Australia has been one of the world’s best performing economies. But its success in avoiding the worst of the global economic problems may not continue. Australia’s future is inextricably linked to China and the commodity “super boom”. Australian economic prospects remain vulnerable to international developments outside its control.
Escaping Acronyms…
The popular narrative is that Australia escaped the GFC (global financial crisis – Australians are acronymic) through their own planning.
The country was certainly in a better position to cope with the problems. The Federal government did not have much debt. However, some State governments have significant borrowing. Governments also systematically shifted some of their debt into public private partnerships (“PPP”). Because of the strategic nature of this infrastructure, these projects de facto enjoy the indirect support of governments. Private household debt is also high.
At the start of the crisis, Australian interest rates were relatively high, providing greater flexibility.
But Australia did not escape the crisis unscathed. One major bank lost nearly a billion Australian dollars. Investors, including a number of charities and local councils, suffered significant losses from investments in various financial products. A number of highly leveraged infrastructure and commercial real-estate investors failed.
Local banks escaped the problems of their overseas counterparts. The near death experiences in the recession of the early 1990s encouraged them to stay home eschewing overseas adventures and complex financial structures. That said, another year or so, they would not have been so lucky.
The local banking regulator, APRA (Australian Prudential Regulation Authority), and politicians take credit for the banks being relatively unaffected. This is curious given that banking regulations are largely uniform around the world. One can only assume that Australia has superior regulators and politicians to the rest of the world – an example of “Australian exceptionalism”.
In reality, Australia’s swift recovery was driven by large cuts in interest rates, government guarantees for banks, government stimulus and a commodity boom.
The central bank reduced interest rates (from 7.25% per annum to 3.00% per annum). The fall of 4.25% per annum translates into a fall in monthly mortgage repayments of nearly 30 % or around $7,000 per year on a 20-year mortgage of $250,000. A government guarantee on bank deposits and borrowing ensured that financial institutions were insulated from many of the problems.
Government spending minimised the effects on the real economy. Cleverly directed cash transfers to lower income households rapidly stimulated the economy. As part of the ESP (Economic Stimulus Package), government spending on education, housing and infrastructure was also increased.
Some of the spending was not well directed. Environmental initiatives, subsidies for home insulation to reduce energy consumption, have proved less than successful.
The main driver of the recovery has been a commodity boom. This is not a new phenomenon in Australian history. It can be traced back to the famous gold rush of the 19th century when many travelled to Australia in search of their fortunes.
Boom…
Former Prime Minister of Australia Paul Keating recently remarked that Australians were luckier than most races having been given an entire continent. He might have added that it was also remarkably rich in mineral wealth.
Australia has benefited from a substantial increase in demand for and prices for its mineral products. The country is enjoying its best terms of trade (measured as Price of Exports divided by Price of Imports, showing the quantity of imports that can be purchased theoretically from the sale of a fixed amount of exports) in 140 years. Australia’s terms of trade have improved by 42%, just since 2004.
The commodity boom is driven by a sharp increase in demand, supply constraints because of under-investment in mineral production and associated infrastructure and some unexpected effects of the GFC.
In the 1990s, as a result of persistently low prices, mining companies did not invest sufficiently in expanding production capacity or infrastructure, such as transport, refining or processing capacity. The increase in demand from purchasers, particularly emerging economies, quickly created bottlenecks and shortages. This led to sharply higher prices as well as improved volumes for many commodities.
The GFC also boosted investment in commodities. As traditional investments fared poorly (stocks, interest rates and property prices all fell), investors switched to hard assets, like commodities. The underlying logic was that these were real assets with genuine underlying uses rather than the fictions created through financial engineering.
Low interest rates also assisted demand and prices as it cost less than before to buy and hold commodities, which paid no return.
As central banks commenced printing money in an effort to restart growth, investment in commodities increased further as investors sought a hedge against the risk of inflation. Former Board member of the Reserve Bank of Australia, Professor Warwick McKibbin suggested that perhaps as much as 40% of the improvement in Australia’s terms of trade surge was being driven by US and European monetary expansion.
One of China’s priorities is to preserve the value of its foreign exchange reserves, currently around US$3.2 trillion. The bulk of these funds are invested in US dollar, Euro and Yen denominated securities. To reduce the risk of losses as these securities lose value due to the actions of governments to devalue the currency against the Renminbi, China has purchased and stockpiled large amounts of strategic commodities.
Boomier…
The economists, who failed to forecast the rise in commodity prices or the GFC, now speak of a “super” boom lasting decades. The boom is more fragile than currently understood.
As growth in China and other emerging countries decelerates, demand for commodities is likely to slow. High prices have encouraged investment in expanding existing mines, building new mines and additional infrastructure as well as exploration. As new capacity and supply comes on stream, there will be pressure on prices.
Australian mining entrepreneurs and politicians point to a massive pipeline of projects, which will underpin Australian prosperity. The Australian Mines and Metals Association estimate that there is A$427 billion of resources in train, including A$146 billion in Liquid Natural Gas alone. A$236 billion of projects are current under way with a further A$191 billion awaiting approval.
There is also A$770 billion of infrastructure spending required to renew and develop Australia’s economic and social infrastructure. This will compete with commodity projects for funding. Chairman of Infrastructure Australia Rod Eddington has warned that financing will not be available for many projects. Infrastructure Australia has identified a smaller list of priority project totalling A$86 billion.
Commodity projects depend on demand for the product and also on the ability to finance it. Deterioration in money market conditions and also problems in the banking system mean that the availability of funding is becoming more restricted and expensive. If previous commodity booms are a guide, then many of these projects may not eventuate.
Sinophilia…
Around 23 % of Australian exports now go to China. The real quantum is higher as some Australian exports to Asia are then re-exported to China.
China currently faces significant challenges. Its two major trading partners – Europe and America – face serious problems which will lead to a slow down in our own exports. Recent statistics, such as the volatile Purchasing Managers Index that measures manufacturing activity, suggest a sharp slowdown. In turn, this will affect suppliers such as Australia by way of lower demand and also lower prices for commodities.
Unlike 2008, China’s capacity to respond to any slowdown is reduced. Then, China increased lending through our policy banks to boost demand. In 2009 and 2010, loan growth of around 30-40% of GDP drove growth. Unfortunately, unproductive investment will result in bad debts for the banks. The need to support the banks and cover their bad debts will restrict China’s ability to support the economy.
Around US$ 800 billion or 25% of China’s US$3.2 trillion in foreign exchange reserves is invested in “risk free” European government bonds. Continued losses in these investments and on investments in US government bonds also further restrict our flexibility. China’s economic growth may be slower than widely anticipated.
European Tsunamis…
Australians believe that physical distance from Europe and proximity to China and Asia affords protection from European debt problems.
Despite record terms of trade and high export volumes, Australia continues to run a current account deficit with the rest of the world of around 2-3% of GDP, around US$30-40 billion per year. This must be financed overseas. Sovereign debt problems and the resultant problems in the banking system will affect international money markets for some time to come. Australian borrowers will face reduced availability of funding and increased borrowing cost.
