Escape is Impossible

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

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

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

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

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

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

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.