Author: Nickolai Hubble

March of the Penguins

Markets have passed the St Kilda penguin colony and headed further south since last week. Next stop Tasmania, or perhaps even Antarctica. Check out the five day chart of the ASX 200 here. Markets around the world looked equally bad, if not worse. There is no shortage of reasons why markets should fall , but politicians continue to add to them.

The Germans have decided to ban naked short selling. In other words, they have stopped people from agreeing to sell now, while being under the obligation to buy back in the future. This means that buying pressure that would previously have existed in the future will no longer be there, which bodes ill for prices.

Short-covering rallies often mark the end of corrections or bear markets. But if there are no shorts in the market, you can’t have a short-covering rally. And value investor who goes bargain hunting at market bottoms may be locked out too since the ban on short-selling prevents the needed capitulation and correction.

Talk about a lose lose situation! Oh wait, political gain is all important, isn’t it?

Meanwhile, the quality of sovereign debt remains the same. But if you try and sell it, you’re a demon.

In the German media itself, furore over “speculators” continues. But isn’t every share purchaser a speculator? Obviously Initial Public Offerings (IPOs) provide capital, and dividend paying stocks provide cash flow, but beyond that, a market for shares simply allows you to cash in on gains when you find another sucker, right?

The answer is sort of. Having a primary market for shares (IPOs) is made possible by having a secondary market. If you can’t sell shares in a business easily, your risk is substantially higher, making investment out of reach for many people. By having a secondary market for shares, the risk is lower, creating more demand for shares, which in turn provides larger amounts of capital.

And don’t go thinking the secondary market is some kind of necessary evil – at least not necessarily. It allows diversification and participation in economic growth on an affordable level.

What the government cosy corporations have turned the financial markets into is another matter to the theory.

What it means to be German

It is rather odd that while other European states have their debt yields fluctuating all over the place, Germany’s are at a record low. Yet the Germans are obsessed with getting their fiscal house in order. At least they claim to be.

Anecdotal evidence from the German population suggests that whinging is on the agenda, without any obvious plan of action. “Germany works, while the rest of Europe parties” is the phrase on everyone’s lips. But mentioning “austerity measures” wipes the morbid smile off everyone’s faces quite quickly. And it’s a conversation killer if your aunt and uncle work for social welfare services.

The other matter on the agenda is to ensure that “the German culture of fiscal responsibility” is “exported” to other Eurozone nations. Best of all, however, was when your editor tuned into a German radio station to hear a song which consisted of a speech by former Chancellor Helmut Schmidt explaining how important it was to have a sound currency. The speech excerpt was an old one, but the application quite new.

Yes, you read correctly. Radio – song – speech about sound money. Only in Germany.

One blogger reported that the banks have already decided what will be happening to the Euro:

Big investment bank to clients: “they have it all planned: they are going to sink the ship (Greece). Merkel is now drafting law for orderly insolvencies, but they don’t want anyone to make money out of it, hence the [short selling] ban.”

The only problem with this is that the banks don’t usually warn their clients of imminent financial crises.

So will the Germans boot the Greeks out of the Euro? That would imply they will have to boot the US out of the reserve currency of the world (the US dollar) pretty soon too. More likely is that the Germans will abandon the Euro instead. Let Europe ruin itself. But if the Germans leave, who will hold up the Euro?

The currency exchange booth attendant didn’t appreciate being asked for Deutschmark when your editor arrived in Frankfurt on Sunday. She didn’t get the joke. Neither of us knew who was supposed to be laughing.

But the action isn’t just in the EU. Bloomberg follows up Paul Krugman’s investment advice (hide under the kitchen table) with these words of wisdom:

“Put your helmets on if you are long risk here,” Nicolas Lenoir, chief market strategist at ICAP Futures LLC in Jersey City, New Jersey, said in a note to clients before markets opened today. “A lot of stops have been triggered when the S&P future crossed 1,100 and anybody still long will probably have to bail out and head for cover.”

The key words there are “bail out”. If the Fed can print money covertly, and it is authorised to purchase securities, do you think it will sit idly by as its credibility falls with indices around the world? Nope.

The economies of the world, and their citizens, are dependent on the drug of government spending and central bank credit. That started to falter in 2007, so government stimulus was next. By 2008, the economy was so high on artificial spending, going back would have been a painful experience.

But stimulus can only last so long too. Now, the central banks of the world find themselves having to step in to support the surreal reality. They have to use their most powerful tool to maintain the status quo, which is of course their job.

We often discuss where money printing will leave us, but the point is that it is historically the final trump that governments have to pull. After money printing comes the hyperinflation and the official end of the preceding boom in pretend wealth. This is the final act of the welfare economy that has served you oh so well…

What comes next is one question. How long it will take for the “next” to arrive is another. In the meantime, the Daily Reckoning will continue to warn you of what may be coming, based on the many crises found throughout history.

But wait, we could be wrong:

“This is not a typical retracement,” El-Erian, 51, whose firm runs the world’s biggest bond fund, wrote in an e-mail. “We are in uncharted waters on account of several issues, including what is going on in Europe and other important structural regime changes. In economic terms, European developments are unambiguously bad for global growth.”

So, there you have it. This time is different…

Where do you go, my money?

The market rout’s intensity is having trouble reaching the small group of publishers we have gathered with in France. A near four percent fall in global markets doesn’t mean much when you’re stuck in the middle of Normandy with a moat around you.

But things take on a whole new perspective when you have time to actually think about them. The logical begins seeming illogical. Maybe it’s the food. One can’t be sure if you don’t know what it actually is.

One thing is sure; the old French chateau we’re staying at certainly isn’t a liquid investment. It can’t be sold at the push of a button. And yet it probably gives a lot more comfort than holding a US Treasury bond.

Still, market’s famous “flight to liquidity” continues. The fact that you can sell Treasuries quickly makes them a good investment when credit is freezing up again. Just ponder that for a moment… Something is a good investment because you can sell it quickly… Any logical five year old would tell you you’re barmy to think so.

But instead, it’s the world that’s barmy and the investor that’s rational. At least for now. Soon, both will be barmy. Treasuries have few places to go but down. When that happens, the consequences could outgrow your personal investment decisions anyway, but that’s no excuse to be imprudent.

Exit the Dragon, Enter Dan Denning

Perhaps the most important development in all this is that Dan’s prediction on China is playing out, largely under the radar. At least compared to Europe, it’s under the radar. While newspapers around the world were reporting on the “contained” European crisis, Dan discovered something that could really pull the carpet out from underneath the Australian economy.

More and more analysts are coming to agree with the claims in our recent “Exit the Dragon“ promotion. Dan discussed some of their views on Thursday.

Considering how much hate mail we received as a result of Dan’s prediction, we knew we were on the right track. It was just a matter of time. But now it seems Dan’s long awaited return to an editorial role of a paid newsletter couldn’t have had a better timing.

Things are hotting up, or really cooling down, if you prefer. All across China, bubble popping symptoms are appearing like a skin disease. And considering we have just had the bubble of a lifetime pop with a bang, you would think the world could spot another one under its nose. But no, Europe is far more interesting right now. And it could just be the prelude to something even bigger…

Have a great weekend.

Nickolai Hubble.
The Daily Reckoning Week in Review

Similar Posts:

• Eurozone Drops GDP Bombs
• Dollar is Merely Retreating in Good Order
• European Governments of the Eurozone are Separately Responsible for Their Euro-debt
• Whiskey & Gunpowder
• It Should Cost the Germans and the Greeks Roughly the Same to Borrow

Will it backfire?

Wednesday, April 21st saw Reuters publish not one, not two, but six articles on the Greek debt mess.

Basically, they discussed what could be an amusing procedural hiccup for the planned Greek bailout. Papandreou’s “gun on the table” strategy could jam, ironically because of a German political dilemma.

The German Chancellor Angela Merkel faces some pretty stiff opposition to bailing out what many Germans consider to be a rogue spending state. (Surprise!)

Both the (left leaning) opposition party and the Bavarian sister of the (right leaning) governing party have expressed the desire to drum up some opposition. The Bavarians for ideological and financial reasons and the opposition for political opportunism, as they face an upcoming election race in the state your editor was born in.