Before the crisis, Australian bank deposits totalled 50-60% of loans made. The difference was funded in wholesale markets, generally from institutional investors.
In 2007, deposits made up around 20% of bank borrowing down from 34% a decade earlier. Domestic wholesale borrowing and foreign wholesale borrowing were 53% and 27% of bank balance sheets. Following the GFC, increases in the cost of overseas funding and regulatory pressure, Australian banks significantly reduced their loan to deposit ratios, with deposits now around 70% of loans. They also reduced their dependence on international borrowings.
Nevertheless, Australian banks face significantly international re-financing pressures, needing around A$80 billion in 2012. Around A$35 billion are AAA rated government guaranteed bonds, which will need to be financed without government support, unless the policy changes. In addition, the banks have a further A$28 billion worth of bonds that mature in the domestic markets.
In the period before the GFC, Australian banks relied on securitisation to raise cheap funding from overseas. When these markets closed, Australian banks used debt guaranteed by the Federal Government to raise funds. With the guarantee now not available, Australian banks are increasingly using covered bonds to raise funds.
Covered bonds are secured over specified assets such as a pool of mortgages, giving investors priority over depositors. Regulators have limited the quantum of covered bonds permitted to a maximum of 8% of assets, limiting the ability of banks to use this form of financing.
To date, covered bonds have not proved a cheap source of finance for banks, as originally envisaged. Inaugural international issues by ANZ and Westpac have cost around 1.50% over inter-bank rates. In early 2012, the Commonwealth Bank issued at around 1.75% over interbank rates in the domestic markets. Given that the covered bonds enjoyed the highest rating of AAA, the funding cost for Australian banks for unsecured borrowings would be around 2.00-2.50% over inter-bank rates, a sharp increase over the last 6 months. This higher cost will be passed on to customers at some stage.
In testimony to a parliamentary committee, John Laker, the head of APRA, acknowledged the funding challenge. He hoped that improvements in market conditions would allow the Australian banks to access the overseas funding required.
Money Too Tight To Mention …
Facing reduced availability and higher cost of funding, Australian banks may reduce loan volumes and increase rates to customers.
The problems of international banks, especially European banks, previously active in financing local businesses, will compound the problem. These banks are required to increase capital to cover losses, including those on their sovereign bond investment. As they can’t or do not want to issue equity at deeply discounted prices and the limited investor appetite for such issues, the banks may sell assets or reduce lending to raise the required capital. Estimates suggest that these banks could have to sell (up to) $2.5-3.0 trillion in assets, resulting in a sharp contraction in availability of credit.
Before the GFC, European banks provided around 35% of loans to Australian corporations. This has fallen to around 16% in 2011 and is likely to decline further as a result of losses on sovereign bond holdings, pressures on bank capital and increases in US$ funding costs. European banks are actively looking to sell all or a portion of their Australian loan portfolios to alleviate the pressures. They are also cutting back on new lending to Australia clients, focusing on their home markets in Europe.
The reduced participation reflects losses on sovereign bond holdings, pressures on bank capital and increases in US$ funding costs. European banks are actively looking to sell all or a portion of their Australian loan portfolios to alleviate the pressures. They are also cutting back on new lending to Australia clients, focusing on their home markets in Europe.
Given that Australian companies will need to re-finance around A$80 billion of maturing loans in 2012, these pressures are not welcome. The problems of European banks, active in commodity financing, may reduce the supply of credit to the sector by about 25-30%, which would impact Australia’s resources businesses.
The contraction of credit will also affect Australia indirectly. The withdrawal of European banks from Asia and other emerging markets is affecting the ability of companies to finance trade and investment projects. This affects Australian exports.
In 2007, European banks and US banks accounted for 30% and 10% of loan in Asia-Pacific. This has fallen by around half to 15-16% for European banks and 5-6% for US banks. The level of participation is likely to shrink further as a result of the problems of these banks. Troubled French banks account for about 11% of maturing loans in Asia Pacific. It is unlikely that these banks will maintain their level of commitment. Asia-Pacific banks have taken up the slack but are not sizeable enough to fill the gap completely.
Australian companies’ overseas earnings also face significant pressure due to economic weakness in Europe and its effect on the other markets. A proportion of Australian retirement savings are invested overseas. These will also be affected by the problems in Europe and internationally.
The European crisis has affected Australian public finances. Falls in income and capital gains have reduced tax revenue. The government is cutting expenditure and tightening taxes to offset the reduction in revenue. Falls in income on retirement savings, reduced business investment and general loss of confidence is likely to adversely affect the domestic economy. Australia may not escape the possible European tsunami.
© 2012 Satyajit Das All Rights Reserved.
Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011). He is a keynote speaker at After America: the Port Phillip Publishing Investment Symposium, March 14th-16th at Sydney's Intercontinental Hotel.
Ed Note: Tomorrow, Satyajit Das examines the Australian housing market and the perfect storm that could engulf Australia.
While flattering, we must admit we have no control over the stock market whatsoever. It doesn't matter which way we push or pull. The stock market couldn't give a hoot about our opinions.
For the past few weeks we've been telling our readers at Sound Money. Sound Investments that this current rally is a bear market rally. It will end in tears. And for the past few weeks the stock market has disagreed.
It thinks Ben Bernanke and Mario Draghi have it sussed. That they can just feed liquidity into the market by taking bad assets off the banks and giving them chips - oops, we mean cash - to play with in return. And then the banks can give that cash to insolvent governments so they can try to reverse decades of systemic welfarism WITHOUT fracturing their societies.
At least that's the plan in Europe. The US keeps borrowing hand over fist for we don't know what. There's no spending reform going on there. And anyway, isn't the US economy recovering? Why does it need the US government to run a budget deficit of US$1.1 trillion in 2012 (around 7.5 per cent of GDP) if things are looking brighter?
That's because they're not. Bear market rallies are tailor-made to make you think things are getting better when they're not. Actually, they're designed to make you stop thinking, full stop. After worrying for months about Europe and Greece and the slowdown in China, a rising stock market makes you think all is well. You don't examine the reasons behind the rally - you just accept them.
We discussed this issue in yesterday's Sound Money. Sound Investments report. We also discussed the crucial difference between hindsight and foresight. To preserve your wealth in this post-bubble world, the use of foresight is crucial. Hindsight will provide an explanation, but it will be a costly one.
Everyone understood the reasons for the GFC in hindsight. But very few had the foresight to see it coming. We're not saying we know what's ahead. What we do know is that this rally is based on nothing more than the hopes and dreams of central bankers. The stock market is living the dream at the moment. The question is - for how long?
What about Australia's role in this global drama? Glenn Stevens at the Reserve Bank of Australia thought the price of credit was just about right this week. He thinks the European and US economies have improved and China's slowdown is going according to (central) plan.
That's a conventional opinion and it's based on hindsight. For an unconventional opinion, with liberal use of foresight, have a read of Satyajit Das's recent article: Vulnerable to External Influences - The Economic State of Australia (Part I)
For the record, Das was one of the few experts in the world who foresaw the credit crisis well before it happened. He's speaking at our upcoming conference in March. Das requested extra time for his presentation and question-and-answer session so he could deliver something really worthwhile for attendees.
