the answer according to Ross Gittens in his recent article. The article comes on the back of a report to be released by the Australia Institute, alleging that the mining industry receives numerous subsidies. Despite receiving numerous subsidies, the mining industry contributed, "$121bn paid in Federal and State revenues over the last six years," according to the Minerals Council of Australia. That's an average of about $20bn every single year. Compared to assistance AI calculations: "the states gave the mining industry $3.2 billion in concessions in the financial year just ending."

At the end of the article Gittens says:

And this while governments, federal and state, are crying poor and cutting spending on many worthy causes.

Apparently, the end of the age of entitlement applies to poor people, not to big corporations. And that’s true for foreigners, not just locals.

As Ian McAuley, of the University of Canberra, has pointed out, we’re slashing our planned spending on foreign aid because we can no longer afford such generosity, but by abolishing the mining tax we’re being very generous to big foreign mining companies.

This makes sense?

To cut a long story short, Gittens wants the mining industry to pay more tax but doesn't say how much more.

While I agree that subsidies should be reduced or better yet abolished, taxes and royalties should be reduced to offset the reduced subsidies. The result of which is a mining industry that builds its own infrastructure and has the funds to do it from reduced taxes and royalties. Then we could say we no longer subsidise the mining industry which would also reduce compliance costs and other inefficiencies associated with regulations.

Once that is done, then we can have a debate about the mining industry paying more tax. Indeed taxing natural resources is one of the preferred factors of production to be taxed. A tax on minerals is more economically efficient than incomes taxes and corporate taxes. See the next chart by KPMG in a submission to the Henry Tax Review (where PRRT is the Petroleum Resource Rent Tax similar to a mineral's tax in that both tax factors which are completely immobile):

Does that mean I support the current "mining tax" that the Abbott government plans to scrap? No. The current mining tax bares little resemblance to the mining tax originally suggested in the Henry Tax Review. I agree that the current mining tax should be abolished. If you want a mining tax, then do it right and reduce the inefficient tax burden elsewhere in the economy (cutting payroll tax, corporate tax or income tax - see KPMG chart above). Doing it in this fashion is revenue neutral in the short-term and revenue positive in the long-term as economic growth is larger due to more efficient taxes.

Gittens article starts of well by describing the benefits of foreign direct investment but then entangles itself in a messy debate about the mining industry paying more tax. Unfortunately Gittens ignores the numerous savings that could be achieved if government was more efficient (as proposed by the National Commission of Audit) and instead calls for more economically harmful tax revenue to fund political and social programs.

Bear in a China Shop

2014-03-10T20:14:00.000+11:00

Photo: Wen-Chun Fan - CNN

It’s been a few months since I placed China firmly in my crosshairs. Since then, the evidence continues to portray a mind-boggling debt bubble, not only in the property and construction markets, but also in corporations financed by the shadow banking sector.

Initially, I thought the main problem was the property market but after realising how leveraged the corporate sector is, my attention turned to the copper, coal and iron industries with connections to the shadow banking system. My updated thesis is that the overleveraged corporates (specifically the coal mining, iron ore, copper, cement and property industries) will be the first to crack causing defaults in the shadow banking system. Loan defaults inevitably lead to tighter credit conditions and further defaults, falling asset prices and collateral impairment. The vicious cycle is complete and suddenly the economy is in free-fall.

There is no question in my mind that the defaults will occur but what will the policy response be? The Chinese government will respond with bailouts, debt guarantees and more fiscal stimulus. Despite the financial firepower that Beijing has, the scale of the problem is so vast that it will overwhelm the economy before Beijing reacts.

But let’s say that Beijing is successful in preventing a few defaults initially. The distortion of risk will perversely cause investors and speculators to pump more funds into bad investment products as any losses incurred will be recovered via a bailout (increasing moral hazard).

The main catalysts for the China collapse in order of most likely to least likely are:

Government inaction (no bailouts) that results in tighter credit conditions or intervention to deliberately depreciate the Yuan (reversing leveraged carry trades)

Falling commodity prices causing collateral impairment, forcing collateral liquidation which causes further falls in commodities in a self-reinforcing cycle

Defaults relating to property market speculation occur causing a downturn in the economy and falling demand for commodities

In this post I will provide evidence for the aforementioned conclusions. You can decide for yourself if this is just doomsday permabear talk or if China is on the precipice of the abyss.

Chinese banks and bad loans

The borrowing binge of the last couple of years has seen a rise in Non-Performing Loans (NPLs) for the largest Chinese banks. Beijing has tried to clamp down on the leveraged banking sector and the reports of rising NPLs is seen as a pre-emptive move to mitigate a future surge in NPL ratios amid rising defaults in 2014.

This raises suspicions that if the largest banks are reporting rising NPLs, one can only imagine the amount of bad loans in the opaque shadow banking sector. To illustrate the relative size of the shadow banking sector, the five largest state owned banks and the 12 largest national lenders control more than 60% of China’s banking assets with other financial institutions owning the rest. There is cause for concern with NPLs rose by 28.5bn Yuan in last quarter of 2013.

NPL ratio rising since Q3 2011 (time axis reversed)

Despite the worrying trend in NPLs, this has not dampened confidence in lending. In fact, total social financing increased by the largest amount in history:

Credit boom continues

Shadow banking

At the heart of the excessive credit is the shadow banking system in China. Essentially, the shadow banking system refers to the unregulated financial intermediaries and the investment trust products they produce. These trust assets are marketed as “wealth management products” (WMPs). A good analogy for WMPs is the mortgage backed securities that went bust during the GFC. But instead of institutions buying these products, it is small retail investors and instead of mortgages backing these trusts, it is loans to corporations and local governments. The growth in these trust assets and WMPs have been enormous to say the least, with growth in the last few years averaging 40%p.a.

Trust asset boom is unsustainable

Bailouts and moral hazard

One of the counterpoints put forward by the China bulls is that the government can just expand credit and bail everyone out. Unfortunately this creates huge moral hazard and encourages reckless risk taking throughout the entire system.

Wealth management Products (WMPs) offering double digit returns are presumed by investors as being guaranteed by the issuers. Avoiding the default has misleadingly confirmed that presumption leading to that perennial distortion of risk… Ye Olde Moral Hazard.

In a JPM report they conclude, “Avoiding defaults will only delay or even amplify the problem in the future.” Get ready for the first wave because in the short-term there are a large volume of WMPs maturing which poses substantial rollover risk.

To summarise, bailing out losing trust products creates moral hazard and exacerbates the risk of further volatility. The lack of perceived risk will entice further investment, further inflating the bubble and worsening the inevitable crash.

Chinese commodity collateralised loans

While the central government is aware of the accumulation of leverage in the system, the crackdown on lending has driven companies to use raw commodities such as iron ore, copper and coal as collateral. These schemes increase the risk on loans by exposing lenders to a fall in commodity prices which will impair collateral. This creates the dual risk of either loan defaults causing collateral to be liquidated or commodity prices falling first and the value of collateral being insufficient, leading to lenders calling for more collateral.

Given the above, the record build-up of iron ore inventory at Chinese ports is a worrying sign and could precipitate a collapse in commodity prices:

Inventory piling up and does not bode well for prices
Source: Unknown

Already iron ore prices are declining as inventory is at all-time highs. Adding to the pessimism is falling industrial demand and speculative activities by commodity traders. There is anecdotal evidence that commodity importers have been using their inventories as collateral to bet on Yuan appreciation. Some have even borrowed dollars, converted them to Yuan and invested the money in “high yielding” accounts.

Iron ore prices at new monthly lows
Source: Barchart

From SoberLook, “With banks cutting back lending to this sector and the recent decline in the Yuan, traders are being forced to dump inventory and that is sending prices lower and causing some mills to close. All of this points to tighter credit, weaker demand and slower industrial activity going forward.”

China upcoming trust defaults

There have already been reports by the media of potential trust defaults. The upcoming trust defaults seem to be concentrated in Shanxi province and in the coal mining industry. Repayments may be extended to avoid default in the near term and Coal mine trusts are most likely to default because coal price has fallen recently.

The maturity wall is fast approaching

Chinese housing market

Residential property in China’s 70 largest cities is also coming off the boil. It is still early days but if the fall in property prices gain momentum, this will dampen the speculative frenzy. A rapidly cooling property market and falling coal and iron ore prices will compound the contraction in credit growth as trust products default.

Chinese households have invested vast amounts in property and are now massively exposed to a housing bubble. China housing prices have increased substantially with households holding on average 65% of their assets in real estate and 90% of households already owning a home. Supply is coming to market at a rate of 15mil new units per year.

Chinese house prices in a speculative fervour

Impact on the world

I remember watching an episode of NCIS and the veteran detective saying, “I don’t believe in coincidence.” There is a link between Chinese capital flows and the US Federal Reserve’s QE program. We have seen the effect QE tapering on emerging markets (EMs) as the carry trade unwinds. Tapering will speed up the withdrawal of capital causing financial conditions in China to tighten. This is relevant because the Chinese trust sector is partly financed overseas. Low global rates and expectations of perpetual Yuan appreciation have resulted in higher investment returns promised by trusts. Part of the debt raised overseas is probably invested in the trust carry trade. Hong Kong banks are big participants and if China goes bust, you can expect the Hong Kong banking system and property prices to come under pressure.