The amusing thing about all this springs from the fact that Angela doesn’t want to commit to a bailout until after the election:

“If Germany pledged aid immediately after the election, that would leave 10 days to secure parliament’s approval before a key trigger event for markets tracking Greece’s efforts to manage its debt – the May 19 refinancing of an 8.5 billion euro bond.”

“They’re really playing it close. What they need is the money a few days before the bond comes due” on May 19, said Christian Keller, a strategist at Barclay’s Capital.”

Supposedly there is a serious risk that the German political process could be drawn out enough to make the Germans turn up late to the bailout party. Not to worry, the French and the IMF will save the day. With “177 billion Euros in debt coming due over the next 5 years”, it’s going to be a blast, to say the least.

But what of the Greeks themselves? The crisis is about them after all.

They are apparently too busy protesting to pay their taxes:

“Hundreds of dockworkers blocked passenger vessels at Greece’s largest port, Piraeus, on Wednesday to protest the austerity measures.”

Maybe there were German taxpaying tourists on the boats, who wanted to see for themselves where their money would be going. They may just get to see what they are looking for on a grand scale:

“About half a million Greek civil servants are planning another 24-hour strike on Thursday.”

Wow, half a million civil servants! And those are just the ones protesting!

Run for the hills – the lender is coming

The most concerning news of the week was when the IMF reported that everything was A-OK and the world would grow by over 4% this year. When the IMF says that, it’s time to run for the hills. Having ruined many developing nations with their loans, the IMF now has its fingers in the Greek pie as well.

2 bubbles remain

The Australian housing bubble seems to be getting a lot of press lately. The World Socialist Web Site (WSWS) has thrown a real left ball* with its article on the matter:

“Household debt in Australia is now a higher percentage of GDP than in the US. If Australia has so far dodged the worst effects of the global crisis, this is because its private sector has not yet-in stark contrast to the rest of the world-deleveraged, that is, reduced its ratio of debt to assets. Such a development could be triggered by a significant fall in house prices, the first signs of which might be now emerging. Despite the housing bubble, the number of mortgages entered into by owner-occupiers (as opposed to investors) fell for a fifth consecutive month in February and was 22 percent down from the June 2009 peak.”

* cross between “coming out of left field” and “throwing a curve ball”

Wednesday’s Daily Reckoning pointed out that even the heroic International Monetary Fund has decided to have its two cents on Australian property:

“In its Global Financial Stability Report published last night Australia time, the IMF wrote that, “The dramatic rise in residential property prices in recent years, especially in Australia, Ireland, the Netherlands, Spain and the United Kingdom has heightened concerns of an asset price bubble and thus the likelihood of a sharp price correction.”

A more reliable evaluation comes from Jeremy Grantham, who has done a detailed study of bubbles and concluded that two remain: The UK and Australian housing bubbles. Check out an interview of him here – but be warned the interviewer is awful. Grantham also has some harsh words for central bankers, which makes the interview doubly worth watching.

Gen Y is coming to their property buying senses and may be the first to stop buying into the sucker’s game of relying on capital gains and ignoring cash flows. But it may not be by choice. The Age reports:

“More young Australians see themselves as lifelong renters as the dream of home ownership fades, a new survey has found.

“The prospect of onerous debt has soured the hopes of more than half of generation Y members surveyed in a poll of new home buyers and perspective purchasers this month.”

Regardless of whether it’s a rational response to unaffordable housing, or just the end of a bubble, homeowners could soon be hit hard if Gen Y doesn’t start buying. Especially overleveraged and invested “home” owners. Funnily enough, gen Y might find themselves with relatively affordable housing when it’s all over. Hopefully the bubble mentality will have disappeared for good.

But poor Steven Keen will already have done his walk to “Kossie-oscar“. Perhaps we will see an Australian version of this musical soon.

What’s on the horizon?

To make sure the media focused its attention on financial reform and not the apocalyptic volcanic dust cloud, the Democratic majority of the U.S. Securities and Exchange Commission (SEC) decided to sue Goldman Sachs last Friday. It did so in time to gain some attention for the passage of the Dudd, sorry Dodd Bill, a financial reform piece of legislation authored (sort of) by the retiring Senator from Connecticut, Christopher Dodd. The SEC move caused an impressive sell off in the market and a lot of anxiety about the future exposure of banks and brokerages to similar lawsuits.

Daily Reckoning regular Eric Fry reported on Tuesday that, when “you shine a light on a cluster of cockroaches, they scatter and hide. But when you shine a light on a cluster of investment banking con men, they simply stare back and reply, “The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation.”

Dan explained what happened here. Not that it’s much of a revelation.

“The product was new and complex,” explained Robert Khuzami, a director from the SEC’s Division of Enforcement, “but the deception and conflicts were old and simple.”

The implications for several other investment banks, which happen to have very similar cases against them in progress already, could be huge. Why Goldman Sachs gets all the press isn’t entirely clear. Especially considering that their case deals largely in CDSs, not CDOs, which means there has to be a counter party betting the opposite way and clients would have known this. The fraudulent aspect still stands though.

Who is really getting bailed out?

Something that has been lost on the press and their readers is the nature of a bailout. When a company, or a country, requires a bailout, they aren’t getting the money for themselves. That money goes to the creditors. Otherwise they wouldn’t need a bailout.

Kris Sayce in our sister publication, Money Morning, pointed out where the UK taxpayer’s money went in the Royal Bank of Scotland bailout:

“It turns out that of the billions of dollars the UK taxpayer gave to Royal Bank of Scotland, USD$841 million of it went to Goldman Sachs to pay for the losses incurred by the bank from its investment in the collateralised debt obligation (CDO) structured by… the “fabulous” Fabrice Tourre.”

Can you guess who AIG’s single largest creditor was? Yep, Goldman Sachs. So AIG gets bailed too. And the Treasury Secretary just happened to be a former Goldman Sachs CEO…

When you bail out a company (or country), you pay their creditors. The attention should be on them.

Are you wondering who Greece’s creditors are yet? We know Goldman is involved in Greek CDSs again, which they used to help hide Greece’s debt levels.

Yu’an us to Revalue?

The focus of Dan’s Tuesday article wasn’t volcanic ash or fraud. It was the process of turning Australian dirt into Chinese steel. Obviously, the engineering side isn’t terribly relevant to the Daily Reckoning. Besides, in a free market that takes care of itself once you have demand for steel. So that is what the Chinese government went about doing – creating demand. Communist planning, capitalist execution. But how is it working out for them?

Quite well so far… Just like with subprime up until 2007. So Dan reckons it’s just a question of timing:

“The basic economic question at stake is how long can you keep producing things in excess of demand for a political objective?”

Funnily enough, American congressmen don’t want to wait and find out. They want the unfair subsidy of currency manipulation to end now. “I want, I want!”

Everyone is telling them that the Chinese don’t respond well to pressure. Maybe President Obama should make a statement outlining how cleverly China has managed to build up such huge dollar reserves. Then the Chinese could happily make a return gesture and use the reserves to bid up the Yuan.

But reverse psychology doesn’t come with much political glory when it’s successful. And political glory is the Holy Grail for a politician. (Surprise!) Playing golf apparently comes a close second.

We wish Barack Obama would do nothing but play golf and leave the people to their tax day tea parties. But when it comes to elections, image is everything and actions mean little. Some politicians are so good at creating an image of themselves in people’s minds, they can even act directly contrary to their supposed values without destroying their image.

A few are so good at this that they manage to be remembered for their image, despite having enacted laws that directly contradict what they supposedly believed in. Ronald Regan and Herbert Hoover are two of these. Supposedly both free market, low debt enthusiasts, they did the opposite in office. But they are still remembered for their rhetoric, not their policies.

Shopping for Banking Regulations in Basel

The Basel Committee has got the Big Four bank’s knickers in a twist. Actually, it’s more their capital that’s being twisted. Because Aussie banks hold large amounts of mortgages without securitising them, they cannot be sold quickly, creating liquidity issues. This makes them different from those successful banks in the UK and US. (Another eight US banks failed last weekend.)

So having been shown up by the financial crisis, the Basel Committee is having another go. Dan discussed it here.

But why not tie banks to the mortgages they make? That would stop them from making stupid ones… Oh, that’s right, the banks pay the campaign bills.