To benefit from Das's foresight - and much, much more - sign up for the show here. And read on below to find out why Australia remains vulnerable to events in Europe...
Regards,
Greg Canavan
for The Daily Reckoning Australia
"Decline," writes Charles Krauthammer, "is a choice."
And it's a choice the candidates think they can avoid just by giving more money to America's military industry.
"I will insist on a military so powerful no one would ever think of challenging it," adds Mitt Romney.
But military spending is not a way to resist decline; it is a sign of it...and a cause of it. Osama bin Laden understood how it worked. By 2000, he had already brought one great empire, the Soviet Union, to its knees, luring it to spend money it didn't have in a war it couldn't win. He thought he could do the same to the US. So far, it looks as though he was right.
Lt. Col. Daniel L. Davis has been described as a "whistleblower." He's ratting out the military for failing in Afghanistan, just as Osama bin Laden predicted.
He doesn't seem to understand. The military is not protecting the US in Afghanistan; there's nothing to protect it against. Nor did it ever intend to "win" a war in Afghanistan. It never even identified what winning would mean or how it would know when it had won. This was always a zombie war, not a real war. Its purpose was only to transfer wealth and power to the military industry. In that sense, the war is a great success.
The Armed Forces Journal has the story:
Truth, lies and Afghanistan
How military leaders have let us downBy LT. COL. DANIEL L. DAVIS
I spent last year in Afghanistan, visiting and talking with US troops and their Afghan partners. My duties with the Army's Rapid Equipping Force took me into every significant area where our soldiers engage the enemy. Over the course of 12 months, I covered more than 9,000 miles and talked, traveled and patrolled with troops in Kandahar, Kunar, Ghazni, Khost, Paktika, Kunduz, Balkh, Nangarhar and other provinces.
What I saw bore no resemblance to rosy official statements by US military leaders about conditions on the ground.
Entering this deployment, I was sincerely hoping to learn that the claims were true: that conditions in Afghanistan were improving, that the local government and military were progressing toward self- sufficiency. I did not need to witness dramatic improvements to be reassured, but merely hoped to see evidence of positive trends, to see companies or battalions produce even minimal but sustainable progress.
Instead, I witnessed the absence of success on virtually every level.
Regards,
Bill Bonner
for The Daily Reckoning Australia
Well, Dear Reader, we're here to tell you: America is in decline.
We can give it to you straight because we're not running for public office. And if we were elected, we would immediately demand a recount.
Anyone who tells you America is not in decline is either running for office...or not paying attention.
In 1969, more than one out of every three dollars of income in the entire globe was earned in the US. That's what the IMF's World Economic Outlook tells us.
By 2000, that number had fallen...but not by much. The US still took home 31% of global income. But in the last 10 years, the US share has fallen hard - losing more than 7%. Now, only 23% of the world's income is generated by the US.
Ten years ago, China's economy measured about 1/8th the size of the US. Now, it is 41%. Another decade and it will be the biggest in the world. It is already bigger by several measures. And even if its growth declines to 7% a year, it will still surpass the US in a dozen years.
Hey, don't take it personally. The entire developed world is in decline - with America leading them all down.
By 2050, according to a new study from HSBC, today's emerging economies - as a whole - will be larger than Europe, the US and Japan put together.
The New York Times reports:
The American economy's reported 2.8 percent growth in the fourth quarter, at an annual rate, was seen as mildly encouraging. But it meant that over the previous 10 years, the economy had grown at a compound annual rate of just 1.7 percent. Until the current cycle, there had been no similar prolonged period of slow growth since the Depression.The International Monetary Fund's latest forecasts indicate that there is not likely to be a pickup in growth anytime soon, either in the United States or other large industrialized countries.
..if the fund's forecasts of 1.8 percent real growth in 2012 and 2.2 percent in 2013 prove to be accurate, the 10-year American rate at the end of 2013 will have fallen to 1.5 percent... But it will still be a little above the 0.9 percent compound growth rate in the decade from 1929, the year the Depression began, to 1939.
For Britain, which endured a horrible decade in the 1970s that led to talk of the "British disease," the previous postwar low, not shown in the charts, was in the 10 years ending in the second quarter of 1983, an annual rate of 0.95 percent. The figure for the 10 years through 2011 is 1.4 percent, but the I.M.F. predictions indicate the 2013 figure will fall to just 0.94 percent. The fund expects the British economy to grow by just 0.6 percent this year and by 2 percent in 2013.
The situation is even worse in Italy, where the fund expects the economy to contract by 2.2 percent this year and 0.6 percent the following year. If that happens, Italy's economy will be smaller at the end of 2013 than it was 10 years earlier. The French economy is forecast to have grown at a 1 percent annual rate over the same 10- year period.
As the developed economies stagnate, the 'emerging' economies grow. Nineteen of the world's top economies in 2050 will be those we regard as "emerging" today. China and India will hold the number 1 and number 3 spots, with the US sandwiched between them.
So far, we are just talking about numbers. Try to imagine a world in which today's emerging markets have more economic power, and vastly more people, than today's leaders. It is not just China and India who will be calling the shots, but Brazil, Turkey, Russia, Mexico and Indonesia too.
New technologies, new fashions, new ideas, new music, new cars, new movies...all are likely to come from countries where, today, Westerners are afraid to drink the water. Now, they are imitating us. Soon, we will be listening to pop Indian sitar music, eating doner kebabs and watching movies made in Jakarta.
Military power, too, is likely to shift to the growing economies. Like a body builder with a protein shake, they will use their increasing resources, human as well as material, to add muscle. But their muscle will be young, built with new technology and new techniques. America's geriatric, expensive, bureaucracy-ridden, zombified military industry will be unable to match it.
It is one thing to talk nonsense to the voters. They love that kind of stuff. It flatters them. It comforts them.
But only a fool would believe it.
Regards,
Bill Bonner
for The Daily Reckoning Australia
The most recent summit failed to reach even the lowest expectations. Euro-Zone leaders displayed poor understanding of the problems, confused strategies, political bickering and infighting as well as inability to take decisive steps and stick to a course of actions.
The actions need to try to stabilize the European debt crisis are well recognized. Countries like Greece need to restructure its debt to reduce the amount owed – a euphemism for default. Banks suffering large losses as a result of these debt write-downs need to be stabilized by injecting new capital and ensuring access to funding to avoid insolvency.
A firewall needs to be erected to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from the further spread of the debt crisis. Steps must be taken to return Europe to sustainable growth as soon as possible.
Even if all these measures could be implemented as soon as possible, success is not assured. But without them, the chance of a disorderly collapse is increasingly significant.
What’s Chinese for Begging Bowl
Another option proposed is to enhance the European Financial Stability Fund using resources from private and public financial institutions and investors through Special Purpose Vehicles (SPV). Few details are available currently.
The idea seems to be to raise money from emerging nations with large foreign exchange reserves, such as China, or sovereign wealth funds. The EFSF would provide the equity in the SPV with the investors providing senior debt to increase the funds capacity. The scheme appears reminiscent of leveraged investment vehicles such as collateralized debt obligations (CDOs) and Structured Investment Vehicles (SIVs).