Honk Kong financials are heavily exposed to Chinese borrowers

BAML says if China blows up there will be safe haven bids for developed market (DM) government bonds, overseas property and precious metals. One of their alleged smartest clients said, “The main theme in the past 5 years was QE. If that is coming to an end, investments and themes that worked in the past five years must therefore be questioned.” This is an important reminder about the immense global implications of any crisis given China’s contribution to world economic activity.

Yuan leveraged bets

The “managed economy” that China espouses has resulted in massive speculation in property, commodities and of course the currency. China has steadily allowed the Yuan to rise and has gradually allowed increasing volatility over the years. Corporations have taken out derivatives known as target redemption forward contracts to bet on the increasing currency in what many have described as the “easy money, no risk, no brainer” trade. Unfortunately, the government has ended the party in recent weeks with the Yuan depreciating significantly during a short period of time. While in absolute terms the move is not dramatic, it does cause the problem of huge losses for corporates who are exposed to these leveraged derivatives.

To summarise the problem, the longer the currency depreciates the more losses are sustained. Even if the currency remains below certain loss thresholds, collateral or margin calls will be used to reduce the risk of positions for banks. This means corporates will have less cash and will become more leveraged. You can read in more detail about the derivatives here.

Arguments against a China collapse

Another argument against a major crisis is that China runs a“non-commercial” financial system, that there is no counterparty risk since it’s just one giant state run labyrinth and bailouts will flow at the first sign of trouble.

Such a system is not immune to shocks and is in fact more fragile and more susceptible to adverse events. I have already mentioned that avoiding losses will result in moral hazard and lead to more risk taking and leverage. Eventually the boom will become too inflationary (as seen in 20%YoY property price increases) and they will be forced to tighten, which then causes tighter credit and eventually defaults that further destabilise the system.

The “China is immune view” also emphasises that market forces deal with problems and governments do not. Loss making decisions are eventually purged from the market, while they are perpetuated and exacerbated in a government controlled system.

Picking the top in the market

There’s that old adage in the investing world that the markets can remain irrational longer than you can remain solvent. This is especially true for bearish investors and traders calling the top in any bubble. I have previously said I expect Australia to be in recession before 2016 based on many risks including a Chinese financial crisis. That is still my base case. In making this prediction, I am committing the cardinal sin of picking the top of the market or trying to time the collapse. Jim Chanos (runs a short-selling hedge fund) has been predicting the Chinese collapse since 2009 and five years later it still has not happened! I am happy to be wrong on timing the crash because I am convinced that it will happen given all the facts listed above.

Conclusion - warning signs

We all know that inflationary debt bubbles burst eventually because central banks and governments understand the instability caused by rampant leverage and speculation. By then it is too late, and the economy must undergo a remedial recession to purge the malinvestments.

China’s highly leveraged economy has numerous risks that would trigger a chain reaction throughout the entire system. The property market, the commodity market, the currency market, the banking system and leverage corporations form a powder keg that will soon find a spark.

When someone says, “China is immune”. What I hear them saying is, “this time it’s different”. The same denials you hear when history has proven that credit fuelled bubbles never last. You will always hear the same bubble mantras that defy logic like, “property prices never go down” (US sub-prime 2007), “earnings don’t matter” (Tech boom 2000), “they have a super-productive economy and are different” (Japan 1990) etc. When central planning and debt is involved, nothing ever changes and you can expect history to repeat again and again and again.

Source

How the Government Pisses Your Money Up the Wall

2014-01-07T19:09:00.000+11:00

In recent elections, cutting government spending has become a political taboo. Who can forget the Labor Party’s fear inducing “cut to the bone” slogan? The reality of Australian state and federal governments is that there is always inefficient and wasteful spending occurring. It is a certainty that taxation revenue will be squandered because unlike a business or an individual, there are no market prices or accurate profit and loss statement to tell the government if resources are being used efficiently. How do we know what a customs/border security officer is worth? Without market pricing there will be inefficiencies that are usually ignored because the government of the day will always prioritise the political solution over the economic solution.

This post will outline wasteful spending and that there is ample room for reducing government expenditure.

Currently, the federal government is forecast to be in surplus by 2016. This will not happen simply because recessions or financial crisis are likely to occur between now and then. The negative impact of such risks has been ignored when forecasting the budget trajectory.

Recessions are never predicted in advance, which means that forecasts are always optimistic. This is why I doubt Australia will run a surplus in the next 10 years. Consider that for most of 2010 and 2011 the Australian Treasury forecast that they would have a surplus in 2012-13 only to abandon that prediction at the end of 2012!

It was only a year or two ago, these same mainstream economists were saying running deficits are okay during “low-growth periods”. But what if these are the good times and the worst is yet to come? It means that the deficits will grow and we will enter a debt spiral in which deficits cannot be contained without political blowback and the debt balloons into the stratosphere. Eventually, markets lose confidence and interest rates spike as the threat of default looms. The fallacy that people make when thinking about debt crises is that the problem does not start when rates spike but in the years prior when debt accumulates. It is still early days but remedial action needs to be taken now before the government is left to the mercy of the markets.

But why cut spending and not increase taxes? The simple answer is that the economy grows when the private sector is free to invest capital at high rates of return. A crude example is if a business can invest and generate 20% ROI, while the government builds a highway that collects tolls and generates 5% ROI. Then the private business should invest that money instead of the government taxing or borrowing from the private sector to deliver lower returns. This is fundamentally why increasing taxes is the worst way to reduce the deficit. Cutting spending is the best path to balancing the government budget. There is plenty of waste, fraud, abuse and middle class welfare which can be eliminated to deliver instant expense reductions:

Political remedies to cutting spending

Of course the government is constrained politically in cutting government spending because there will be some interest group that will protest less money flowing their way. The best way to reduce the political blowback is by reducing spending and reducing taxes simultaneously. For example, if $1,000 in government expenditure is cut, reduce taxes by $500 and use the remaining $500 to reduce the deficit. As the deficit is reduced further the tax reduction can increase to make further cuts more appealing. For examples if the deficit is relatively small then a $1000 reduction in government spending can then be used to reduce taxes by $800 and the deficit by $200.

This is why the austerity measures in Europe have been unpopular and ineffective. The European governments reduced spending and raised taxes which slowed the economy and resulted in political turbulence. By cutting taxes in tandem with government expenses, the political cost is reduced and the economy benefits.

But where to cut? As you can see from this chart that the major growth in expenses over the next three years comes from social security welfare, health and education. They are not in percentage terms but it does show where the budget is bleeding the most in dollar terms:

Source: Budget Paper 1, Statement 6, page 10

The table below shows the top 20 expenditures for the federal government. GST distributions are at the top with $51bn going to the states, followed by the pension and family tax benefits. This highlights the burden of the welfare state that will sink the Australian budget if spending is not reduced or made more efficient:

Source: Budget Paper 1, Statement 6, page 12

CLICK HERE for my own list of expenditure to be cut.

List of Government Expenditure to be Cut

2014-01-07T19:08:00.003+11:00

PLEASE BOOKMARK THIS PAGE AS IT WILL BE PERIODICALLY UPDATED

If you have any suggestions then please let me know in the comments section below.

Things that should be cut at the Federal level:

· Joint strike fighter (the cost has already blown out by billions and will continue to do so)
· Withdrawing all Australian military forces from all foreign countries (Insurgents have taken over cities in Iraq recently. So much for mission accomplished)

· Baby bonus

· Family tax benefits (up to $30bn saved per year that can be passed on in tax cuts)

· Paid parental leave (at least $4bn per year)

· Car industry subsidies (Holden is winding up assembly by 2017, Toyota will hopefully follow soon)

· All sports subsidies and $7bn in arts subsidies
· Foreign acquisitions of submarines instead of building them in Adelaide ($20bn saved)

Total saved from spendings cuts: At least $10bn per year

A report by the Centre for Independent Studies saves up to $20bn per year, which you can read in more detail by clicking here.

It outlines nine budget fixes:

Total saved from all of the above including CIS report: At least $25-30BN PER YEAR

Other spending to cut:

$200 to newlyweds for marriage counselling

To privatise:

· Australia Post

· Medibank

Before you say this is radical privatisation, the ACCC agrees with me!

Other waste:

Politicians abusing taxpayer money

Stop politicians travelling so much and get them to embrace video conferencing. Bob Carr spent $4,220 PER DAY in his last 6 months. Compared to previous foreign ministers at $2843 per day.

State government waste

To anyone in Victoria, reading things like this infuriates me and I live in NSW:

“Another state authority that was also under the spotlight last year, the Victorian Building commission, has dramatically cut its corporate expenses after being labelled by Victoria's Ombudsman as being rife with ''cronyism'' and misuse of funds.”