Back to the Boomers

According to Tim from Canada, the Baby Boomers blamed for many countries abysmal fiscal finances were in fact victims, not villains:

“With the greatest respect, the baby boomer generation did not start this collapse into the abyss.

“Again, with the greatest of respect, the Roosevelt generation perfected what was created during the era of the creation of the Federal Reserve.

“The baby boomers, because of our sheer size, merely paid for the mistakes of the Roosevelt generation. Social Security and Medicare, the twin monster which will destroy America, were not created by the baby boom generation. However, the baby boom generation did get to pay to keep the Roosevelt generation in a manner they could not afford and never could. The Roosevelt generation grew old and died on the backs of the baby boom generation.

“The baby boomer generation have made their share of mistakes, but the creation of the abyss facing your great nation was created during the generation of one of your most revered Presidents, Franklin D. Roosevelt.”

For the theorists

The article introducing the gold and silver fraud to our readers has generated some interest. A UK reader wrote in wit the following:

“Dear Mr. Hubble,

“Your comments about Andrew Maguire are interesting. In Britain we found it curious that after the hit and run accident to Mr. and Mrs. Maguire the driver had two other collisions in his anxiety to get away from the scene. The police, using a spotter helicopter, finally apprehended the driver but much to everyone’s fascination, refused to release the driver’s name, or that of his employer. The driver now seems to have disappeared without being charged???”

There is a movement in America that believes President Obama is not constitutionally eligible to be President. The claim is that he wasn’t born in America, banning him from the position. But now the Arizona state government is onto the case:

“The Arizona House on Monday voted for a provision that would require President Barack Obama to show his birth certificate if he hopes to be on the state’s ballot when he runs for re-election.”

Oh … bummer.

Have a great weekend.

Nickolai Hubble.
The Daily Reckoning Week in Review

Similar Posts:

• Government Sachs
• Rule Thumb for Modern Times
• It Should Cost the Germans and the Greeks Roughly the Same to Borrow
• Germany Bails in for the Bailout
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Every now and again, something comes up that is so curious it just needs to be mentioned, regardless of how paranoid it makes us look. The emerging scandal over manipulation of the silver market is one of those things. Some have said it is the largest fraud in history. To make the story even more dubious and enthralling, we shall start … at the beginning:

How many US presidents have been assassinated while in office? (That’s right, the story begins here.)

The answer is four.

Of those four, how many were sound money advocates (favoured gold or silver backing of the currency) and had sound money as one of their key policies?

All four of them.

Lincoln favoured silver backing of the currency after the America Civil War. McKinley and Garfield fought for the gold standard against their presidential opponents. Kennedy managed to reintroduce silver backed dollars before being knocked off. Those silver backed dollars were subsequently taken out of circulation by the Federal Reserve. The “Dead President’s Society” conspiracy is its own story, but not one to be covered here.

The next intriguing bit of history comes from the Credit Rivers case, an obscure but insightful 1968 U.S. court case that bears on whether or not bank money is “real” money. But before we get into that case, one has to understand a basic concept of contract law. For a contract to be binding there must be an exchange of consideration, which is something of value. That is why gifts are not legally binding exchanges. The giver does not receive consideration in return.

The importance of the Credit Rivers case comes from the fact that the presiding Justice recognised that fiat currency is not valid consideration, as it is simply created out of thin air by banks. “Only God can create something out of nothing” is the famous quote from the case. For all the proceedings from that case, you can go here. But the main point is that the Justice (of the Peace) held that the bank could not foreclose on the house in question, as the loan it had created was not valid consideration.

Justice Mahoney then held that the bank could not appeal the decision, as it failed to pay the $2 court fee for lodging such an appeal. Amusingly, the bank had paid this fee, but had done so in the same fiat currency that was previously held to be worthless, thus invalidating their payment!

Justice Mahoney died in a fishing accident after giving his decision. His precedent was not followed.

You may be wondering how on earth is all this relevant to the latest development out of the gold and metal market.

Well, to understand the concerns that people have, you have to understand the history. Now, on to the more recent developments.

Precious metals trader Andrew Maguire informed the commodities trading regulator, the Commodities Futures Trading Commission (CFTC), that there was substantial manipulation of the metals market occurring on a regular basis. For example, he alleges that by purchasing Bear Stearns, JP Morgan had gained control of the precious metals market and was using this control to make significant profits. Other savvy metals traders caught on and simply hung on for the ride.

The CFTC didn’t seem particularly interested in his claims, so Maguire gave them several predictions, based on the manipulations that metals traders expected. Those predictions were completely accurate, but the CFTC simply stated that it was investigating, as it had previously done.

Imagine the police had an informer telling them that a rape would occur, when it would occur and who was going to be the perpetrator and the victim, but they merely watch it happen and then “investigate”. That is what the CFTC did.

Andrew Maguire was thoroughly annoyed at this point and went to GATA, the Gold Anti-Trust Action Committee. GATA has campaigned to expose such market manipulation for many years. The organisation is frequently ridiculed by the mainstream press. But with Maguire’s claims it is now apparently armed with the credible witness it needs.

Representatives from GATA appeared at a CFTC hearing, armed with their new whistle blower’s information, and promptly blew the commodity regulator’s committee out of the water. Unfortunately, the camera filming the testimony happened to break shortly before the GATA chairman began speaking. It began working again shortly after he had finished.

Andrew Maguire, the whistleblower, was recently subject to a hit and run traffic accident. All major media organisations have cancelled their scheduled interviews with GATA. The press is not covering the developments.

It has since emerged that the London Bullion Market trades on 100 to 1 leverage, meaning that for every ounce of real gold, there are 100 ounces of paper gold being traded. If, or when, people try to take delivery, there could be a dramatic shortage, leading to a huge spike in the gold price.

Some have estimated the size of the fraud to number in the trillions.

[Editors note: Please take the time to inform yourself of developments in this story. Only a fraction of it was covered here.]

These two interviews are a good place to start:

Interview with the whistle blower and a GATA representative

Interview with the GATA board and the whistle blower

Nickolai Hubble
for The Daily Reckoning Australia

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Paying the rent in Yuan

Our reserve bank governor got some rare praise from Dan on Tuesday:

“Well you have to give RBA governor Glenn Stevens credit (no pun intended).”

Why the sudden appreciation? (Pun intended.) Well, Glenn came up with a pearl of wisdom in his interview with Channel 7:

“It’s a mistake to assume a riskless, easy, and guaranteed way to prosperity is just to leverage to property.”

Whether the property spruikers take it to heart is another matter. Their “zero the hero” man, Ben Bernanke, continues his quest for global liquidity. But it’s other financiers of Australian property that are in the crosshairs of our readers.

Going by our Daily Reckoning inbox, suspicion of Chinese property investors bidding up Australian property prices is rampant. Responding to demand, as any free market enthusiast would, Dan discussed it in detail on Tuesday.

But what about the implications? Having our flagship resources industry rely on foreign credit and politically driven Chinese demand is unstable enough. Now our house prices rely on them as well!

But why is Glenn talking down property mania? A cynic, and a Daily Reckoning editor, would be inclined to scan for vested interests. You don’t have to scan far in this case. A few paragraphs down from Glenn’s earlier comment, one finds the following:

“I’ve got kids that within not too many years are going to want somewhere of their own to live and you wonder how is that going to be afforded.”

That’s right; it’s exactly the problem that featured in last week’s edition.

Who would want to spread their wings and fly the roost when you have nowhere to go? Why not stick with home and let the parents foot the bills? It’s a logical and financially responsible reaction to house prices. Your kids aren’t making it look like they’ve done an in depth CBA (cost benefit analysis), but who knows?

Metaphorically speaking

About the best metaphor for the direction the world is heading in comes from Daily Reckoning veteran Eric Fry:

“The US government – as well as several governments in Europe – is attempting to supplant aspects of the private sector.

“I don’t think that’s going to work. You cannot ever convert a parasite into a host. They are completely different organisms, which perform completely different functions. So right now we have credit contracting rapidly in the private sector, while it is expanding dramatically in the public sector.”

Discovery Channel fans might recall the zombie snails, who are controlled by the parasite that possesses them. Governments are remarkably similar to those parasites. They lead their host to doom as well. Likening fellow taxpayers to snails is probably not favourable, so we will leave it there.