Support for the idea amongst potential investors is uncertain. French President Sarkozy solicited Chinese support by a direct appeal to Chinese President Hu Jintao. China’s position remains guarded in the absence of additional information. The Chinese position to date has been that Europe must get its house in order first and then China will assist. The current European position is different – China must give money to Europe to get its house in order.
China has considerable "skin in this game." Europe is China’s biggest trading partner. China has around $800-1,000 billion invested in euros and European government bonds. Continuation of the European debt problems will have serious effects on China’s economy and its investments.
The Chinese leadership also has to consider the internal political reaction to increased investment in Europe. Chinese foreign investments, including in foreign financial institutions in 2007 and 2008, have incurred losses. China’s leaders face criticism from a large section of population for having invested Chinese savings poorly. China’s officials will not want to be seen to risk even more capital on a potentially lost cause. It is not clear that the EU proposal has sufficient chances of success to encourage China increasing its exposure to Europe, especially as relatively wealthy European countries, like Germany and France, are unwilling to put up more money and are seeking to limit their exposure.
China also faces domestic problems – inflation (partly as a result of the weak currency policies of the developed nations) and attendant wage pressures that are reducing its competitiveness, serious bad debt problems in their banking system and pressure to accommodate the economic aspirations of an increasingly restive population. China’s flexibility to act may be limited.
But China seems desperate to be seen as a "global power." Ego might seduce them into committing more money.
Contributions from China and other emerging countries will not resolve the problems. China’s contribution, expected to be around euro 70 billion, is small relative to the total requirements. As its foreign exchange reserves have risen in recent years, China has purchased substantial volumes of euro-denominated assets, both directly and via bonds issued by the EFSF, without preventing peripheral European bond yields rising. The need for this special scheme is also not clear as the Chinese can presumably invest directly if they wish to and see value in doing so.
Any Chinese involvement would probably require additional support from the Euro-zone countries, which may be opposed by Germany and other nations. China is inherently risk averse and will seek to negotiate additional political concessions, such as reducing pressure on the revaluation of the Renminbi, trade and currency sanctions and criticism on human rights issues. It is not clear whether these will be acceptable.
The negotiating stance of China is evident from its desire to denominate any funding in Renminbi. The EFSF have not ruled this out. The idea is dangerous, as Europe would incur currency risk, becoming exposed to an appreciating Renminbi, adding to its long list of problems.
The entire proposal smacks of desperation and belief in a simple, quick solution where no such option exists.
At best, the plan provides funds to tide over the immediate funding problems of weaker Euro-Zone members. It does little to deal with the Euro-Zone’s structural problems. There is still the risk that Europe enters a prolonged period of low growth or recession. The plan does not address the economic divergences that exist within the Euro-Zone or ease the painful adjustment processes that weaker members will still have to undergo within the constraints of the single currency. These problems are far more difficult to fix than the task of finding buyers for the required amount of government debt.
Balancing Imbalances
The EU refuses to deal with fundamental problems. The austerity and balanced budget measures, reinforced and reiterated in the plan, cannot deal with the primary problem - the deflation of the debt-fuelled bubble.
The EU is seeking to enforce the rarely adhered to rules for membership of the euro, the Stability and Growth Pact requires a deficit no larger than 3% in any one year and a Debt to GDP ratio no larger than 60%. Based on 2010 figures, Austria, Belgium, Cyprus, France, Ireland, Italy, Portugal, Spain and Greece do not meet one or both of these tests on current measures. Only Germany, Finland and the Netherlands are in compliance and would pass in 2013 on current projections.
Strict enforcement of this rule about deficits would prevent counter-cyclical spending by governments undermining economic recovery and lock the Euro-Zone into a death spiral of budget deficits, further budget cuts and low growth.
The problem is compounded by the competitiveness gap between Northern and Southern countries, estimated at 30% difference in costs. The EU’s refusal to contemplate a break-up or restructuring of the euro makes dealing with this problem difficult.
For many of the weaker countries, the best option would be to devalue their currency in the same way that the U.S. and Britain are debasing dollars and sterling respectively. Unable to devalue or control interest rates, these weaker countries are trapped in a vicious and ultimately self-defeating cycle of cost reduction.
An additional problem is the internal imbalances exemplified by Germany’s large intra-Euro-Zone trade surplus at the expense of deficit states, especially the Club Med countries like Greece, Portugal, Spain and Italy. German reluctance to boosting spending and imports makes any chance of resolving the crisis even more remote.
German hypocrisy, in this regard, is problematic. German banks lent money to many countries to finance exports, which benefited Germany. Germany also gained export competitiveness from a weaker euro--an exchange rate of euro 1 = U.S. $ 2.00 would be a realistic exchange rate if the euro were to be a purely German currency. Reluctance to confront these problems makes a comprehensive resolution of the crisis difficult.
Endgame
In chess, endgames require using the few pieces left on the board to achieve a result. Strategic concerns in endgames are different to those earlier in the game. The King becomes an attacking piece. Pawns become more important because of the potential to promote it to a queen. Endgames are more limited and finite than say openings.
The plan has bought time, though far less than generally assumed. As the details are analysed, weaknesses, unless remedied, will be quickly exposed.
The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidize the weaker economies); debt monetization (the ECB prints money); or sovereign defaults.
The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow the printing of money. This assumes that a cost-benefit analysis indicates that this would be less costly than a disorderly break-up of the Euro-Zone. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetization.
Unless restructuring of the euro, fiscal union and debt monetization is removed from the verboten list, sovereign defaults may be the only option available.
Regards,
Satyajit Das
Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk. He is a keynote speaker at After America: the Port Phillip Publishing Investment Symposium, March 14th-16th at Sydney's Intercontinental Hotel.
© Satyajit Das All Rights Reserved.
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The unlimited loans in Europe and the prospect of more printing from the Fed has inspired the current rally. Even though I think it is hot air I have to respect the trend and therefore I have backed off from a strongly bearish view. Long term I remain bearish but while the volatility of the market remains low and the intermediate uptrend remains in place we should expect to see higher prices. Next target in the S+P 500 is the high from April last year which isn't far away.
Meanwhile, let's get back to the basic premise we've been working on the last few weeks: the golden age of iron ore profits is ending for Australia. Europe's banking system is slowly going bust because of the government debt crisis. Europe is a big customer of China's. China is a big customer of Australia's. Europe's banking crisis impacts Australia by way of Chinese demand for base metals. And Chinese demand for base metals is falling.
Pretty simple isn't it?
Let's look at more proof that energy resources are replacing metals as the world's most valuable commodities. Item one is BHP Billiton's half-year result. The company reported lower profits on higher revenues. Its half-year profit through December of 2011 was down 7% to $9.94 billion from $10.52 billion the period before.
Don't bother sending BHP CEO Marius Kloppers any flowers. $9.94 billion is a respectable result and still one of Australia's great half-year corporate profits. But what's interesting is that BHP is basically an iron ore and coal company trying to become an oil and natural gas company. It's hoping to diversify the structure of its earnings before iron ore and coal prices correct.
