Economics and Politics

Source: Lena Groeger

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

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

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

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

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

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

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

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

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

Examples of biased economists

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

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

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

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

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

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

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

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

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

Same Foundations, Different Perspectives

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

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

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

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

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

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

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

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

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

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

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

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

To summarise:

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

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

Review of Past Predictions

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

Anyway let's go back and review my posts:

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

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

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

2012 Articles

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

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

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

2013 Articles

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

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

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

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

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

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


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

Updated Predictions and Forecasts

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

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

Mea Culpa

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

Rebuilding the model

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

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

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

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

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

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

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

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

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

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

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

What are my current economic thoughts?

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

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

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

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

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

Cannot recommend this book highly enough!

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

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

What lies ahead...

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

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

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

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

At the end of the article Gittens says: 

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

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

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

This makes sense? 

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

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

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

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

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

Bear in a China Shop

Photo: Wen-Chun Fan - CNN

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

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

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

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

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

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

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

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

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

Chinese banks and bad loans

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

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

NPL ratio rising since Q3 2011 (time axis reversed)

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

Credit boom continues

Shadow banking

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

Trust asset boom is unsustainable

Bailouts and moral hazard

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

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

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

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

Chinese commodity collateralised loans

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

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

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

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

Iron ore prices at new monthly lows
Source: Barchart

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

China upcoming trust defaults

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

The maturity wall is fast approaching

Chinese housing market

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

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

Chinese house prices in a speculative fervour

Impact on the world

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

Honk Kong financials are heavily exposed to Chinese borrowers

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

Yuan leveraged bets

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

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

Arguments against a China collapse

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

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

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

Picking the top in the market

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

Conclusion - warning signs

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

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

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

Source

How the Government Pisses Your Money Up the Wall

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

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

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

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

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

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

Political remedies to cutting spending

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

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

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

Source: Budget Paper 1, Statement 6, page 10

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

Source: Budget Paper 1, Statement 6, page 12

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

List of Government Expenditure to be Cut

PLEASE BOOKMARK THIS PAGE AS IT WILL BE PERIODICALLY UPDATED

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

Things that should be cut at the Federal level:

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

·         Baby bonus

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

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

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

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

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

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

It outlines nine budget fixes:

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


Other spending to cut:

• $200 to newlyweds for marriage counselling

To privatise:

·         Australia Post

·         Medibank

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

Other waste:

Politicians abusing taxpayer money

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

State government waste

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

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

• First Home Owners Grants and various construction grants