It’s fair to say that the bond vigilantes are casting an eager eye over the scene, just waiting for the first course of escargot.

Bonding with Kevin

KRudd’s draft legislation for amending tax laws contains some spectacularly exciting provisions.

What, dear reader, do you think of having to pay a bond to the ATO?

We won’t bother with a poll. The Australian provides the details:

“Thousands of small businesses could be forced to put up a security deposit for the tax office under Rudd government draft laws meant to target foreign taxpayers and the shonky operators of Australian phoenix companies.”

The draft supposedly contains some provisions that have libertarian blood boiling:

“You commit an offence if the (Taxation) Commissioner requires you to give the security [bond] under section 255-100 and you fail to give the security as required.”

It even includes the words that give bureaucrats around the world wet dreams:

“… or any other means deemed reasonably appropriate by the tax office.”

Administrative justice anyone?

Obama forgets the kids

As the healthcare debate continues to rage on this side of the Pacific, Americans are proving to be a stellar example of how to get it wrong.

The New York Times explains one aspect of the plight of a national takeover of healthcare:

“Because of the new health care law, Arizona lawmakers must now find a way to maintain insurance coverage for 350,000 children and adults that they slashed just last week to help close a $2.6 billion budget deficit.

“Louisiana officials say a reduction in federal money to hospitals that treat the uninsured under the bill could be a death knell for their state-run charity hospital system.

“In California, policymakers estimate they will have to come up with an additional $500 million a year to make necessary increases in payments to Medicaid providers.

“The federal government has to account for states’ inability to sustain our current programs, much less expand,” said Kim Belshé, secretary of California’s Health and Human Services Agency.”

The stories go on.

But even the supposedly good aspects of the law are proving questionable.

One of the main benefits of Obamacare is that insurance companies cannot turn down people because of pre-existing conditions… unless those people are children. They aren’t provided for by the bill, according to Republicans.

Pelosi’s infamous quote is turning out to be true for Democrats.

“We have to pass the bill so you can find out what is in it.”

It seems the Democrats are relying on the Republicans to do the reading and editing of their law for them.

Apart from the administrative bungles being exposed, there are other issues. It stands to reason that many of those who did not have health insurance before Obamacare were in that position for a reason. There are several examples, but let’s take the favourite example of the poor.

If these people are now spending some of their money on health insurance, what will they spend less money on? Perhaps the food and hygiene items that keeps them healthy?

Home Sapiens

Is it possible that Australians have a unique gene, which causes them to suffer from house price obsession? There seems to be few more plausible arguments.

On Monday, Dan commented on the latest hype:

“President of the Real Estate Institute of Australia, David Airey told the same paper that the increases in sale prices and total properties listed reflected the “surging confidence” in the housing sector. He said that after the financial crisis, Australians were more interested in investing in property than on the stock market.”

Buying high, selling low has worked out well for investors all throughout history…

Meanwhile, at our sister publication, Money Morning, Kris Sayce points out that housing is an unproductive asset.

In other words, buying and selling houses doesn’t really get the economy anywhere. They serve a purpose, but don’t create anything. Building new ones sort of does further the economy, but only in the same way that buying a tulip does.

Both housing and tulips have been caught up in manias that ended in panics. But is it the panic, or the mania that is to blame?

19th century economist John Mills (not to be confused with John Stuart Mill) expressed his opinion clearly:

“Panics do not destroy capital; they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works.”

So, if he had it figured out, why have we still got it wrong? It’s because modern policy makers confuse indicators with goals. They want house prices to keep rising to make people feel prosperous.

But in a market, the reason prices rise is because people want more houses. It’s an indicator to developers that more houses are needed. A rise in prices indicates the market is out of equilibrium and profits are there to be made. Once more houses are built, prices will come down again.

But there exists an institution, infamously known as government, which stops the equilibrium from emerging. It creates laws to limit supply, so the price can’t fall. The weird thing is that people in Australia seem to want it that way.

But eventually, the distance between the market price and equilibrium will become too great. There is no reason why people should want to spend more of their income on housing than earlier generations.

The confusion of goal and indicator is also what leads to the free market being blamed for the crisis. If government policy is directed at improving indicators (thereby making them goals), they cease to indicate anything related to reality. This is known as Goodhart’s Law.

Meanwhile, it seems the indicators themselves are flawed.

An excellent illustration of the property media in action comes from the 5 Minute Forecast:

Bloomberg: Home Prices in 20 U.S. Cities Rose 0.3% in January
Home prices in 20 U.S. cities unexpectedly rose in January, indicating the housing market is stabilizing as the economy expands. The S&P/Case-Shiller home price index climbed 0.3% from the prior month…

MarketWatch: U.S. Jan. Case-Shiller Home Prices Fall 0.4%
Home prices in 20 major U.S. cities fell a not-seasonally adjusted 0.4% in January compared with December, according to the Case-Shiller home price index released Tuesday

It’s not just property mania that is full of statistical flim flam. Check out the latest “Climate Change Error“, although there has probably been another one since I wrote this.

Not Happy Jan!

Social unrest throughout Europe is turning into a serious concern. Put yourself in their shoes. Here is what they might be thinking:

“The bankers caused the crisis, they are getting bonuses higher than ever after being bailed out by our taxes, and now us workers are taking a hit in the form of wage deflation and government budget cuts.”

It really wouldn’t be difficult to stir up a frenzy, and there are plenty of people with an incentive to do so.

Is this the time for a resurgence of unions?

“Union workers across Europe are walking off their jobs as workers protest pay cuts. Britain has been hit especially hard, with newspapers labeling the bout of strikes the ‘spring of discontent’.”

Person of the year is clueless

“An economic puzzle Bernanke can’t solve” is the title of a Reuters article that caught our eye. Of course, the Austrian School of economics has the solution, and has had it for a very long time, but let’s get to that later. First, what is the problem?

“If the U.S. economy is growing rapidly, why isn’t it creating jobs?”

This could aptly be named the paradox of Keynes.

Obviously, there is a concern that the stats are rubbish, but let’s not go there.

Just in case Bernanke is reading this, here is the answer to his puzzle, provided by Peter Schiff in the Wall Street Journal:

“Governments cannot create, but merely redirect. When the government spends, the money has to come from somewhere. If the government doesn’t have a surplus, then it must come from taxes. If taxes don’t go up, then it must come from increased borrowing. If lenders won’t lend, then it must come from the printing press, which is where all these bailouts are headed. But each additional dollar printed diminishes the value those already in circulation. Something cannot be effortlessly created from nothing.

“Similarly, any jobs or other economic activity created by public-sector expansion merely comes at the expense of jobs lost in the private sector. And if the government chooses to save inefficient jobs in select private industries, more efficient jobs will be lost in others. As more factors of production come under government control, the more inefficient our entire economy becomes. Inefficiency lowers productivity, stifles competitiveness and lowers living standards.”

Peter Schiff’s article was from 2008, while the Austrian School of Economics theories he uses are much older. It seems they have been vindicated, but still not recognised at the Federal Reserve.

Out of left field

Renowned professor James Lovelock has come up with some cracking climate change comments. For those of you thinking this is outside of our scope, think again:

“It may be necessary to put democracy on hold for a while.”

Umm. Why?

Humans are “not clever enough”.

Oh.

The last comment we’ll mention here is one that is particularly amusing, as it contradicts the first:

“You need sceptics, especially when the science gets very big and monolithic.”

Being sceptical in a dictatorial regime isn’t good for your health.

Nickolai Hubble
The Daily Reckoning Week in Review

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• Property Buyers Are Not Buying Property at All
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Defiance at the Fed

James Dunigan of PNC Wealth Management sums up market sentiment for the week:

“The recovery is in place and by all evidence looks to be sustainable and at the end of the rainbow, that all filters down to corporate profits.”

Perhaps the St. Patrick’s Day theme got out of hand for James. There is seldom much to be found at the end of a rainbow – not even leprechauns. Apart from that, rainbows aren’t sustainable either. But it’s the “all evidence” bit that is ridiculous. He sounds like a global warming disciple. More on that later.