First Home Owners Grants and various construction grants

Escape is Impossible

2013-12-19T21:28:00.000+11:00

Bernanke taper time
Photo: Bloomberg

Since the end of 2008, the US Federal Reserve has cranked up its monetary easing policies several times to get the US economy growing again. The Fed is like the gambler doubling down on their losing bets, hoping for that next big win which will erase all their losses. The Fed is hoping for that next big win in the form of sustainable job creation of at least 200K new jobs every month and the unemployment rate to fall to 6.5%. Few have asked the question of whether the Fed’s monetary policies even work given the build-up of excess reserves on the balance sheets of banks. Yet here we are, a year on with the most expansionary monetary policy ever and we are debating if the economy is ready for a taper. In economics there is the law of diminishing returns and with the Fed resigned to continually buy bonds, the effects of the purchases has diminished to the point where the Fed has become impotent.

The problem for the Fed and other central banks is that as soon as they set a target for withdrawing stimulus policies, the markets anticipate it months in advance which brings forward the effect on the economy. This is the phenomena of reflexivity that George Soros referred to whereby the economy affects financial markets and importantly, the financial markets affect the economy.

First blood

In the middle of 2013, the yield on the US 10 year bond rose from 1.5% to peak at 3% in just a few months. The rapid increase in rates also affected emerging markets (EMs), which had increased their monetary supply in recent years to offset capital inflows caused by the Fed’s quantitative easing (QE) program. When US yields rose, EM yields followed, and their currencies fell as capital flowed back into the US. This phenomenon caught the entire market with its pants down and highlighted the precarious position central banks had left credit markets in.

This was the market’s canary in the coal mine. Perversely, as capital flowed out of EMs and their currencies depreciated against the US dollar, EM central banks sold their foreign reserves to buy their domestic currencies and slow down the capital outflow. You can read about what happened to India here. If the Fed reduces purchases and foreign CBs are also selling US treasuries as we saw earlier this year, US yields will definitely rise as net supply dramatically increases. The effect of rising long-term rates on the US economy will end the recovery faster than you can say nominal GDP targeting! If EMs let their currencies depreciate, imported energy and food prices will rise and will be devastating to their economies. This is why we should see EMs reducing the reserves to support their currencies.

Everyone knows that the endless purchase of securities is unsustainable because at current projections the Fed will eventually monetise the entire US treasury supply. The problem with this outcome is that US treasuries are utilised to hedge investments and as collateral throughout the financial system. If treasuries become scarcer, liquidity will decline and we will see volatility in short-term rates. This means the Fed will stop ALL treasury purchases at some point.

The Fed is buying most of the US treasury's supply

Repercussions

Rates will rise but will we see another volatile move or a slow melt? There is the argument that the dramatic move in rates this years was caused by MBS convexity hedging, which you can read about here. The next question is can the US economy handle a 10 year yield above 3% without sending the economy into recession? Or what about a confidence boosting 20-30% decline in the S&P500 as investors rotate from stocks to bonds? I’ll let you ponder that. Just look at how higher rates have affected US mortgage applications which hit a 13 year low to understand how higher rates shake up the economy:

US mortgage applications hit a 13 year low
Chart: Bloomberg

The negative economic impact will worsen as rates creep higher. Keep in mind that even with yesterday’s taper of $10bn, the Fed’s balance sheet continues to grow at $75bn per month:

The tiny taper
Source: Zerohedge

A nice trade to profit from further tapering in 2014 would be a US 2s10s curve steepener (long 2yr and short the 10yr). The spread is about 257bp and we would target a spread of 347bp which is 90bp higher. Use a stop loss of 30bp and exit either when the spread hits 347bp or hits the 200 day moving average (whichever occurs first).

While many speculate on when the Fed will completely exit asset purchases, they ignore the market and economic reaction in anticipation and fail to see the reflexive nature of the Fed’s policy. The Fed will soon realise the futility of finding an exit, because when tiny steps to reduce purchases and sell their bond holdings causes huge moves in the market… there really is no escape.

The Destructive Minimum Wage

2013-10-14T21:28:00.000+11:00

If you ask anyone what happens to demand for a good or service if price increases, they will logically tell you that demand decreases. Yet when it comes to the minimum wage (MW), proponents claim there is little to no effect on employment. Could it be? In every other market, higher prices results in less demand, yet in the labour market, government imposed higher wages have little effect?

Fast food workers in the US go on strike demanding a $15 minimum wage

In this post I will explain why most academic studies in economics are unreliable, how the service sector will be impacted by higher labour costs and other problems with the pro-MW argument.

Why academic studies are flawed

The mainstream economic profession believes that they can measure and predict the economic effects of policy change. They usually create regression models to test the effect of independent variables on dependent variables. In the real world, the economy is a dynamic environment with numerous forces acting on prices (inflation, interest rates, fiscal policy, consumer preferences, trade, weather and seasonality etc.). It is almost impossible to accurately model the behaviour of an economy comprising of millions of individual people and transactions. Yet the illusion continues because the mainstream economists see their field as a science like physics. Therefore, they embrace mathematical models to the detriment of dull archaic theory or praxeology.

Take this example of Andrew Leigh’s (now an Australian Federal Labor Party MP) study of Western Australia’s MW increases on employment. He concludes “After each if these increases, the employment to population ratio in Western Australia fell, relative to the Rest of Australia. Aggregating these six changes, the elasticity of labour demand with respect to the Western Australian statutory minimum wage is estimated to be -0.13. The employment impact is most substantial among younger employees, with the elasticity of labour demand for workers aged 15-24 estimated at -0.39.”

I do not want to dismiss the attempt at measuring the effect of an increase in the MW but we all know what the effect was going to be, this study was aimed at measuring the magnitude of the change.

Empiricism is useful to an extent; however I would always place praxeological theory above empirical or model driven evidence. If the empirical results showed that increases in the MW actually increases employment, I guarantee there would be economists rejecting the law of demand and supply in the labour market. Unfortunately, these economists harm the integrity of economics by supporting preposterous claims to support a socialist political bias. I have always applied the common sense rule to economics which is just logic combined with fundamental principles such as higher prices results in less demand. Complicating issues just causes more spurious results and false policy prescriptions.

The service sector is not immune from higher labour costs

The MW will affect industry sectors differently. For example, manufacturing workers are competing globally with foreign workers and capital. Any government mandated increase in wages will result in a loss of competitiveness ceteris paribus. However, the service sector is somewhat protected from competition because many services cannot be imported or exported. The classic example is haircuts because even though China has low labour costs it cannot export haircuts. Once again the free-market will always find a way to undermine government interference. We are seeing an increase in what is known as Labour-Capital Substitution, which is basically people being replaced by automated machines.

I went into Australia Post (AusPost) today and saw a newly installed self-serve machine. Yes even a government owned business is finally making the switch! I say this because the same self-serve machines have been in major supermarkets for a few years now. We saw this first in retail banking when bank tellers were being replaced by ATMs. Eventually banks are going to be entirely self-serve with a few staff on hand to handle more complex services. Going back a few decades, petrol stations had attendants who would fill your tank. Now that wages are too high, it has become self-serve which is a reduction in the quality of the service.

Behold the Postmaster9000

New Australia Post self-service machines

I would have used the self-service machines if it required no AusPost employee to finalise the lodgement. The first time I tried to send a parcel via registered post, it told me to wait for an Australia Post employee. It actually took me longer to use self-serve than just go to the counter and lodge it the old-fashion way.

Coincidentally, while I was standing in line one of the AusPost employees asked the elderly lady behind me if she would like to use the self-serve machines and this is what she said, "I don't want to put anyone out of a job". I felt like turning around and explaining to her the benefits of labour saving devices, the benefits of increased productivity and the fact that in a free-market economy there is always demand for labour... I decided to bite my tongue.

This display of economic ignorance by Luddites is pervasive throughout society. Never mind that despite centuries of technological advancement and machines replacing labour, we continue to prosper and that adoption of labour savings devices have not led to mass unemployment. This is the challenge that faces economists in explaining these matters to people who see the intended consequences and are blind to the unintended consequences. Of course it is not the fault of the economic ignorant, but it does epitomise the reason why economically destructive policies like the MW remain popular.

Early adoption of self-serve is slow to say the least

Clearly unskilled and low-skilled work will be under constant threat by machines that do not require sick leave, annual leave and will not ask for higher wages to work on weekends. The service sector is undergoing this paradigm shift and it will be Australia leading the implementation of machines and robots given the exorbitant cost of labour. This will be appreciated by consumers enjoying lower prices.

A different perspective

MW supporters always look at the policy from the workers perspective with phrases such as a “living wage” and “a fair day’s wage for a fair day’s work” tossed into the debate like a moral trump card. One just has to think of it from an employer’s perspective which is what most economists and other pundits who are pro-MW fail to do. When faced with a government mandated increase in labour costs, the business making slim profits has few options:

The employer reduces costs by cutting the most unproductive staff and works existing staff harder
The employer reduces staff and outsources/offshores the operation, or employs machines instead of labour
The business becomes unprofitable and shuts down. The end result being less output (thus higher prices) and unemployed people
In rare cases, the employer maintains profit margins by passing on the higher labour costs through higher prices, causing a lower quantity demanded. However, the industries that tend to employ unskilled workers usually have products which are very price sensitive or which have a high price elasticity

In all options either unemployment occurs or prices increase. I purposely looked at a business that is marginally profitable because more profitable business can absorb the cost. Cost absorption is negative because a less profitable business will find it more difficult to attract investment capital in the future and lower profits means the value of the business also declines.