The company knows that China's metals intensive phase of industrial development is in the process of peaking. That's why BHP spent $17 billion on shale gas acquisitions in the US last year. It's also why the company spent $10 billion buying back its own shares. If the base metals and iron ore businesses were growth businesses, BHP would be expanding capacity and ignoring shale.
Mind you, iron ore still makes it rain for BHP. Earnings from the iron ore division rose 36% to $7.9 billion. BHP's iron ore assets are what Kloppers describes, as "tier-one, long-life, low-cost" assets. He's right. Scooping up giant piles of iron ore in the Pilbara and shipping it to China is a high margin business, especially with iron ore prices around $140/tonne.
With a 65% profit margin before income taxes, the iron ore division made up over 50% of BHP's total earnings before taxes. By contrast, underlying earnings at the base metals division fell 54% to $1.6 billion. This contrast is what probably caused the company to conclude: "In the longer term, we expect the rate of growth in steelmaking raw materials demand, particularly in China, to decelerate as underlying economic growth rates revert to a more sustainable level."
But let's look at exhibit number two in the great base metals peaking story. This morning we had a look at the Power Shares DB Base Metals Long Exchange Traded note (NYSE:BDG). That's a mouthful! Exchange Traded Notes (ETNs) are unsecured obligations designed to track the performance of an index. They usually use futures contracts to do so. In this case, the underlying index is the Deutsche Bank Liquid Commodity index tracking base metals.
It's easy to get bogged down in how ETNs and Exchange Traded Funds work. In fact, the more we looked at this one the more horrified we were. But if you read the fact sheet for the fund, it tells you quite clearly what the intention is: to provide investors with a cost-effective, convenient way to take a long, short, or leveraged view on the performance of base metals.
In other words, it's a way of gambling on the direction of prices in base metals. The ETNs aren't actually secured by physical metal. They hold futures contracts. And several other ETNs are structured in a way to do "double long" or "double short" base metals. We'll get back to this in a moment.
The share price of BHP's US listing neatly tracks BDG's performance over the last three years. That's the first thing you'll notice when you look at the charts side by side. This is a bit of a surprise. Despite BHP's concerted move into oil and gas, and despite the fact that its asset projects are more diversified than say, Rio Tinto's, BHP trades like BDG. And BDG tracks a base metals index.
In terms of performance, BHP's US listing is up just over 5% since BDG first traded in mid-2008. By contrast, BDG is down 15% since its inception. But then, that's a whole separate point, isn't it? Look at when BDG started trading.
Wall Street offered investors a way to take a leveraged view on base metals prices about three months before Lehman Brothers went bankrupt. BDG began trading shortly after BHP made an all-time high. Do you think these things are coincidental?
The financial industry is in the business of selling you securities. That's why you should always be nervous when it's rolling out new products. The roll out of hot new securities almost always coincides with a top in markets. This is exactly why we're suspicious of the Glencore-Xstrata merger. It's a way of marketing the same business to investors in a new way. Meanwhile, the underlying business conditions - producing base metals and trading commodities - may have peaked.
That brings us to exhibit three in our case against steel and its metal brothers. The International Monetary Fund (IMF) said yesterday that China's GDP growth could decline by half as a result of the problems in Europe. The IMF expects China to grow at 8.2% this year, but says as much as 4% of that growth could disappear because of trouble with China's customers in Europe.
You can try and sell things to people who don't have money. It can work for a while, if they have access to credit. But even then, the willingness to spend money you don't have is a psychological and cyclical phenomenon. In the Credit Depression, we reckon frugality and thriftiness will be the in thing. In the big picture, this is bad for China's export-based economy. And if China isn't making things because Europeans and Americans aren't buying them, it's certainly not good for Australia.
In one of today's essays, Satyajit Das looks at China's relationship with Europe and points out some home truths. Das wrote the article back in November. But you can see that not a lot has changed since then. More importantly, Das shows that China has real domestic problems of its own to work out.
Das, by the way, requested extra time for his presentation in Sydney next month at the After America Investment Symposium. We spoke on the phone about China, Australia, America, Europe and much more. He told us that for a serious conference with serious issues and serious investors, an hour-long presentation and half an hour of questions was the right format.
We didn't disagree and blocked out time on Friday, March 16th, at 11:00 am. In the meantime, you can read Das's full analysis below. And if you haven't signed up for the show yet, you have a few more days to do so before the price moves up and we begin advertising the remaining seats to the public.
Regards,
Dan Denning
for The Daily Reckoning Australia
Okay, so the insiders didn't exactly say their stock is a "sell," but they didn't need to. Their feet did all the talking. Nine Goldman insiders scurried away from their stock as fast as the law would let them.
They cashed out $20 million worth of stock at an average price of $107.44. This is the very same stock (NYSE:GS) that Goldman - on behalf of its shareholders - spent $21 billion buying over the last five years. The average price of those purchases was about $171 per share.
Here's our question: why is Goldman's stock a "Buy" for shareholders at $171 a share, but a "Sell" for insiders at $107 per share?
Something's wrong with this picture. Or, to change metaphors, something's rotten with this onion. Let's peel it back until we find the source of the stench.
First data point: Goldman's revenues and earnings are falling even faster than its reputation. The company reported a whopping 58% drop in fourth quarter earnings, compared to 2010.
This latest quarterly report punctuates a troubling three-year trend. Goldman's full-year net income hit a record $13.4 billion in 2009, then slipped to $8.4 billion in 2010 before tumbling to $4.4 billion last year.
Reflecting this downward earnings trend, Goldman's share price has plummeted from its 2009 high of $192 to the current quote of $111. Perhaps the stock has now reached "deep value" territory. Then again, cheap stocks have a way of becoming even cheaper when a company's core operations are in "deep trouble" territory. Goldman's core operations may not yet be in deep trouble, but they seem to be wading into shallow trouble, at least.
Strangely, the worse Goldman's operations perform, the more aggressively the company repurchases its own shares. During 2009 and 2010, Goldman spent 71% of its net income buying back its stock. But last year, the company spent a whopping 264% of net income buying its stock. Even after excluding the repurchase of preferred stock from Warren Buffet, Goldman still spent a hefty 140% of its net income buying its own shares last year - double the rate of 2009-10.
Furthermore, Goldman did not buy back its stock very opportunistically. In other words, Goldman did not "buy low." The company paid an average of $128.33 for the shares it acquired in 2011, compared to a low tick for the year of $84.27 and a current quote of $111. Is it not a little strange that the same Wall Street firm that is supposed to be packed to the ceiling with genius traitors couldn't trade its own stock any better than a raw amateur?
When stewards of the company are trying to build shareholder value through a share-repurchase strategy, they usually try to buy their stock on weakness...and only on weakness. By contrast, when the stewards are trying to build personal checking account value, they buy their stock aggressively, no matter the price.
Just maybe, Goldman's "investment" in its own stock was executed so carelessly and unprofitably (so far) because it had nothing to do with investing, but everything to do with lifting the stock to levels that would reward Goldman's stock-laden partners.