Any real recovery would be accompanied by interest rate increases from the Federal Reserve. Instead, the Fed stuck to its guns and butter interest rate. Dan Denning is another step closer to his free beer bet coming off. He even doubts that the Fed will go through with its withdrawal of support from the U.S. mortgage market.

Instead of a recovery, at this point, all evidence points to an economy on life support. The drugs are keeping the patient alive, but each day they cause more damage. That’s why the decision to keep rates flat wasn’t quite smooth sailing for the chief moneyprinter – Ben Bernanke.

But what does the FOMC’s sole defiant dissenter say to justify his position? Thomas Hoenig of the Kansas City Fed, and the oldest serving policy maker, inadvertently represented the Austrian School of Economics when he wrote:

“… continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to the build-up of financial imbalances and increase risks to longer-run macroeconomic and financial stability,…”

The lack of reference to inflation is concerning. After all, isn’t that what the central banks are supposed to focus on?

Dan Denning has been hammering out his argument for inflation during the week. This is in the face of deflationist forecasts from those who share his negative outlook. At the heart of his argument is the ability of the government to defeat the deflationary cycle with increasingly absurd ideas – like handing out free money. Who would do something like that, Kevin?

Fed representative Thomas Hoenig also commented on proposed financial regulation in a letter sent to U.S. Senators:

“It is a striking irony to me that the outcome of the public anger directed toward Washington and Wall Street may lead to further empowerment of both Washington and Wall Street in regulating financial institutions.”

Hoenig must be unaware that the author of the proposed regulation is Chris Dodd. This clever politician funded his 2008 presidential campaign in a surprising way. Seven out of his top ten donors were banks that received bailout money in the same year.

How the political system’s funding works:

Taxpayer –» Government –» Wallstreet –» Politicians –» Wallstreet –» Politicians ….

Derivatives Uncovered

Derivatives have come under fire from governments globally. One valuable thing they have done is to expand the financial vocabulary. Trillion is no longer the punch-word it used to be. The Bank of International Settlements brought “Quadrillion” into play. Global derivatives outstanding are now measured in Quadrillions.

Hmm. So if global GDP measures as a fraction of derivatives outstanding, one wonders who actually holds sway in the world. Is it the businessmen and politicians, whose careers are entwined in GDP numbers? Nope, probably not.

Making matters more suspicious is the lack of transparency in some derivative markets. How can something so huge be kept so secretive?

Case in point is the Credit Default Swap (CDS) market. A CDS allows a person to pay another person in exchange for bearing the risk of default – like insurance. According to Dan Ferris in the S&A Digest, which is published by Stansberry & Associates Research, the CDS market is so secretive because it was made to be that way. Can you guess by whom? The government of course.

The Commodity Futures Modernization Act ensured that CDSs were regulated underground instead of by a transparent public futures market, which was being designed before the law put an end to it. A transparent CDS futures market would have caused quite a stir in financial markets.

“Everybody and his brother would have seen prices on CDSs for Lehman Brothers and AIG rising during the summer of 2008, harbingers of impending doom, way ahead of the ratings agencies.”

CDSs are warning of trouble with the PIGS’ bonds now. An ominous sign?

It might explain why governments are being so aggressive towards CDSs in particular.

Hey, politicians are even pulling the sympathy card now:

The matter is “not only an economic problem, but an ethical one” said the Greek Prime Minister, referring to the cost of borrowing he faces. If the CDS markets signal further problems, those borrowing costs will increase.

Doubters of the claim that government regulators would cover up derivative markets from prying eyes of the public, consider their other feat of genius:

“What’s more, banks sold prime mortgage loans and bought “triple-A-rated” collateralized debt obligations (CDOs) only because the Basel II Capital Accords established lower capital requirements for triple-A-rated securities than for prime mortgage loans.”

So, not only did regulators set up the institutions which securitised CDOs, they also told banks they were safer than good loans. Someone had to be forced buy them. No wonder banks struggled during housing collapse.

Road to Nowhere

Countries seem to be racing each other to a debt crisis. That’s why the be-ratings agencies are watching them closely. Occasionally, like a younger sibling, the debt scrutinisers make an irritating remark, before withdrawing into smug state of expressing phony concern about the situation.

Standard and Poor ‘s (could a debt rating agency be named more appropriately?) has warned that the Greek crisis will come to a head next year.

“Three sets of austerity measures this year will lead to an economic contraction of 4 percent in 2010, making it more difficult for the government to raise revenue and carry out the deficit reductions pledged for next year.”

Wow, a 4% contraction.

Credit Agricole analyst Peter Charwell seems to think this is wonderful.

“You’re starting to see some tangible benefits of the austerity measures Greece has put in place.”

Although teargas isn’t technically tangible, stun grenades and rocks are. All of them are beneficial to the person using them, but not so beneficial otherwise.

Germany’s about face on the EU bailout plan has got the Greek government in a pickle. Like any cornered government, it is resorting to threats…

“Greek Prime Minister George Papandreou,” who was elected for his promises to spend more, “set a one-week deadline for the European Union to craft a financial aid mechanism for Greece, challenging Germany to give up its doubts about a rescue package.”

That’s right. They are bullying the Germans into giving them money. Historically speaking, that works best after a world war and leads to another one.

But guess where Greece buys much of its military from?

Germany!

By the way, according to some reader feedback, using the PIGS acronym is racist. Particularly as it includes the proud people of Spain, who would never default, out of a matter of honour, according to one reader. Furthermore – this reader continues – your editor has apparently never been to Spain does thus not know anything about it.

Ay caramba!

The equally racist and untravelled Bloomberg has picked up on the tendency of the Spanish government to simply not complete parts of the budget, and then claim savings equal to the parts left out. They literally left sections blank. Unfortunately, people noticed.

Lombard Street Research points out that, “loan loss recognition, notably in Spain, remains troublingly slow.”

Perhaps they should get Juan Carlos Granda (also known as Robin Hood) on the case. He specialises in public shaming to enhance debt collection activities. According to Granda, and your editor’s Spanish family members, it is about the only way debt collection is likely to happen in a reasonable time frame in Spain.

“The government and justice system don’t do anything … and people think they can get away with anything. We are here to do public justice,” says Granda.

Very honourable.

But it wouldn’t be fair to say that only the Spanish are a bit slow with their loan loss recognition. NAB declared “that its $18.4 billion portfolio of troubled credit instruments had caused losses of $1.3 billion over the past two years… It was NAB’s first disclosure of the damage done by the holdings.”

Dan looked into the implications on Wednesday.

Governments do it with Interest

Meanwhile, Bloomberg reports that “the U.S. will spend more on debt service as a percentage of [government] revenue this year than any other top-rated country except the U.K.”

When interest becomes unaffordable, you’ve got a problem. Unless you can print the world’s reserve currency – then everybody has got a problem.

U.S. President Barack Obama isn’t just neglecting Australia because of his healthcare crusade. His home state of Illinois has a $13 billion dollar shortfall in their $28 billion dollar budget. Libraries are closing down, 20% of busses have ceased running, teachers are preparing for mass layoffs and cop cars have been repossessed! Prisons have stopped taking inmates out of protest that the vouchers, on which the state government has been running since October, are completely unfunded.

It’s a good time to be a criminal in Illinois!

Super Special

Super seems to be dominating the agenda … again. Even morning television can’t leave it alone. TV host Koshie suggested having a “Sunrise Super Special”, much to the distress of his co-host. That was after a viewer sent in an email asking Koshie to “tell it like it is”.

The email, which was read out by the co-host, went something like this:

“If you have $100,000 in your super and you lose 50%, you are down to $50,000. A subsequent 62% improvement will leave you $19,000 short of your original amount.”

That analysis is a bid dodgy, but Koshie’s stuttered reply was the real farce:

“But it’s still gone up.”

No, it hasn’t…

The proportions at work in percentage changes are blatantly obvious, but often misunderstood. It looks like Koshie was in the “misunderstood” camp.

Basically, a fall of 50% requires a 100% gain to return to previous levels. Likewise, a rally of 50% only needs a 33% drop to be wiped out.

Favourable odds?

Anyway, back to Super.

Past Daily Reckonings referenced the OECD report which led to the Sydney Morning Herald’s article “Australian Super Worst in OECD”. With a “$700 bn Shortfall in Super looming,” it hardly seems fair to beat Super while it’s down.