One size fits all

The other problem with the MW is the one size fits all approach. For example, average wages in the Northern Territory or Tasmania are lower than average wages in New South Wales or Victoria given the higher cost of living in the latter states, yet they all have the same minimum wage. Clearly the minimum wage in Sydney is less of a burden than the same minimum wage in rural Tasmania. This is just one example of how a top-down approach or centrally planned economy causes inefficiencies to arise.

Neo-Marxist prejudice

The worst rebuttal I have heard is that without a MW, the unskilled will be paid $1/hr or a pittance as the greedy capitalist drives down the price of labour. This is a slippery slope argument, which will not occur. If the MW was removed, wages may fall but just like in any market, the price of labour will be supported by demand for that labour. Therefore, falling wages will increase demand and the market will find an equilibrium point at which all those who want a job can get one. It is possible that unskilled labour wages could drop to $1/hr but this is impossible in Australia due to the high levels of capital accumulation in the Australian economy.

To illustrate how capital accumulation benefits wages, imagine a hole needs to be dug and an employee has to use his hands to dig. It may take the employee an hour to dig the hole with his bare hands. Now imagine another employee who possesses a shovel and can dig the same hole in 6 mins. They produce the same result (a hole in the ground) and therefore they should get paid the same. However one earns the same payment 10 times faster because they have the shovel (capital). In this example the employee equipped with a shovel will earn 10 times the unequipped employee per hour.

The problems associated with the MW are numerous and are usually ignored by MW advocates. The effect of the MW is downplayed by academic studies employing econometric models. While economic models can estimate effects, they cannot be used to counter fundamental principles in economics. Even if industries face less competition, businesses will find a way to reduce costs to satisfy their customer’s preference for low priced goods and services. Finally, it is only a free-market naturally promoting capital accumulation that raises the purchasing power of wages.

I will conclude with this video which is a simple and easy to understand animation of how the minimum wage affects the economy:

Libertarianism

2013-09-18T19:58:00.000+10:00

I am a strong proponent of freedom and liberty. Not just in society but also in the economy.

This post will be a brief summary of the resources I use to learn about freedom:

Economics

Mises - Everything you ever wanted to know about Austrian Economics (free market economics)

Peter Schiff - Predicted the sub-prime crisis and Austrian economist (Radio show here, YouTube here)

Commentators

Stefan Molyneux - A philosopher with fantastic YouTube videos on EVERYTHING to do with liberty and freedom (YouTube here)

Think Tanks and Other Organisations

The IPA (Institute of Public Affairs) - Australian think tank promoting freedom (Website here)

Reason Magazine - US organisation promoting liberty (YouTube here)

Political Party

Liberal Democratic Party - Australian libertarian party

Liberty
Photo: Todd Cliff

Australian Election 2013

2013-09-16T17:12:00.000+10:00

Every three years, Australians are forced to vote for members of federal parliament. Most elections are predictable, but the last two have been surprising to say the least. In 2010, no major political party had a majority in the lower house, resulting in a hung parliament. A few independents held the balance of power, the majority of which supported a Labor government. For numerous reasons, the Labor government became unpopular, which is why a few days ago, the Liberal and National coalition were given a decent lower house majority in the 2013 election.

The general consensus among pundits is Labor lost the election due to its infighting, while the Coalition presented a small target and a popular policy campaign. The Coalition’s lower house majority was largely expected, but what was unexpected was the number of primary votes going to the Palmer United Party and the preference deals that resulted in minor parties elected to the Senate. This post will cover why Tony Abbott’s campaign was so effective and how Kevin Rudd employed the same strategy in the 2007 election. It will then analyse the swing to the Palmer United Party and what this means for the future of Australian politics.

I'm Checking In!

When I first heard about the Hotelling model in university, I thought it might explain the vacancy rate of a fancy Westin Hotel. But what it really explains is how two agents maximise their market share. The practical example is two ice cream trucks on a stretch of road parallel to a beach on a summer’s day. Both the beach and the road parallel to it, are exactly 1000m and beach goers are evenly distributed across the beach. Ice Cream Truck X (now known as X) parks itself 250m from the east end of the beach while Ice Cream Truck Y (now known as Y) parks itself 250m from the west end of the beach. There is a 500m gap between the two trucks. Beach goers standing in the middle of the beach (500m from the east and west end) are indifferent to which truck they buy ice cream from because each truck is 250m away. A beach goer at the east most end of the beach, prefers truck X since it is 250m away while truck Y is 750m away. Similarly, for a beach goer at the west most end of the beach will prefer truck Y because it is closer.

X realises that moving to the middle of the beach (500m from either end) results in more customers. Someone standing in the middle of the beach now prefers X to Y since X is right in front of them. Someone standing at the east more end of the beach still prefers X to Y since X is now 500m away but Y is still 750m away. Y also realises that moving towards the middle of beach results in more customers so now Y parks right next to X in the middle of the beach (assume that they are both right in the middle). Now people standing in the middle of the beach are indifferent between the two trucks since they are both right in front of them. A person at the east most part of the beach is indifferent since both trucks are 500m away and the same goes for someone at the west most end of the beach.

A is Ice Cream Truck X and C is Ice Cream Truck Y

What this model demonstrates is that the optimal location of an ice cream truck is right next to each other. IT IS NOT IN THE MIDDLE. The middle is the result because both ice cream trucks rationally play this strategy. For example, if Y was irrational and for some reason stays 250m from the west end. X just parks 251m from the west end and captures 749m of beach while Y is only left with 250m.

Hopefully all of this made sense because this is exactly the same strategy used in a political system that is a two party system. However, in politics it is more commonly referred to as Median Voter Theorem. Essentially, both parties converge towards the median voter’s policy preferences.

To capture the most votes, A and B move towards the median

The Real World

Tony Abbott leads the centre-right coalition which is the standard conservative party that claims to believe in free markets and family values. However, Abbott’s move towards the median voter resulted in a massive welfare scheme (Paid Parental Leave) which is funded by a tax on large businesses. The median voter also cares about cuts to government spending which Labor tried to exploit with their claims the Coalition would “Cut, cut, cut …” where … is public sector jobs, education and health spending, economic growth, small babies, you name it. In the end, the Coalition’s budget was marginally better than Labor’s which neutralised the major cuts to spending scare campaign. Abbott also watered down his commitment to a surplus claiming a return to surplus “within 10 years”. As you can see, the welfare scheme funded by a new tax and the lack of major spending cuts is more to the political centre than to the “political or economic right”.

We saw the same thing in 2007 when Rudd’s policies were similar to Howard’s and because of this he was called “Me Too” Rudd. Ross Gittens, who I disagree with on a lot of things, covered this “Me Too” strategy here.

The same occurs in the US Republican primaries where potential nominees try to out-Republican each other in the primary campaign. Then the winner becomes the Republican Presidential nominee and has to moderate their policies to appeal to the median voter who is undecided between a Republican or Democrat president.

Does that mean we are doomed to have two parties that are identical on most issues with a few issues here and there to differentiate them? No, because the further to the centre the two parties go, the further away they are from the ends. This allows minor parties room to move in and capture some of the electorate. The lack of differentiation between the two parties is the reason Clive Palmer’s Palmer United Party (PUP) received a large primary vote given the party was only registered a few months ago. Even though PUP’s policies were populist (cut taxes and increase spending), a lot of the electorate felt disenchanted with the major parties and voted with their votes!

What the PUP?

The Palmer United Party has stunned the political establishment by commanding 5.5% of the primary vote, which was more than the Nationals 4.4% primary vote. They fielded candidates in all 150 lower house electorates and senators in every state. Running on a highly populist campaign of lower taxes and more spending, PUP was the perfect protest vote for voters apathetic to the major parties. There was also millions poured into the campaign by its alleged billionaire leader, Clive Palmer. Despite PUP’s electoral success, cracks have already emerged within the party after the surprising result. Funnily enough, when candidates are recruited a few months before the election, party loyalty is probably lacking. Enter Jacqui Lambie who has already shown insubordination to the party by contradicting her party’s policy of abolishing the carbon tax.

Earlier in the vote count it looked like Jacqui Lambi would be elected but that now looks unlikely.

Election Junkie

The election had me captivated and probably too captivated. The best result to come from this election is that Liberal Democratic Party was elected in NSW to the senate. The LDP is a libertarian party I strongly endorse since I hold libertarian views. That means 6 years of a libertarian senator!

This election has really been about the rise of the minor parties and the backlash against Labor and the Greens. Hopefully this election marks the downfall of the big three parties, with Labor receiving its lowest primary vote in 100 years, the Greens vote down 3.4% since last election, the Liberals only picking up a 1.8% swing and minor parties holding the balance of power in the senate. Who said Australian politics is boring?

