Austrian Malinvestment Theory

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

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

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

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

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

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

Krugman's Criticisms of Malinvestment Theory

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

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

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

Examples of malinvestment

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

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

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

Conclusion

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

References

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

Minsky's Financial Instability Hypothesis

Ponzi finance is like an unstable house of cards

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

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

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

What is the Financial Instability Hypothesis?

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

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

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

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

Financial Instability Hypothesis Theorems

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

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

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

Link to behavioural economics?

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

Other important notes from Tymoigne (2010)

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

Where are we now?

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

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

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

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

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

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

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

This sums up the situation well:

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

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

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

Conclusion

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

References:

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

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

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

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.”

Banks Feed Off Inflation

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

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

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

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

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

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

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

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

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

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

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

Asset Bubbles

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

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

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

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

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

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

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

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

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

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