Last week, the top brass at Goldman cashed in $20 million worth of stock that had been "locked up" for the last three years. (The nine privileged recipients also received another $27 million in stock that they did not sell immediately). "Starting in 2009," Reuters explains, "Wall Street banks began shifting more of their bonus awards into stock that executives are required to hold for multi- year periods in an effort to align incentives with long-term performance."
But as it turns out, "aligning incentives" is trickier than it sounds, especially if management is repulsed by the idea of aligning its incentives with the common shareholder. Under the new and improved "aligned incentives" era at Goldman, for example, the top insiders still found a way to enrich themselves at the shareholders' expense. The only shareholders to enjoy an alignment of incentives were the ones in the mirror.
As noted above, Goldman's management spent $21 billion of the shareholders' capital buying GS stock in the open market at an average price of $171 a share. Today, the stock sells for $111. On a mark-to-market basis, therefore, Goldman's stock buy-back "investment" has produced a loss of about $7.3 billion for shareholders - or more than the company's total net income during the last five quarters! That's the bad news. The good news is that these share purchases helped support the share price so that the top nine guys at Goldman could sell their stock for $20 million.
I think we just found the source of that stench.
Just maybe, the company could have identified a better investment opportunity during the last three years than its own stock...like a Treasury bond or an S&P 500 Index fund - both of which have been rising while Goldman's stock has been sinking.
Goldman's CFO, David Viniar begs to differ. When discussing Goldman's share re-purchases in 2011, he said he felt "relatively certain that at some point we're going to wish we bought back more."
No doubt! Viniar still holds more than one million shares of GS! CEO Blankfein holds more than two million shares. "Aha!" the Goldman apologists might say, "You see, their incentives are aligned with shareholders."
"Think again," we would reply, "If this particular crew of insiders did not hold so much Goldman stock, they probably would not be blowing so much of their shareholders' capital buying it. But these particular insiders have demonstrated repeatedly that they will squander shareholder capital to pay almost any price for GS, while they, for their own accounts, will unload GS at almost any price."
If incentives were truly aligned, you would never observe a gaping spread between what the shareholder pays for his stock and what the insider is willing to receive for his stock. If the stock is a "Buy" for shareholders at $171 a share, then it is also a "Buy" for Lloyd Blankfein and David Viniar at the same price, or any price below that level. But the last three times these guys unloaded large chunks of stock - August 11, 2010, January 25, 2011 and last week - they realised average prices per share of $150, $162 and $107.
On the other hand, if the stock is a "Sell" at $107 for insiders, why did the company spend $6 billion in 2011 to pay $128 per share for the stock?
One final curiosity about Goldman's hefty share repurchases in 2012: they took place in the midst of a period of high market volatility and uncertainty - a period during which the Federal Reserve was mandating all banks to bolster their balance sheets.
"Under the Fed's Comprehensive Capital Analysis and Review, or CCAR," Bloomberg News explains, "US lenders must prove they have enough capital to withstand a 'severe' US recession before they can increase dividends or repurchase shares."
Despite this mandate, however, Goldman continued churning through its precious capital to re-purchase its own shares. This process has contributed to a steady erosion of its Tier 1 Capital ratios since early 2010.
Although Goldman's Tier 1 capital still remains relatively healthy, it is moving in the wrong direction. During the last two years, most major financial institutions have been ramping up their Tier 1 capital - i.e. strengthening their balance sheets. But not Goldman. In fact, as of year-end 2011, Goldman's Tier 1 capital - at 13.8% - had dropped to within a whisker of Citigroup's - at 13.6%.
A 13.8% capital ratio may be just fine in most market environments, but it is hardly disaster-proof. For perspective, Goldman's Tier 1 ratio was 11.6% on the eve of the 2008 credit crisis. That "conservative" capital buffer would have sent Goldman into bankruptcy during the crisis, were it not for the infinite Tier 1 capital of the US Treasury.
"We put in what we want to do and the Fed tells us yes or no," David Viniar, Goldman's Chief Financial Officer, told analysts when asked how the bank was able to spend so much more on buybacks than it earned.
From all outward appearances, this process has always operated in reverse: The Fed tells Goldman what it wants to do and then Goldman says "yes" or "no"... but usually "yes"... as long as Goldman's trading desk is properly positioned.
The US stock market may be a "Buy," just as O'Neill predicts. But Goldman is a "Sell"...until the day it disappears completely.
Regards,
Eric Fry
for The Daily Reckoning Australia
Eric Fry is the Editorial Director of Agora Financial.
This article originally appeared in The Daily Reckoning USA.
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For the United States of America, the road to hell has never been so smooth. The country has been borrowing its way to ruin for many years. But now, the skids are greased. The wheels are oiled. Strap on your seat belt. Whee!
Lenders practically insist that the US government take their money. Reuters reports:
The US government may ask investors to pay for the privilege and safety of holding short-term debt issued by its Treasury Department.In response to clamor from investors, the Treasury said on Wednesday it was looking closely at allowing negative-yield auctions. This would mean bidders who want the security of US government debt in the face of global insecurity, might have to pay a premium for it.
Doing so would allow the US government to benefit from something that is already occurring on the secondary market, where investors have accepted negative yields in recent months to protect their cash from financial strains.
Remarkably, Wall Street is asking to be able to pay a premium for US debt even after the United States lost its prized AAA rating last year and as the government heads for a fourth straight year with $1 trillion-plus budget deficit.
"It is the unanimous view of the committee that Treasury should modify auction regulations to permit negative rate bidding and awards in Treasury bill auctions as soon as feasible," according to minutes of the Treasury Borrowing Advisory Committee, which includes 21 financial institutions that make markets for US government securities.
On Tuesday, the nonpartisan Congressional Budget Office said the United States was headed for a fourth straight year of $1 trillion- plus budget deficits, a condition that Republicans want to use as ammunition to hammer President Barack Obama's spending record in the November voting.
Debt is still rising. At some point, it has to stop. Then, the feds go broke.
Why?
Because they are all living on borrowed time and borrowed money, only paying current expenses - including the interest on past borrowing - by borrowing more and more money. When the borrowing stops, they will no longer be able to pay their bills. And when that happens, their bonds will drop in value - fast. Governments will go broke. So will all the people who depend on the feds and their IOUs. Banks. Insurance companies. Retirees. Investors. The defence industry. The education industry. The healthcare industry.
Will this be a bad thing? Not necessarily. What has to happen sometime might as well happen now; get it over with. The longer debt builds up, unchecked, the more debt there is to liquidate when the end comes. Better for the end to come sooner, rather than later, in other words. If the end were allowed to come, we'd soon be at the beginning again.
But if there was one theme that ran through all the "Capitalism in Crisis" essays it was this: the end must be prevented, at all costs. Capitalism is inherently unstable, the writers agreed. Governments must use their power to keep it from going nuts. Otherwise, it may put an end to things.
We disagree. Markets - free markets - are meant to be unstable. They are meant to crack-up from time to time. And thank God they do. Otherwise, we'd be stuck forever with zombie industries and dead end investments. Every once in a while, capitalism throws a tantrum. But so what? Crises, breakdowns, crashes, washouts, liquidations - they're just fast and efficient ways to get rid of the zombies.