Lower house votes

How a Currency Dies

2013-09-07T17:42:00.002+10:00

India is a prime example of a broken country and squandered potential. Years of mismanagement and interference has mutilated an economy which is now disintegrating before our eyes.

The fires of inflation destroy purchasing power

The volatility over the last year in Indian financial markets resulted from years of government monetary intervention and bureaucracy choking productive activity. In this post I want to explore the causes of dramatic currency depreciation and possible remedies.

Burning Down the House

Firstly, we have to look at how this happened. India was part of the infamous BRIC nations. Supposedly, India was a new engine of global economic growth that would unleash millions of middle-class consumers demanding more goods and services from the rest of the world. China was the poster child and India was its little brother waiting for its chance to live up to the high expectations set by its sibling. But as any free market or Austrian economist will tell you, economic growth can only occur when there is less government involvement in the economy.

Fundamentally, India has not escaped its historical communist influences. The government is strangling the private sector with a byzantine regulatory system, numerous taxes and a corrupt bureaucracy. The political actions of recent weeks epitomise the intrusive and destructive handling of the economy. By placing restrictions on gold imports and then banning currency derivatives resulted in greater capital flight and a greater loss of confidence. This then leads to a vicious cycle of more regulations and more capital flight until the government and society capitulate to reality.

A depreciating currency is always caused by loose monetary policy. Interest rates are kept too low, resulting in excess credit creation and eventually rising prices. Unless interest rates are raised to quash rising prices, the currency loses its integrity as a store of value. People quickly convert the depreciating currency into commodities (e.g. precious metals), hard assets and alternative currencies to avoid the loss of purchasing power. At some point, the government is forced to act correctly as social tension rises amidst a financial and economic crisis. If the government denies its prior economic mistakes and maintains loose monetary policy, hyperinflation and a complete loss of confidence is the inevitable conclusion followed by transition to a new currency. We have seen this throughout history and thus none of this is a revelation; it is the certain truth.

Eye-Watering Results

To give you an idea of the extent to which the Rupee has lost purchasing power, we will look at a staple of the Indian diet, onions. As seen in the chart below, onion output and productivity has dramatically increased and is a testament to India’s agricultural industry harnessing better farming techniques and utilising capital.

In a free market economy, such a large increase in onion production would result in lower prices but guess what prices have done:

This is exactly why Indians have an insatiable appetite for gold. Gold has always been a part of Indian culture and has become more sought after due to the realisation that gold is a better store of value than the Rupee.

Behind the Curve

When exactly did the Reserve Bank of India (RBI) commit the crime of inflating the money supply? At the same time most central banks did, in the aftermath of the global financial crisis of 2008/2009. Below is a graph showing the changes in the consumer price index which measures the average prices (dashed red line) in the economy compared to the interest rate set by the RBI (solid black line).

Before 2009, the CPI was slightly below the interest rate which means the cost of borrowing was very low. After 2009, the RBI slashed interest rates but made the fatal mistake of raising rates too slowly. During 2010, the CPI was increasing at 8-10% p.a. while interest rates were below 6% and slowly rising. Real interest rates were negative, which meant credit had no cost and resulted in a booming property and stock market. This attracted foreign capital as interest rates around the developed world were at or close to zero. There was a huge yield differential that could be exploited via borrowing in the US at a low rate and then investing in India at a higher rate. This caused upward pressure on the Indian Rupee as portfolio flows flooded Indian capital markets (bonds and stocks). Portfolio flows (equities, bonds etc.) were favoured over foreign direct investment (building factories, buying entire businesses etc.) because of India’s hostile business environment which made it easy and less risky to buy equity and debt in companies.

India is just the worst case out of all emerging markets. A few years ago, emerging markets joined the currency war. They were complaining about QE because it was causing all this hot money to flow into their economies. But instead of allowing their currencies to rise which would have ended the inflows. They bought USDs and US treasuries and sold their domestic currency to stop it appreciating. Now that USDs are being repatriated from emerging markets, their domestic currency has come flooding back.

Similarly in India’s case, what goes up must come down. The Fed’s rhetoric changed in late May with hints that asset purchases will taper. This sent a shockwave around the world as US treasury yields rose, narrowing the yield differential between the US and economies with higher interest rates. The Australian dollar was one currency that depreciated as the RBA cut interest rates. Likewise, other Asian and emerging market economies saw their currencies tumble. As the situation unfolded, the market became aware of the precarious position India was in and panic took over. But what can India do to stop the Rupee depreciation?

Do It! Do It Now!!!

Things India can do to turn the tide:

Sell all foreign currency reserves (US$275bn) and gold (US$25bn) to buy rupees. Then destroy the purchased Rupees. The effect is a reduction in the Rupee money supply which will have an immediate impact on the exchange rate. It also sends a message to the market that the government is serious about a strong Rupee
Raise interest rates to squash inflation. There’s no balance between growth and inflation. The only way to get India growing again is to liquidate bad investments and rebuild after the recession has reset the economy. This is what Regan and Thatcher did in the 1980s.
Fully deregulate the domestic economy. This will encourage long-term foreign direct investment instead of portfolio capital which can leave the country quickly
Reduce government spending to balance the budget. A good place to start is defence with India being the largest arms buyer in the world. By reducing the deficit, the government borrows less money from the private sector and therefore the private sector has more capital to invest in productive investments. A submarine is not a productive investment!

However, Indian elections are around the corner and reform measures are not popular. This is what happens if no reforms take place:

Rupee continues to plunge, which results in lower confidence and capital flight. Could result in a vicious cycle till the government is forced to act
Import prices sky-rocket. Oil is already 50% more expensive in recent months
Long-term stigma and sovereign risk due to the perception of a dysfunctional economy

The only way India can seize its potential is by deregulating the entire economy and restoring faith in its fiat currency as a store of value. Both these actions are difficult given their political implications, which is why I am doubtful they will be done voluntarily. It will be the market who makes an offer they can’t refuse, and will be the driving factor behind change. Unfortunately, this episode has proven once again that the actions of the few in government torture the many living under India’s rule.

Apocalypse Now

2013-06-20T20:33:00.000+10:00

This blog update will focus on the main risks I see on the horizon for the Australian economy.

I warn you that I haven’t really bothered to format and edit it, so I apologise in advance if it’s difficult to read.

I will start off with the simple premise: All booms come to an end. The Japanese boom of 80s and 90s, the 1994 Tequila crisis, 1997 Asian financial crisis, the 2001 tech boom, the 2007 US housing boom and in 2013 the China boom. All of these eras culminated in major increases in asset and commodity prices, usually accompanied by debt, until central banks removed the punchbowl through contractionary monetary policy.

A Bear in a China Shop

Australia is a major beneficiary of the Chinese boom by supplying the energy and minerals needed to fuel China’s economic activity. China’s rapid industrialisation has resulted in many malinvestments, which will be liquidated as capital flows dry up. The excess capacity and debt accumulated during the boom will haunt the economy for years to come. It is generally accepted that the bigger the boom, the bigger the bust.

The Chinese banking system has also been dysfunctional in recent weeks with SHIBOR spiking as banks face liquidity problems. This is a microcosm of the systemic imbalances and instability plaguing China. It’s only a matter of time before a tiny bump in the road crashes the economy.

Falling iron ore, copper and coal prices will be the harbinger heralding the beginning of the end for the Australian mining sector. The government will stimulate as usual but just like in 2009, it was the currency devaluation and the stimulus from China that did most of the heavy lifting.

Big in Japan

Japan is rolling the dice with its audacious monetary policy. The volatility seen in JGBs will have consequences for institutions that are sensitive to high volatility investments. I know this from experience that banks look for positive carry and low volatility assets. JGBs are likely to sell-off given higher future prices from today’s QE. (Funny how a few years ago if you said QE causes inflation, you were ridiculed). Like all government actions, the unintended consequences will be largely unknown. However, it is certain to cause massive market disruption as long-held beliefs are shattered.

If JGB yields rise significantly then the consequence for the Japanese government’s budget is dire. This is what Kyle Bass refers to as the Keynesian Endgame which is when the interest cost of servicing the debt rises in a non-linear way which means simply increasing taxes will be ineffective. Then it will be Japan’s turn to experience its own Greek moment, however there’s no Troika to bailout Japan. Inevitably, the social fabric of Japan will be torn and the historical outcome of mass social unrest is the rise of extreme politics (See Greece and Golden Dawn, see Weimar Germany and the Nazi Party) followed by conflict and war.

Everybody was Kung Fu Fighting

Chinese and Japanese economic risks are not the only factors but also geopolitical risk stemming from conflict over the Senkaku Islands. Both sides are irrationally attached to these islands and are willing to go to war to seize control. If there were a conflict, it would first result in economic sanctions between the warring nations followed by armed conflict unless the UN intervenes to negotiate a cease fire. The impact on financial markets would be huge with the yen likely to rally substantially in risk-off flows bringing an abrupt end to Abenomics. Equities are guaranteed to sell-off. It would be hard to imagine any rallying (maybe domestic producers) but with so much of the global supply chain located in Asia, most multinational companies will face major disruptions.