But the cat is out of the bag.

The Australian newspaper has been looking at a Coredata polling effort, which drew the following conclusions:

“Almost two-thirds of Australians support an increase in compulsory superannuation contributions to 12 per cent, …”

That’s odd. People want to give away their money to a government scheme, which ranks last, and has a shortfall which amounts to New Zealand’s GDP seven times over.

Are Australian’s that dumb? No, obviously not, as the article explains:

“But the same survey … showed only 34.4 per cent of members were satisfied with the investment performance of their super fund.”

So, only a third of those polled are dumb. Two thirds (including the dumb one) are gullible.

Where do the politicians sit in this division? The Australian correspondent, Jennifer Hewett (not the Love one), reckons they aren’t bothered much at all. Even if your title is “Superannuation Minister”, you can relax.

“There is no sign [Superannuation Minister Chris Bowen] believes raising the current compulsory 9 per cent figure is a matter of urgency.”

$700 billion? No worries!

Going Green

Another spin-off from the global warming hype has been identified by the UK Guardian.

Apparently, being a global warming disciple does not make you a bad person – unless you act on it. Canadian psychologists Nina Mazar and Chen-Bo Zhong have published a study claiming those wearing a “halo of green consumerism” are “less likely to be kind to others, and more likely to cheat and steal.”

As Al Gore supposedly uses green energy to provide his astronomical home energy needs, it would not be fair to say he is hypocritical on this count. But if the study is right, does that mean his more likely to cheat and steal in an unkind way than your run of the mill global warming denier? Hmmn.

Have a great weekend.

Nickolai Hubble.
The Daily Reckoning Week in Review

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Bacon, Bacon, Bacon…

The bacon reference has been claimed. Marius Gustavson has written a brilliant article on the sovereign debt crisis facing the world. From The Market Oracle:

Smells Like Bacon

“The Greek debt crisis has led many observers to believe a eurozone-wide contagion is in the making, including all of the PIGS – Portugal, Italy, Greece and Spain – and it could spread to the north-western periphery as well. As Ian Bremmer and Nouriel Roubini recently commented in the Wall Street Journal:

“The current crisis in Greece is only the worst example inside the EU. The PIGS … all boast public debt above or headed for 100% of GDP. Though the PIGS acronym was apparently coined by British bankers, Britain, Ireland and Iceland also smell distinctly of bacon.”

Debt distressed nations being called PIGS, countries smelling of bacon, and dubious political spending referred to as pork. What’s next? Maybe Bernanke will bypass money dumping helicopters and grow wings himself – pigs might fly.

The U.S. budget deficit certainly is soaring. It “widened to a record in February as the government boosted spending to help revive the economy.” How spending money that had to be borrowed from someone else can stimulate is a mystery. It just moves money around. How it indebts future generations is not a mystery:

“The figures show the deficit this year will likely surpass the record $1.4 trillion in the fiscal year that ended in September.” The light at the end of the Keynesian tunnel is a runaway steam train loaded with debt obligations.

Wall Street still only sees the light. It has marked its best 12 month performance since the rebound from the Great Depression.

Who done it?

The latest European blame game has begun. After believing the Keynesian free lunch would provide for a cushy future, it seems Europe’s politicians are descending into an even deeper state of denial and delusion. Marius Gustavson at The Market Oracle continues:

“So far the two PIGS most afflicted by the European debt crisis, Greece and Spain, blame mysterious foreign conspirators, rather than home-grown macroeconomic mismanagement.

“Greek Prime Minister George Papandreou expressed the view that the crisis is “an attack on the euro zone by certain other interests, political or financial,” whereas the Spanish government has, reportedly, ordered an investigation into the alleged “collusion” between American investors and the media to hurt the Spanish economy.”

Considering those evil financial institutions hold vast amounts of government debt, as well as facilitate bond markets, the Greeks and Spaniards might want to keep their mouths shut.

Biting the hand that feeds you is a bad idea. This is no less true if that hand is attached to something as unscrupulous as a bank. In fact, it holds even more true.

Amusingly, those unscrupulous banks find themselves in the same fix as Shylock did. If they hold countries accountable for their excesses by requiring higher bond yields, then the bank’s capital base weakens. If they continue to buy bonds, they expose themselves to sovereign risk.

And yes, losing a pound of flesh does compare to losing capital. The real difference is that Shylock could walk away from the debt. Although, with million dollar bonuses, I suppose bankers could walk away quite comfortably. That’s where derivatives like Credit Default Swaps come in. We’ll leave that for another day.

Me, Myself and the Lenders

Sadly, it seems the delusions of politicians have filtered down to the citizens. They now also feel some sort of entitlement to being lent money.

The vast benefits promised by governments and provided by debt markets seemed endless. When it turns out they aren’t, trouble brews. Greece is just the beginning.

“The importance of the shock to public finances in advanced economies is not yet sufficiently appreciated and understood,” said El-Erian, co-chief investment officer at Pacific Investment Management Co, known as PIMCO.

If Greece is where the world is headed (metaphorically speaking) then things could get interesting.

Bloomberg reports that “Greece’s unions will shut down hospitals, airports and schools today in the country’s second general strike this year to protest Prime Minister George Papandreou’s latest round of budget cuts to curb the European Union’s biggest deficit.”

The Economist, far more insightfully, reports that “Militant pensioners unexpectedly broke through a police cordon blocking the road to Mr Papandreou’s office as he was announcing the new measures.”

Please take a moment to picture that.

Militant pensioners… And it’s not like they have nothing better to do. It’s just that they want to claim what they can while they still can. Marko Papic of Stratfor has forecasted that interest will amount to 6% of GDP for the Greeks by next year. That is past the point of no return, according to Professor Altman, who developed a popular model used to calculate corporate defaults.

His reasoning is that Greece faces structural problems, which are difficult to turn around, even in the long run. Based on this, any bailout will be like a bandaid for a cancer patient. Nobody but two year olds and stock brokers would be comforted. That does leave room for a short term rally. Caveat emptor. Please don’t confuse that with Carpe diem.

One clever solution did pop up in the press. According to two German senior ministers, it would be a good idea for Greece to sell a few of its islands to pay off debt. No kidding, zose German politicians are getting power hungry again.

Meanwhile, the Italians are being themselves as well. “For Greece, the problem is completely over,” said Romano Prodi, a former Italian prime minister. The reason this is newsworthy is that a predictor of the Argentinean debt crisis, Charles Calomiris, has stated that Italy is the next Greece in terms of debt problems – because of political corruption.

Be-ratings Agencies

Those ratings agencies are still at it. Having been beaten and humiliated by the public and the government, they are getting their own back.

The ratings agency Fitch warns of sovereign debt downgrades for the UK if plans for austerity are not outlined. If they are outlined, Fitch will realise the severity of the problem and decide to downgrade anyway.

Karma in action.

So, when will the crisis hit? When does the sovereign debt bubble burst?

After staring into a crystal ball for several moments, the answer strikes as being obvious. The sovereign debt crisis begins when people get rational again. It’s that simple.

Rationality isn’t a terribly difficult thing to get a grasp on. But irrationality is a pain in the neck for an economic forecaster. How long it can last cannot be explained, as it is by nature irrational. So you see the quagmire.

For now, my claim is to be telepathetic, not telepathic, of Mr Market’s intentions.

Tightwire to Nowhere

Regarding forecasts on economic growth, talk has again turned to the letters V U W. V being the rapid recovery that often follows recessions, U being a longer period of anaemic growth, and W being a double dip recession. Nouriel Roubini and his team at RGE have indicated they see an increased risk of the W scenario developing.

That is stating the obvious. Government has gone from being a major player in the economy to being the major player in the economy. If its institutions stuff up, the ability of the free market to correct the mistakes is now severely hampered. The problem is that governments inevitably stuff up.

They can’t even manage their own balance sheet, despite having the power of the law to play with. Now they claim to be gallantly walking a tightwire between inflation and deflation.

The managing director of the International Monetary Fund, Dominic Strauss-Kahn, explained this supposed balancing act policy makers face in their use of fiscal and monetary stimulus:

“If we exit too late … it’s a waste of resources, it’s bad policy, it’s increasing public debt, we should avoid this … But if you exit too early, then the risks are much bigger.”