And it's not just developed countries that are subject to the temper fits of capitalism. Even China - a country still run by people who call themselves communists - is subject to capitalism's mood swings.
Here's a report from Bloomberg:
China's economy is headed for a "hard landing" this year as weaker demand overseas chokes off exports, said Gary Shilling, who correctly forecast the US recession that began in December 2007.A Chinese government report yesterday showed that export orders fell last month even as manufacturing expanded. The Shanghai Composite Index (SHCOMP) dropped 1.1 percent yesterday as stronger manufacturing boosted concern that the world's second-largest economy will decelerate further as the government refrains from loosening monetary policy to tame inflation and curb property prices.
"They slammed on the brakes," Shilling, president of A. Gary Shilling & Co., a Springfield, New Jersey-based consultancy firm, said at the Bloomberg Link China Conference in New York yesterday. "Transition is not easy because they are geared up to exports."
China's economy expanded 10.4 percent annually in the past 10 years, five times the pace of the US, as the government boosted spending on roads and bridges and manufacturers exported everything from toys to socks. Shilling defines a hard landing as a growth rate below 6 percent.
The economy grew at a 9.2 percent rate in 2011 and its expansion will slow to 8.5 percent this year, according to economists' estimates compiled by Bloomberg.
Shilling, 74, has been calling for a hard landing in China since at least a year ago, advising clients to sell copper and the Australian dollar as a play on the downturn.
Shilling forecast the US recession in 2007 and warned investors a year earlier that residential real estate was a bubble about to burst. As the Standard & Poor's 500 index fell [to] a more-than 12- year low in March 2009, he said that higher unemployment would curb consumer spending, leading to "weaker stocks." The gauge has since rallied 96 percent.
Nobody can be right all the time. Even here at The Daily Reckoning, our timing is occasionally off - by a year or two. After all, we figured the US stock index, the Dow, would be down to 6,000 by now. We thought the post-crisis bounce would have come to an end years ago. Instead, the Dow is over 12,000...and still bouncing along.
But give it time!
Regards,
Bill Bonner
for The Daily Reckoning Australia
That's an interesting question. But is it relevant? ANZ is just one of the Australian banks to go on record and say that the RBA's price of money isn't what ANZ pays. See the 12 December 2011 Daily Reckoning for more on this. This is the banks' way of saying they're not obliged to match the RBA's rate cuts point for point.
It's kind of quaint to think there are some people in Australia who think the RBA actually controls the price of money. But some people do! Take Ged Kearney for example. He's the president of the Australian Council for Trade Unions (ACTU). Kearney told the Herald Sun...
Last year the big four banks made profits of $25.2 billion - easily more than the rest of the banking sector combined. They now have a greater share of the home lending market than before the global financial crisis....If the banks cannot behave in a socially responsible manner, it may be time to consider stronger government regulation to drive greater competition, improved consumer protection and more sustainable corporate behaviour in the banking sector.
Heaven forbid that we'd defend the banks in this space. But someone might want to tell Mr Kearney that Moody's has just released a report claiming that Australian banks are the "most exposed" banks in the Asia-Pacific to a worsening of Europe's sovereign-debt problem. What exactly does that mean?
Before you go bagging out Moody's for being an unreliable ratings agency that shouldn't be trusted, consider the main point in the note. Moody's isn't worried about the amount of European government debt Australian banks own. That's not the problem. The problem is that Australian banks get at least 19% of their funding externally.
In a genuine liquidity/credit crisis, external funding a) gets more expensive, b) dries up for all but the highest credit-quality borrowers. The cost of money goes up and there's less of it to go around, in other words. This is why banking is a lousy business in a credit depression and why bank stocks make lousy investments.
By the way, we'd started to go into detail examining the current situation in Greece and Europe...but to be honest, we just couldn't bear spending another precious second analysing a situation that's so hopelessly doomed...and so cynically and horribly mismanaged. As our colleague Dylan Grice at Société Générale writes:
Flawed thinking got us into this mess. But rather than change that flawed thinking, our policy makers are applying it with even more rigour: we have more debt for insolvent borrowers, more financial engineering, more complicated banking regulations, more blaming speculators for everything, more monetary experimentation by central banks. Our policy makers have absolutely no idea what they're doing, but they're giving it a go!
Grice refers to the "Lost Pilot Effect". That's a term invented by behavioural psychologists to explain a certain kind of irrational behaviour. You see it when a pilot gets lost but tells his passengers, "I have no idea where we're going...but we're making good time!"
There's no point in hurrying along somewhere if you don't know where you're going. And it's even more insane to hurry along to a place where you don't want to be! The best move, if you're lost, is to get out a map and a compass and find out exactly where you are.
Hopefully Dylan will bring his map and compass with him to Sydney next month. He's one of our four keynote speakers at the After America conference. We invited a thoughtful group of keynote speakers for our first conference for a reason. We want you to hear from people who can help will help you figure out where we are on the map.
The particular map we'll be looking at is the Asia-Pacific region. The main players are China, the United States, and Australia. It's a big map. It covers a lot of territory. There's a lot to talk about. But hopefully the conference is small enough - only space for 344 attendees - that we'll be able to really dig into some of these ideas.
By the way, we're opening up the conference to the general public later this week. You can still get the early bird price of $799 for a few more days. After that, the price moves up to $999.
It's been an eye-opener organising a conference around one big idea. One mistake we realise we made is not giving people enough time to make travel plans and arrangements. We won't make that one again! In fact we're already planning next year's show.
Another concern is location. Up until now, all of our events have been in Melbourne because that's where we are. We thought an event in Sydney would make it easier for readers in New South Wales and Queensland to attend. Hopefully we can have events in Brisbane, Perth, and Adelaide too. But maybe not this year.
Price is an interesting one. One friend told us that for the line-up we had put together and the small crowd and the number of new ideas from Port Phillip Publishing editors, the price seemed too cheap. Another financial professional told us that when you factored in travel and hotel arrangements, the price was too expensive.
Either way, this is not a money-making venture for us. For five years we've been having a conversation with you about Australia's future. We thought it was high time to set aside a few days, invite some guests, and really talk about it, including some specific ideas. It's going to be a cracking show.
One of our other keynote speakers is Dr. Paul Monk. Like Dylan, Dr. Monk is interested in how we think, how we make decisions, and the quality of our knowledge. In the article below, he reviews Daniel Kahneman's latest book on how we think.
The Brain: A machine for jumping to conclusions
By Paul Monk
Daniel Kahneman's Thinking, fast and slow should be required reading for everyone this summer. Not because it is entertaining or a mere diversion, but because it is a subtle and beautifully scientific guide for the perplexed. If you see yourself as a citizen in a democratic polity, read this book. Self-indulgent cynics and self-important ideologues probably won't read it, but they are the ones most in need of what it has to teach. Do yourself a favour, whoever you are: rush out, buy this book and read it quietly and thoughtfully, absorbing its highly readable insights.