Up the Creek

In addition to foreign risks, domestic risks are a slow grind lower in property prices as the boom over the last few decades ends, and the factoid of property prices rising forever is rejected.

There are also known unknowns (as Donald Rumsfeld likes to say), which include terrorism, global health pandemic (watch the movie Contagion), natural disasters, wars, government policies (QE, protectionist trade and capital policies). Individually they are unlikely to occur but collectively one of these happens every 3 years (Swine/Bird flu, Fukushima, QE, Boston bombings).

Of course it’s not all doom and gloom. There are a few unlikely upside risks which include: New technological development that makes Australia a world leader, major resource discovery, massive Chinese economic stimulus. This is the Bon Jovi equivalent of living on a prayer.

The fundamental problem with the Australian economy, along with most advanced economies, is the heavy debt burden which must be alleviated through deleveraging or defaults. Just think about it like this: It’s 2009 and interest rates are at record lows. John decides to buy a $500k house to take advantage of the low interest rates. This means upwards of $400k in new money (expanding the money supply) has entered the economy courtesy of fractional reserve banking when the mortgage is originated. It’s now 2013 and interest rates are coming down. Joe can now repay his loan faster (contracting the money supply) or use the money saved in interest payments for other consumption purposes. The key point is unless new loans are being originated, falling interest rates have a diminishing effect on monetary expansion given it was only 4 years ago that people took out massive loans which they are still repaying.

This causes the economy to deleverage which means businesses go bust, unemployment rises and prices fall. All of these outcomes force the RBA to cut interest rates to ignite another cycle of inflationary monetary expansion and the illusion of economic growth. Keep in mind we haven’t had a technical recession (two consecutive quarters of negative economic growth) in over two decades. We are due for a recession because markets and economies NEVER move up in a straight line. There are dips along the way and the longer we postpone the recession, the deeper it will be.

Breaking Windows Will Boost GDP

Already we have seen the fallacy of stimulus spending. The moment we try to pay back the debt, jobs are destroyed through contractionary fiscal policy (less spending or higher taxes). This means when the next recession comes, the government will go deeper into debt. On average, recessions occur every 7-10 years which means we should expect an Australian recession between 2015-2018 using historical data. However, given the inability of the RBA to raise rates substantially before the economy begins to deleverage (as seen post 2009), the business cycle is contracting in duration. So much so that I am sure a recession will come before 2016. Obviously the government will try to stimulate and rates will be cut closer and closer to zero.

As a personal anecdote, I know financially unsophisticated boomers who bought their homes a few decades ago that are now cashing out their investment properties and living off term-deposits. This is exactly why interest rates continue to fall. The economy is trying to delevereage which means property prices and other assets will decline while the RBA tries to push prices back up to avert pessimism overcoming the property market.

There is a theory that claims the closer rates go to zero, the more risk averse investors become and the more they invest in government bonds and other relatively low risk investments. This theory is only true for advanced economies with an ageing population such as Australia.

Forecast: Cloudy With a Chance of Thunder Storms

My predictions: base case rates go lower in Australia to 2% and in combination with the lower AUD (70c-80c) causes the economy to re-leverage. Worst case scenario is an implosion in Asia due to any of the factors mentioned above, will cause rates to go to zero in Australia and the AUD to go sub 50c as commodity prices collapse and the high unemployment prevents credit growth from occurring. It’s difficult to see any bullish scenario simply because “we’ve been there and done that” for a few years now.

The obvious plays for a long-term investor in a falling interest rate environment are defensive stocks and high dividend yield stocks. But a safer option would be corporate bonds that would still offer a decent yield while central bank rates approach zero. If you want to trade it then the obvious trade is shorting AUD against a reserve currency like the USD or EUR. Or a safer currency trade would be short AUD against another commodity currency less affected by China such as the NOK (Norway). Other trades include shorting high cost iron ore miners which will see their businesses go under overnight as commodity prices plunge.

Anyway I hate predicting anything financial or economic more than one year out because there are so many variables that could throw a spanner in the works. It will be amusing to see how it plays out compared to the aforementioned predictions.

Summary of Predictions

Australian recession before 2016
Interest rates to go to 2% and AUD/USD 0.80-0.70 base case with rates going to zero and AUD/USD below 0.50 worst case (financial/political crisis in Asia or global macro risk mentioned above)
Corporate bonds to outperform, short AUD and iron ore miners trades to also outperform

“I don’t get paid to be an optimist or a pessimist. I get paid to be a realist.”

The Keynesian Endgame

2013-03-06T22:03:00.001+11:00

I absolutely despise the Keynesian school of economic thought. The Keynesians worship three gods: demand, jobs and inflation. All of which have given us the world that we live in today. A world mired in debt due to government policies designed to stimulate demand and “create” jobs. The parabolic rise in debt across the economy since the 1970s cannot go on forever. It should be obvious to anyone that anything rising at an exponential rate will eventually hit a constraint that will reverse the trend.

The constraint to hit parabolic debt is deflation. Deflation is a contraction in the money supply. Most people will say deflation is falling prices but changes in the price level are a consequence of the supply of money relative to the goods and services produced in an economy.

During the boom times, economic activity is rising and money is being borrowed. Fractional reserve banking creates a vicious cycle of rising asset prices, followed by rising levels of equity relative to debt, further leading to more money borrowed which is then used to bid asset prices higher. Eventually, this cycle is reversed as central banks increase interest rates to a point where asset prices stop rising and debts are repaid or defaulted upon. What follows is a cycle of falling asset prices and as debt is repaid, a contraction of the money supply (deflation). Central banks (CB) see this as a major problem which is solved by slashing interest rates to get people borrowing and see rising asset prices. Before you say this is crazy talk, Bernanke has explicitly said the Federal Reserve has propped up not only the housing market but the stock market in what he calls “the wealth effect”. Every major central bank has this secret third mandate of propping up both housing and the stock market (the first two are inflation and employment). It was only a few years ago that no central banker would admit to having this secret third mandate.

This model of monetary policy has worked “fine” until the demand for new borrowing evaporates and despite interest rates being cut, the economy does not return to the debt fuelled inflation boom. This is my theory of the economic cycle, which closely resembles Austrian Business Cycle Theory and it may even be the same. Eventually debt becomes too high and no matter what the CB does the deleveraging process continues.

Either the government slowly tries to reflate the economy (Japan last 20 years) or they go nuclear with continuous debt monetisation (US Federal Reserve) or threats to go all in (Bank of Japan in recent months) with seemingly outlandish policy options such as negative interest rates, nominal GDP targeting and monetising private sector assets (corporate bonds, equities etc.).

With central banks increasing underestimating the risk of rampant inflation as a consequence of their unconventional monetary policy (debt and asset monetisation), the inevitable conclusion is hyperinflation. CBs have made it clear they will not tolerate deflation. Nothing is stopping them from expanding the money supply by trillions as long as they fear the threat of deflation. This is exactly why asset prices will skyrocket and the only thing likely to destroy confidence and asset prices are an exogenous shock (natural disasters, political risks, terrorist attacks, wars, social unrest etc.).

The consequence is rising interest rates as investors realise the CBs have poured gasoline on the fire through their reckless monetary inflation. Bond markets will collapse and anyone holding long duration debt will be burned (insurance companies, banks and pension/superannuation funds). Government borrowing costs will rocket higher as rising interest rates will mean any debt that is rolled over will rollover at higher interest rates. This is very similar to the sub-prime mortgages crisis when low teaser interest rates made the mortgage affordable until the interest rate reset to a much higher rate a few years later. This will result in the government slashing government expenditure in an attempt to service the debt and appease the bond vigilantes. The current European debt crisis is a glimpse of what we can expect when governments have to make tough decisions that are very politically unpopular.

The penultimate result of the chaos will be a deep recession as unemployment rises, causing social unrest (riots and protests) as governments struggle to deal with the problem (see Greece and Spain).

Central banks will be forced to increase interest rates but I guarantee they will be too slow to act or worse remain in denial and downplay the inflation risk as “transitory”. The UK has already experienced the effects of monetisation on consumer prices.

What’s worse is there are now calls in the UK to drop inflation targeting in favour of nominal GDP targeting. This essentially means if the nominal GDP target is 4%, inflation can be 3% which means real GDP is only 1%. Another combination is a target of 3%, real GDP of -2% and inflation of 5%. There are numerous permutations but it just shows how ridiculous nominal GDP targeting is.

What is the solution? Over the years I’ve realised it’s usually the politically unpopular decision that is the correct decision. The only way we can address the debt issues not only on the public balance sheet but also the private balance sheet is to embrace sound money and back currency with gold or at the very least some other commodity. This stops the limitless expansions of the money supply and links it to a steady growth rate. There will be pain initially as people realise of the features of a gold backed currency is an end to the continual debasement and the end of rising prices economy wide.