Michael Pomerleano sees it very differently. Rather than bothering with a balancing act, take a look at where the economy is headed:

“Nationalisation of private debt injects considerable inefficiency into the economic system, inhibiting Schumpeter’s process of Creative Destruction that is essential in a market economy and needed to maintain the private sector.”

But what of the audience watching the spectacle? A V shaped recovery isn’t much different to a U or W if the jobs situation remains awful. One quickly gets the impression they just want to see someone plunge to their death instead of prancing around for applause.

For the “history repeats itself” buffs:

“As historical research conducted by University of Maryland economist Carmen Reinhart and Harvard University economist Kenneth Rogoff shows, financial crises are usually followed by government-debt crises. This starts as private debt is shifted onto the balance sheet of the government, through bailouts and purchases of toxic debt. The government-debt problem is then made worse as the economic downturn leads to an increase in expenditures in the form of unemployment benefits and stimulus spending, coupled with a decrease in tax revenues.”

Here in Australia, the economic outlook could not be more ominous for history fans. According to The Age, the profit outlook for SMEs is the best it has been for 2.5 years.

“Optimism among small and medium size firms about future profits is at its highest level since before the global financial crisis, a survey finds.”

“… before the GFC” are the key words. Just like in 2007, the future is based on optimism. When that turns out to be a load of rubbish, the games will begin again.

Capital Crunch

Enthusiasts of the Austrian School of Economics have mixed feelings for legendary economist Adam Smith. Nevertheless, we don’t like to think of him rolling over in his grave. He must have done so when it was decided that the 20 pound note would bear his face.

You see, Adam Smith was an investor and firm believer in Scottish Free banking. The idea that government should hold a monopoly over issuing currency would not be agreeable to him. Putting his face on a Bank of England note is like having Tony Abbott on abortion ads.

Strangely enough, the UK still has 10 note issuing Banks. People don’t seem interested in the reason. They have bigger things to worry about – like what their government has in store for “its” banks. The Telegraph reports:

“Jonathan Pierce, from Credit Suisse, believes UK banks will have to reduce the size of their balance sheets by as much as £530bn over the next three to four years to meet new regulations.

“According to his analysis, British banks need to issue £420bn-£750bn of long-term wholesale funds. “We don’t think this is plausible and hence we expect balance sheet footings to fall by 6pc-18pc to compensate,” he said.”

In a world that relies on credit to turn, somebody has to get burned if bank balance sheets really do contract that much.

House Prices Uncovered

Based on feedback, it seems property comments are fair game for the Daily Reckoning. So here goes.

That reputable institution, the Reserve Bank of Australia, has not informed us that house prices could rise. It has warned us that house prices could rise. Hmm, so that’s a bad thing now.

It doesn’t have to be. In a free market, an increase in house prices is a signal to builders to build more houses. Once they do, prices normalise again, as supply balances demand.

The idea that house prices can steadily rise relative to incomes is flawed. Why would one generation want to pay more as a percent of their income on housing than another?

More importantly, why would builders not build more homes as prices rise?

The answer is zoning laws, town planning and all regulations remotely similar. Yes, it’s the government again.

If you examine where house prices rise (and then plummet) the most and compare those areas to where prices remain stable relative to income, you will find a remarkable correlation to the intensity of planning and zoning laws.

This was best illustrated in the US. Areas that had the most planning experienced the biggest booms and busts because supply couldn’t adjust to demand. Areas with low planning had little problem and simply built more as demand increased. They haven’t experienced the same subsequent bust either.

Have a great weekend.

Nickolai Hubble.
The Daily Reckoning Week in Review

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Marked up Discounts

Monday began with jitters over the market’s reaction to a raise in the U.S. discount rate. In other words, the Federal Reserve increased the rate at which select banks can borrow from it.

The so called ‘discount window’, was intended to be an emergency lending facility. The lender of last resort. Instead, it’s become the lender of any resort. The increase in the discount rate means it won’t be as cheap to borrow money from the Fed.

The relevance to you shouldn’t be underestimated. Aussie banks get much of their funding from overseas, so they are affected by what happens in the global interbank market. If the increase in the discount rate is a signal that the broader interest rate is going to be raised as well, then this would affect the availability of funds and their cost.

In a debt drugged, liquidity obsessed world, a change in interest rates can go from affecting profitability to affecting solvency very quickly. And it’s not just the banks that are high on cheap credit. Take a look at a listed company’s balance sheet. Most of them use leverage to boost their returns.

Low interest rates encourage this.

The reason the western world economy has become particularly interest rate sensitive is because of the way it uses debt. Instead of funding an asset with debt and then paying it off with the increased revenue, more debt is used to pay off the previous borrowings as they come due. This is referred to as rolling over debt.

By doing this, a company (or government) is able to sustain a high level of leverage over time. The debt is never truly repaid.

But, if interest rates rise, then the cost of borrowing goes up. Traditionally, this would have decreased the amount of borrowing. In our modern economy more must be borrowed in order to pay off the old debt. That means companies have no choice but to accept a change in rates.

The financial market reaction to a potential increase in the more important Fed Funds Rate would not have been pleasant. However, this unpleasantness didn’t eventuate, indicating that financial markets expect rates to sit tight for some time to come. Based on this, Dan Denning is a step closer to declaring victory over our Money Morning editor Kris Sayce, with several beers at stake.

Neither editor is being suspicious enough in their analysis. Let’s take a trip down memory lane with a former Federal Reserve economist, Michael Belongia. What happened in the past when the discount rate was changed?

In this podcast, Mr Belongia talks about how a change in the discount rate can lead to a change in the actual interest rate without FOMC approval, or much media attention. Going behind the back of the FOMC, which is supposed to set the interest rate, is scandalous. That didn’t stop it from happening regularly, according the Belongia.

He explains that the spread between the discount rate and fed funds rate should be kept constant according to Fed policy. So, if the Fed’s Board changes the discount rate, then the Fed Chairman can march down to the Fed’s trading desk and instruct the traders to change the Fed Funds rate to maintain the spread. This conveniently avoids the often less complicit FOMC.

Belongia’s accounts are shocking to anyone who believes in the integrity of that particular institution and sickening to the sensible people who don’t.

As mentioned, governments around the world are also exposed to the problem of having to roll over debt. To Senator Joyce’s delight, the lucky country is no exception. Dan Denning points out that “… according to 2008 data, over $400.1 billion dollars of Aussie foreign debt – or 35.4% of the total – matures in 90-days or less. Nearly half the debt total – $514 billion – matures in one year or less.”

That’s a lot of debt to refinance on such a regular basis, so any change in interest rates will be felt quickly.

The press often refers to the shortening maturity of government debts. This implies governments will have to roll over debt more often. Such shortening has occurred in the U.S. and is now a major concern. Former Federal Reserve Chairman Alan Greenspan has referred to it as the “critical Achilles heel”.

The “greatest financial crisis globally ever”

On Tuesday, Bloomberg reported the confession of Kingpin Alan Greenspan. At least, we consider it a confession. Low interest rates have largely been blamed for the financial crisis by those who warned of its imminence. Greenspan set those rates artificially low. Often in a cunningly deceptive way, according to Mr Belongia. Anyway, here is how Greenspan’s conscience was finally cleared on Bloomberg:

Former Federal Reserve Chairman Alan Greenspan said the financial crisis was “by far” the worst in history and called the recovery from the global recession “extremely unbalanced.”

The world economy has undergone “by far the greatest financial crisis globally ever.”

Greenspan said that while the economy was in worse shape in the Great Depression, the recent financial crisis was potentially more harmful than that in the 1930s because “never had short-term credit literally withdrawn.”

Greenspan also said “fiscal affairs are threatening this outlook” for recovery, as Congress and the White House face difficulty raising taxes or cutting spending.”

So, not only is his reconciliation late, but his diagnosis is too.

Speaking of confessions, our other ‘favourite’ economist, former Enron adviser and Nobel Laureate Paul Krugman, has declared his ignorance publicly:

“I’m craving the chance to do some deep thinking, and I haven’t been doing a lot of that.”

While this fact is familiar to most, it does not excuse Krugman’s behaviour. Having consistently advocated the inflation of economic bubbles, to the devastation of homeowners, employees and shareholders around the world, he now advocates a level of government debt that would make Senator Joyce faint, or pop, whichever comes first.