Kahneman was awarded the Nobel Memorial Prize in Economic Sciences in 2002 for his work on prospect theory. To understand what is meant by this, how Kahneman got into thinking about it and what his key insights were - in collaboration with his long time research partner Amos Tversky - go straight to chapter 26 'Prospect Theory'. It's a fascinating excursion into clear thinking all on its own. Prospect theory is about gambling, risk-taking and expected returns. It's a body of theory with considerable practical relevance to the king-sized mess both welfare economics and financial markets got themselves into by the late 2000s.
Kahneman re-examined the fundamentals of utility theory, articulated by Daniel Bernoulli, almost three hundred years ago. He did this long before the past decade or two's extravagant follies came close to wrecking economies from California to Greece. Utility theory lies at the foundation of modern economics and there is a rather urgent need right now to understand what has gone so awfully wrong in so many economies. Falling back on Marxism or some kind of self-satisfied ideological cliché does not amount to such understanding. Kahneman confers considerable understanding. That's why he deserved his Nobel Prize.
Thinking, fast and slow has five parts: Two Systems, Heuristics and Biases, Overconfidence, Choices and Two Selves. It also contains, as appendixes, two of the classic papers for which Kahneman won his Nobel: 'Judgment under Uncertainty' and 'Choices, Values and Frames'. Part I sets cognitive science in an easy to understand frame of reference which acts both as a disciplined corrective to a good deal of pop psychology and a lucid introduction to the theoretical work in the following four parts of the book.
He suggests that we think of our brain - our "machine" for making judgments - as consisting of two basic systems; which he calls System 1 and System 2. He describes the characteristics of each and explains how their faults and standard ways of interacting result in many kinds of error, bias and illusion - universally and predictably, not in merely unusual or idiosyncratic cases. System 1 is the intuitive, unconscious, fast reaction part of the brain. It is emotional, holistic and instinctual. It is, as he expresses it, "a machine for jumping to conclusions".
In certain circumstances and often in everyday life, its functions are reliable, rapid and even remarkable. But when it comes to matters that require complex, abstract thinking it is in deep trouble. System 2 is better equipped - if trained and switched on - to handle such matters. The problem with System 2 is that it is lazy and highly inclined to rationalize rather than critically examine the intuitive judgments of System 1.
In Parts II, III and IV of the book, drawing upon the work of many psychologists and cognitive scientists, Kahneman offers an endlessly fascinating dissection of the brain of Homo sap. The chapters include 'The Law of Small Numbers', 'Anchors', 'The Science of Availability', 'Availability, Emotion and Risk', 'Causes Trump Statistics', 'Intuitions vs Formulas', 'Risk Policies' and 'Frames and Reality'. And at every point Kahneman exhibits a demeanour at once keenly curious, meticulously scientific and utterly unpretentious. The implications of what he imparts are enormous and need to be digested by our education systems (not least all business administration courses), our public policy systems and our methods for public debate.
An indication of the ways in which such insights can be applied was offered several years ago, in Richard Thaler and Cass Sunstein's Nudge: Improving Decisions About Health, Wealth and Happiness. Originally completed in 2007, it was reissued in 2008 with a Postscript titled 'The Financial Crisis of 2008'. They drew attention to the alarming reality that almost no economists or financial analysts had foreseen the crisis, or issued public warnings as it approached. They praised the behavioural economist Robert Shiller for having done so.
Shiller's warning in 2005 had been that "social contagion" was creating a massive housing market bubble that would inevitably burst. Shiller's books, Irrational Exuberance (2000) and The New Financial Order: Risk in the 21st Century (2003) are recommended reading. Thaler and Sunstein's own observation is that sound public policy, informed by the insights of cognitive science and behavioural economics, needs to invent ways (they suggest a number) to prevent or defuse such outbreaks of social contagion, or what Charles Mackay long ago called 'extraordinary popular delusions and the madness of crowds.'
As Michael Lewis's peerless writing shows, a little thoughtful analysis can reap enormous dividends. If markets and capitalism are to flourish and the costs of human stupidity are to be contained in future, then many things will need to be rethought and reformed. Lewis's latest book, Boomerang: The Meltdown Tour, a characteristic tour de force shows this from Iceland and Ireland to Greece, Germany and California. If you don't read Kahneman this summer, you simply must read Lewis.
Kahneman, meanwhile, is hard at work trying to engineer better thinking in the marketplace, or at least to nudge the unwilling and unwitting in that direction. He is a partner in a firm called Greatest Good, committed to applying cutting-edge data analysis and the insights of behavioural economics to real business challenges. His associates are a highly impressive group of people, including Steven Levitt (of Freakonomics fame), innovative economists Gary Becker and John List, the checklist manifesto man Atul Gawande and the brilliant theoretical physicist Lisa Randall. Now that, to paraphrase Groucho Marx, is a club of which I'd like to be a member.
About the author: Dr. Paul Monk has a PhD in international relations from Australian National University. Paul worked for the Australian Department of Defence and the Defence Intelligence Organisation, where he later became head of China analysis and chairman of the inter-agency working group on China. He is a keynote speaker at After America: the Port Phillip Publishing Investment Symposium, March 14th-16th at Sydney's Intercontinental Hotel.
Regards,
Dan Denning
for The Daily Reckoning Australia
"With what?"
"The whole Glencore and Xstrata thing. Sometimes I can't figure out why you put that stuff in your letter. It makes no sense."
"Oh. Well, my point was that when you can't figure out any other way to make more money, you announce a merger. It makes you look busy. Everyone gets excited. You say you're creating more shareholder value. But really you're just trying to find efficiencies or "synergies" to squeeze a bit of extra profit out of the business...because the easy profit growth is gone."
"You should've just said that."
Yep, we should have. So we just have. And today, more proof that the days of easy money selling dirt and coal to China are over. First cab off the rank is the Reserve Bank of Australia's index of commodity prices. Have a look below.
What you see above is the biggest downturn in the RBA's commodity price index since the big crash in 2008. Mind you it doesn't look quite as severe, at least not yet. Last time around in 2008, the rush to cash in global markets caused people to sell a lot of their speculative commodity positions. Base metals in particular got smashed.
Base metals - lead, zinc, copper, nickel, and aluminium - make up 15.7% of the index, according to the RBA. Metallurgical coal (for steel making) makes up 14.7%, iron ore 9.3% and thermal coal (for power plants) makes up 9.7%.
If metals consumption in China is really peaking - the claim we made yesterday - it's not hard to imagine the index crashing again. And if the index crashes again, it won't be good news for base metals producers or explorers.
But let's not be a Danny Downer. Oil is omitted from the RBA index. LNG is included (4.8%). But unconventional energy is not. In other words, a whole sector of the commodities complex that's in a long-term bull market isn't measured by the RBA's commodity index. Do you realise what this means?
It means the RBA's commodity price index can go suck an egg for all we care. If energy - oil, natural gas, uranium, and coal - is going to be the most important sector of 2012, the RBA index won't tell you anything about it. All the RBA index will tell you is if base metals price crash and China's metals demand has peaked.
We'll be keeping an eye on it.
Regards,
Dan Denning
for The Daily Reckoning Australia