This solution is unlikely to happen because firstly, the mainstream pundits support the current monetary system and secondly, moving to a gold backed currency will be politically unpopular as vested interests scream and shout in protest (banks will probably the most vocal opponents given their mortgages denominated in the old currency and because the new system limits their ability to lend).

It will usually take a crisis to change people’s perceptions but even then, there’s no guarantee that perceptions will change for the better. I will strongly support the minority that adopts the new system first because it will take the minority view becoming the majority view before we see real change for the better.

How To Make Housing More Affordable

2012-09-23T13:06:00.002+10:00

It never made sense to me how a country of Australia’s geographic size can have some of the highest property prices in the world. Australian cities are on par with population dense cities like Hong Kong, Singapore, Tokyo and high profile cities like NYC, Paris and London. This raises questions like why haven’t we developed inland Australia? Sure it’s a hot desert with arid land but that hasn’t stopped middle-eastern cities developing or even one of my favourite cities Las Vegas springing up.

There are actually a number of issues explain why property prices are unusually high in Australian and with most economic issues that sees costs rise consistently or quality deteriorate; government has some involvement in the issue.

The following notes have been sourced from the policy monograph released by the Centre for Independent Studies entitled: Price Drivers: Five Case Studies in HowGovernment is Making Australia Unaffordable by Oliver Marc Hartwich and Rebecca Gill (December 2011) ISBN: 978 1 86432 133 3.

Main reasons that make housing less affordable include:

Land supply
Tax incentives for property investors (negative gearing)
Subsidies for owner-occupiers (first home owner grants)
Stamp duties
Infrastructure levies

Land supply

The population is concentrated in the metropolitan capital cities.

Canberra has a lot of land, and yet its house prices are nearly as high as prices in Sydney and Melbourne.

Housing prices have risen far more than construction costs. One can then conclude that land scarcity has been the main driver of property price rises.

Negative gearing

Property investors whose capital costs exceed their rental income, can offset their net losses against their income tax liability. This incentivises investment in property using debt with the prospect of capital gains. Hence, highly leveraged property investors increase the demand for housing which results in higher prices.

First home owner grants

Unfortunately these grants increase demand since buyers in this segment of the market all have access to the grant and will bid up entry level property prices.

Stamp duties

There is no economic rationale for stamp duty and is set from state to state at an arbitrary level. An interesting fact is that taxes on financial and capital transactions in Australia, which includes stamp duties, are twice the average of OECD countries. The effect of stamp duties is just to make housing less affordable.

Infrastructure levies

Local councils have been increasingly resorting to using levies to pay for infrastructure investment. These levies are borne by property developers, who pass them on to their customers.

Housing is one of the most distorted markets in Australia. All these interventions have made housing unaffordable because the market supply is restrained. Governments respond by perversely boosting demand and making housing less affordable.

Key recommendations:

Increase supply by encouraging councils to take on more residents through local government finance reforms
Abolish both negative gearing and the first-time buyers grants
Abolish stamp duty
Abolish infrastructure levies and permit the private sector to own and operate infrastructure

Debt-fuelled buying and a slowing economy

The other issue that tends to appear in most inflated markets is debt fuelled buying. Australian banks have made billions over the years lending to property buyers and investors. In the period during the GFC, prices fell dramatically as the entire economy deleveraged. The Rudd government stimulated the economy and the RBA slashed interest rates to 50 year lows. This resulted in a property market recovery with prices rising from the bottom by 20%! Clearly, movements in interest rates affect property prices since higher rates increase the debt burden and vice-versa for lower interest rates. In the last few years, rates have been steady but have declined in 2012 and are expected to decline further as China appears to be slowing. However, the entire interest rate cut has not been passed on by banks because they claim that their cost of funding has increased. This is somewhat true but we have also seen profits rise at all the banks, which suggests the banks are price makers and not price takers. The market concentration among the big four banks is high and the slow shift from offshore funding to onshore funding over the years should give the banks the ability to pass on more of interest rate cuts than we have seen in the past.

Despite the interest rate cuts we have seen over the past year, property prices continue a slow grind lower. With the economy expected to slow further, the current trend of lower property prices should persist until the government or the RBA decides to stimulate the economy through increased borrowing or lower interest rates.

Going forward

The government imposed distortions are unlikely to be reduced at any time in the near future since there is no political debate whatsoever around the housing market. Should the economy continue to slow, it is even less likely that these barriers are removed since they generate taxation revenue and would be negative for the state budgets. However, a slowing economy will also see property prices decline until the politicians decide it’s time to be Keynesians and stimulate the economy.

Banks Feed Off Inflation

2012-08-15T19:33:00.000+10:00

Firstly let’s define inflation. Today’s common usage refers to inflation as rising prices either caused by an increase in aggregate demand with aggregate supply remaining static (demand pull inflation) or a decrease in aggregate supply while aggregate demand remains constant (cost push inflation).

So if there are tax cuts and there is more demand for all goods, is this considered inflationary? Yes by modern definition there will be an increase in aggregate demand causing demand pull inflation.

But my own view of inflation/deflation is the same as the classical definition of inflation which is an expansion of the money supply. The symptom of inflation is rising prices, which is why over time the factoid equating inflation to rising prices exists.

When the central bank adjusts interest rates, this affects the money held in bank reserve accounts and in turn affects a bank’s ability to make loans and increase the money supply.

When banks originate loans the money supply expands since a 10% reserve requirement will lead to banks using a $100 deposit to create a $1000 loan. This means when borrowers repay loans, the money supply contracts and similarly if a borrow defaults, the money supply really contracts. However, banks will use buffers to protect themselves against a default by first making sure the borrower is credit worthy, then requiring a deposit to banks are not taking the full risk, finally collateral will be linked to the loan (e.g. the property will be collateral for the mortgage loan).

As the money supply expands (inflation), asset prices rise since there is now more money chasing the same amount of goods. This in turn increases the demand for loans since people see asset prices rising and believe the economy is growing and additionally collateral value increases allowing potential borrowers to increase the leverage on their loan. Loan serviceability is another important factor when banks assess a potential borrower. Since all prices are increasing, including wages, pretty much all the factors a bank will look at to originate a loan improve in favour of the borrower.

This is the inflationary cycle that causes borrowing to lead to higher asset prices and then more borrowing. The central bank then tries to control this by increasing interest rates which should decrease the demand for new loans. However, there is a time delay in the effect and because the bulk of loans are long-term in nature (longer than a year) the economy doesn’t feel the full effect of a string of interest rate rises until a few years into the future. Eventually the economy begins to contract after a string of interest rate rises result in a fall in borrowing and then it is up to the central bank to re-start the game by slashing interest rates to begin a new cycle of borrowing and rising asset prices. This is how the business cycle works and is why under the current system any deflation is considered bad because if the central banks leaves the economy to contract and allow deflation to take hold, it will continue unabated until prices are so low that demand for loans increases. This could lead to a substantial contraction in the money supply and prices falling more than 10% in a single year.

The problem with this system is that banks depend on inflation the resulting loan origination to increase and maintain their current profits. If there is deflation, people demand less loans and repay their loans faster to reduce debt burdens. This causes a huge contraction in bank profits and when the economy really contracts, collateral values plunge as a vicious cycle of loan defaults and collateral devaluation takes place. One only has to look at what happens when a country has a bubble economy to see this scenario play out. Japan in the early 1990s, the US in 2008 and soon Australia will have its day of debt deflation.

Australia has hitched its wagon to the Chinese growth engine and Asia in general, which is where I fear the economic shock is likely to manifest itself. In many financial and economic crises we see banks come under severe stress and in many cases collapse as their reserves vanish via asset impairment, exposing their leveraged business model. Governments then become involved via bailouts and hence taxpayers are now proud owners of zombie banks.

This is exactly why substantial deflation (>2% deflation) will never be allowed to occur and why eventually rates will go to zero. Banks will not survive unless they dramatically increase their reserves, which I do not foresee happening during extreme economic uncertainty. The government will nationalise banks claiming that the economy will implode if nothing is done.

These are dire predictions and I am sure the majority will disagree with this forecast but is there really another outcome when the current solution to any downturn is to spur spending and borrowing via lower interest rates?

We Want a Stronger Currency!

2012-07-25T12:44:00.001+10:00

I wanted to write a timely article on the effects of a strong currency. We are currently seeing the Australian Dollar (AUD) rise to lifetime record highs against the Euro as problems in the Eurozone continue to fester and investors look for perceived safe haven economies to park their money. The Australian economy is a very attractive location for capital because of its stable developed economy, stable political system, relatively low government debt and is generally business friendly.

Safe haven status takes years to attain but can be lost in few months. The most recent currency to lose some of their safe haven credibility is Switzerland, which pegged its currency to the Euro and now has to print unlimited amounts of Swiss Francs (CHF) to maintain the currency peg. Since the Eurozone fears lead people to buy CHFs, the Swiss are forced to increase their money supply to meet demand, which will eventually cause prices to rise as those newly created CHFs leak into the wider economy.

The economic pundits will tell you that the high AUD or CHF is hurting domestic industries and jobs are being lost. This fails to recognise that the fundamental goal for an economy is not to have more jobs but to increase productivity. Maybe every Swiss person could have worked for 35hrs a week instead of 40hrs a week since their purchasing power is increasing in EUR terms. That’s obviously a good thing and helps them achieve a higher standard of living by making their lives easier and more enjoyable to live.

The Swiss government fell for the myth that a weak currency stimulates exports. But what they continually forget to mention is the reduced cost of imports that benefits EVERYONE in Switzerland. There will be changes that will occur in an economy with a strong currency including job losses since marginally productive exporters will face greater competition through cheaper imports. Some businesses will close down but others will become more productive. The business that closes down will result in job losses but does that mean the newly unemployed will never work again? OF COURSE NOT! There is always a productive use for labour in an economy and as long as wages and labour regulations are flexible, the unemployed will find work elsewhere within the economy. Maybe new employment opportunities will come from a growing business reliant on imports that have seen demand rise as their products are now cheaper. The net result is an increase in the overall productivity of the economy and is an example of Schumpeter’s creative destruction, where the resources from a non-productive business are reallocated to a more productive business.

The other point touched on before was that a stronger currency will benefit everyone since they can buy goods from the rest of the world cheaply. Exporters may see stiffer competition but they too will see costs decline if they import supplies or raw materials from foreign businesses.

The Australian economy is a great example of an economy that has thrived despite seeing a rising currency. This does not mean the economy is completely healthy because households continue to have high debt levels due to large mortgages and we are likely to see the property market continue its slow decline. Australia is also heavily exposed to Asia and if there is a slow down or financial crisis our economy could be slammed. But things continue to function and we have not seen our economy die as a result of the strong Australian dollar. Next time you see the Aussie dollar make a new high, don’t frown, fist pump the air and shout YOU BEAUTY!

Back to Surplus

2012-02-02T15:44:00.000+11:00

So I'm back after my hiatus and will hopefully pick up where I left off...

Public debt has become a hot issue in the last few years as governments rack up enormous budget expenditure and finance it by borrowing from the private sector. Unfortunately for some governments this debt load has become unsustainable and will inevitably lead to a default unless harsh austerity is embraced. Since austerity is the least politically feasible option, governments will either print money or default/restructure their debts.

Thankfully Australia is not in this predicament with an electorate that has been conditioned to fear public sector debt, and rightly so, which has led politicians to pledge returns to surplus and debt reduction. However, there have been calls from pundits and economists to deprioritise repaying the debt and returning to surplus since it is "manageable" at these levels. So who is right? Are the politicians bowing to popular opinion or are the economists right? I am firmly in the camp of reducing the debt as fast as possible because of the following problems:

Firstly, there are limited funds available for entities to borrow and when the government borrows over $100 billion it crowds out private activity by preventing businesses from accessing that capital and therefore increases the cost of borrowing economy wide.

Secondly, it is generally accepted that the larger the size of government, the more inefficiencies in spending (diseconomies of scale if you like).

The benefits of returning to surplus and repaying the debt:

More funds are available to businesses which will lower borrowing costs and raise profits allowing the business to expand by hiring more people, for example.

Inefficiencies are reduced for the government leading to an improvment in the expenditure quality as the government is forced to trim expenses with the most wasteful spending likely to be cut first. A good example of this is when the flood levy was established and the cash for clunkers scheme was abandoned.

Future taxes are lower since interest on the debt decreases as the debt is repaid.

Puts the government balance in a good position to respond to future crises such as natural disasters (QLD floods) or economic crisis (GFC).

Although both sides of government have committed to achieving surplus and paying back the debt only one has said firmly that they will reduce the size of government. This week Tony Abbott outlined his view of Australia and vowed to “permanently [reduce] the size of government”. This is clearly a good policy for all supporters of freedom and will lead to greater prosperity. (Edit March 2013: Labour has abandoned its pledge to return to surplus).

I will say upfront that I usually vote Liberal because they are reducing the size of government and are committed to a greater level of freedom for everyone. Labor unfortunately believes in big government and spending, which will send Australia down the path towards Greece, Portugal and other fiscally irresponsible nations. If Australia wants to remain strong it will pay off the debt and run budget surpluses.

Accusations of Racism in Australia

2010-07-20T21:37:00.001+10:00

A couple of months ago when I decided to write about this topic, Australia and racism were two words that dominated the Australian media. With attacks on Indian students every week, the Australian and Indian media fanned the discussion of racism in Australia. It is my opinion that Australia is not a racist country but does have racist elements like any other country. However, I would also say that Australia is a much more tolerant and egalitarian society, more so than most countries but in particular India, which continues to be plagued by religious, caste and class divisions.

Firstly the numerous attacks on Indian students were not because of racial hatred but because of disregard for personal safety. Most of the attacks occurred at night in locations where there were hardly any people. This just plays into the attacker's hands and it is no surprise that this was a common feature of these attacks. I'm in no way saying the attacks were the victims fault, but rather there are precautions most people take and unfortunately foreign students may not be aware of those cautious actions which could have prevented the attacks.

Then there's that Hey Hey it's Saturday skit which had the Americans deeply offended. You can watch it here:

Anyway I think the world has moved on past the racial tensions that have separated societies in the past. I can understand American opposition to the skit but from the audience's reaction it was hardly viewed as a offensive and I think it is acceptable in Australia because of our larrikin culture and ability to take the piss out of anything. Just like many Islamic societies are socially conservative in comparison to western societies, Australian audiences are different to American audiences. I'm glad Australia viewed it as a humorous skit and not despised it due to a perceived racism.

My favourite, world has gone mad story related to this issue is the "racist biscuit". You know the PC brigade is out in force when you read a headline like this.

http://www.smh.com.au/national/coles-backs-down-over-racist--biscuit-20091027-hhhk.html

The whole idea that Australia is a racist nation is propagated by those who have not experienced Australian society or do not understand that a small degree of xenophobia is normal for most societies. Australia is a country built on migrants and is becoming increasingly multicultural which is evidence of a tolerant and welcoming society. I will reiterate that Australia is one of the least xenophobic/racist countries in the world and any tensions that are on display are normal given our diverse mix of cultures and people.

This will be the final post on this blog. I have found that I do not have the time to pursue this interest and it is unfortunate that the journey ends here.

Carpe Diem.

September 2013 EDIT:
I had to include this map, enjoy!

Asset Bubbles

2010-02-26T00:27:00.000+11:00

In a capitalist system, the market forces of demand and supply is driven by people. Thus if the market represents the aggregate view of its participants then it is prone to bouts of fear and greed just like its participants. When greed takes over, it will drive the price upwards with many bears asking themselves, "What are the reasons for these higher prices?" The irrationality of greed is the answer to this question.

So how do we spot a bubble? We look at price inflation and see if incomes can sustain those prices. At the top of markets the general populace are the most bullish. Prices appear to be vertical when viewed on a larger timeframe. They are "self-reinforcing" on the way up and brutally fast on the way down as people realise the boom is over.

As with the US housing bubble, many pundits will claim that the price rises are justified for any number of reasons including strong economic growth, population growth/migration, low supply and high demand. What is not talked about is the amount of leverage (debt) in the market. Like any market that uses debt as the primary source of funding, the prices of the market will be affected by monetary policy of the central bank and the lending policy of the banks. Once these two factors put enough pressure on demand, asset prices will collapse. Higher interest rates and tougher lending policies not only put pressure on the housing market but also on jobs and hence average income per person declines.

The Sydney property market has risen remarkably over the past decade. But are the price rises justified by population growth, income or anything the pundits claim? No. You only have to compare median income with median house prices and you will find Sydney to be one of the most unaffordable cities in the world. See here: http://www.demographia.com/dhi.pdf

When this bubble eventually pops not only will banks fail but the economy will grind to a halt as it deleverages in a similar style to the US.
It's not just economic but social and political change that comes about through economic shocks. The rise of the Nazi party from hyperinflationary Germany, collapse of the soviet union and rise of the US, the south American debt crisis giving rise to socialist governments. The world as we know it will change.

Another bubble that is generating a lot of debate is China. This bubble is a mix of inflation and the belief that Chinese growth will continue forever. Who's to say that this isn't another 1980s Japan style bubble inflating in China.

Fixed currency rates have been another problem that has inflated many bubbles as history has shown. Several South American countries during the 1980s and early 1990s had fixed exchange rates that caused their economies to implode as the bubble popped and were forced to float their currencies causing further instability. The Chinese government thinks it can micro-manage a capitalist economy. But only when they wake up to an economic bust will they realise how fraudulent their growth has really been.

Even the Chinese stock market is treated like a casino as the index has been rising at an unsustainable pace. It was not surprising when I read a news headline that the Chinext exchange went up 300% on the first day. It is clear that the Chinese will have a lot to deal with when the house of cards tumble and it will be interesting to see how the single political party state deals with the crisis.

I will end the article with a quote: "There is no means of avoiding the final collapse of a boom brought about by credit expansion.

The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."