But best of all is this part of Krugman’s article:

“I guess doing the really creative academic work does require a state of mind that’s hard to maintain throughout your whole life.”

Creativity! Economics and creativity? Economics is about understanding timeless principles. Perhaps this is where he went wrong – too much creativity. We have seen the results of Krugman’s creative solutions, indicating he doesn’t understand the economy, or wishes to indebt future generations beyond help.

Resources Comeback

RBA governor Rick Battelino explained that the resources boom has overcome an interruption known as the GFC:

… now that has passed, the underlying dynamics of the resource boom are starting to reappear…

It’s hard to put a finger on exactly how much investment is going to take place, but I don’t think it’s unreasonable to expect mining investments to rise to 6 per cent of GDP over the next few years. That would be about twice as high as it got to in the previous boom. It’s a very big boom.

It certainly is big. But so are China’s resource reserves.

In an article on oilprice.com, Dave Forest of the e-letter Pierce Points, warns of the potential price reaction should China decide to begin using those reserves, or even selling them. In fact, they may have already started, with vast steel exports going to Europe.

The effect a short term fall in commodity prices could have on Aussie resource investment and development could be pivotal to the future of the Australian economy.

China itself is of course an economic basket case, as cleverly shown in this business spectator slideshow.

Nevertheless, it seems a BRIC barbeque is roasting the PIIGS and may provide demand for resources to fuel their fire. (Thanks to Daily Reckoning reader Wayne for the inspiration on that one!)

Confidence

Confidence indicators took a hit in the U.S. and Germany, while U.S. new home sales dropped to a record low. This is particularly striking, as central banks often tout these two factors as their primary focus. “Restoring confidence in the market” and “supporting house prices” are phrases that echo through the halls of the central banks on a continuous basis.

Meanwhile, the US unemployment figures are proving disastrous, let alone the unemployment itself. The American Bureau of Labour Statistics has its own numbers in such a mess that the pollster Gallup has decided to help out.

The Poll informed the BLS that “nearly 20 percent [of the 20,000 adults in the work force polled] were working part time in January because they couldn’t find a full-time job or had no work at all, and that they are having trouble affording basic necessities like food, shelter and health care.”

This tells a different story from the BLS estimates of below 10% unemployment.

U.S. banks continue their slide into oblivion, with 4 of the 161 bank failures since 2009 recorded last week. The outlook isn’t much better. Bloomberg reports that “hundreds of banks may face insolvency as losses mount on commercial real-estate loans, according to a Feb. 10 report by the panel appointed by Congress to oversee the U.S. bailout program.”

Meanwhile The Telegraph uses some spectacular phrases in an article titled “Failure to save East Europe will lead to worldwide meltdown”. It even breaks the language barrier with the following: “…set off round two of our financial Götterdämmerung.” Götterdämmerung roughly translates to Godly twilight, implying an age of saviourless darkness.

Next up it suggests a “Monetary Stalingrad” and Eastern Europe “blowing up right now.” A more surgical approach was taken by Latvia’s central bank governor, who declared the Latvian economy “clinically dead”, while protesters “trashed the treasury and stormed parliament.”

Needless to say, an excellent article.

Strangely enough, stock markets remain comparatively buoyant and Australia seems to be trundling along happily. Whether Mr Market has sucked in enough suckers before another crash is unclear. Daily Reckoning editors would probably be more concerned if the media was more optimistic, as this indicates complacency.

The Economic Climate

Former IMF economist Jeffrey Sachs provided some creativity of his own in a recent article:

Climate change science is a wondrous intellectual activity. Great scientific minds have learned over the course of many decades to “read” the Earth’s history, in order to understand how the climate system works. They have deployed brilliant physics, biology, and instrumentation (such as satellites reading detailed features of the Earth’s systems) in order to advance our understanding.

The Guardian, points out otherwise:

Scientists have been forced to withdraw a study on projected sea level rise due to global warming after finding mistakes that undermined the findings.

This article was previously put forward as proof of claims made in the infamous IPCC report. The official withdrawal included the statement that “… it’s one of those things that happens. People make mistakes and mistakes happen in science.”

While we are in agreement that mistakes happen, we do not agree that government policy should be based on anything quite so mistaken. This is especially so, as government policy is more often than not an inherent mistake as well.

In keeping with brilliantly balanced and fair journalism, the Guardian published the article of Jeffrey Sachs two days before the article about the withdrawal of the study. I wonder what readers think of that.

In the name of financial stability!

Dan Denning also reported on the latest government scheme to support its funding aspirations:

Yesterday’s Financial Review even mentioned the possibility that a shrinking government bond market would be a problem for Australian banks. That’s because a new regulation proposed by the Australian Prudential Regulatory Authority (APRA) would require a certain percentage of bank assets to be made up of high credit quality bonds. And MBS.

MBSs are Mortgage Backed Securities, those things that have a habit of blowing up when house prices fall.

Acropolis Now

According to Porter Stansberry, the publisher of Stansberry and Associates Investment Research, the Greeks have pulled off a feat that would make Sun Tzu jealous. Greek military spending has been excluded from the annual budget, because it is a “state secret”. So, according to Stansberry, about 30% of the Greek governments’ spending isn’t even declared.

Nickolai Hubble
The Daily Reckoning Week in Review

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Mainstream Reckoning I

The past week has been confusing. Stock markets around the world have rallied, but the elation doesn’t seem to be spreading. Instead, the bastions of optimism and long standing opponents of the Daily Reckoning have turned gloomy and sometimes downright apocalyptic.

The first exhibit is Mr. Debelle, the Assistant Governor of the RBA:

“While most of the recent jitters have been associated with sovereign concerns, I think the risks stemming from the financial sector are still there. A significant risk is that we are still yet to see the full impact of the weakness in the North Atlantic economies on the loans on the books of financial institutions.”

That is gloomy. But hold on to your hats, here comes worse.

Albert Edwards from Société Générale has broken the mould when it comes to being an investment banker. In other words, he is saying it like it is. Exactly like it is.

“My own view on this is that obviously we should never have got into this wholly avoidable mess in the first place. But having got here, there really is no way out that does not trigger a major market-moving upheaval.

“Ultimately economic prosperity over the past decade has been a sham: a totally unsustainable Ponzi scheme built on a mountain of private sector debt. GDP has simply been brought forward from the future and now it’s payback time. The trouble is that, as the private sector debt unwinds, there is no political appetite to allow GDP to decline to its ‘correct’ level as this would involve a depression. So burgeoning public sector deficits and Quantitative Easing are required to maintain the fig-leaf of continued prosperity.”

The main thing we see missing from Mr Edward’s analysis is the role of monetary policy in financing the mountain of private sector debt, while government legislated to encourage it. By setting rates artificially low, the Federal Reserve made money cheap and the government then put that money to use by implementing affordable housing policies. Strangely enough, this was all done while touting free market rhetoric and the benefits of deregulation.

So now, themselves confused, global institutions are having a bit of an identity crisis. Even the IMF has decided to go against the mainstream by suggesting an “overthrow of inflation targeting as the central goal of economic management.” While we agree in principle, we do not “urge inflation be allowed to rise to 4 per cent to give governments a better ability to manage downturns.”

This idea is blatantly stupid. But who are we to claim that? Unlike the IMF, we have not been accused of destroying African agriculture nor disregarding human rights. In fact, if we had the IMF’s track record, we wouldn’t be able to sleep at night. Our humble suggestion, along with many of the people who predicted the crisis, is to not have an IMF, nor a World Bank, or even a central bank.

On that note, it is worth going off on a tangent for a moment. The idea that government formed institutions can bring about free markets and globalisation is a paradox. The book “Globalization and Its Discontents” by Nobel Laureate Joseph Stiglitz is an amusing illustration of this inherent contradiction. The book is not about globalisation, so the discontents identified aren’t even relevant.

The book is about the IMF and its failures. For some reason, Stiglitz thinks globalisation comes about by management from institutions like the IMF. It is in fact the absence of institutions like the IMF and World Bank that defines globalisation. That is something people need to grasp for globalisation and its “contents” to emerge.

Anyway, let’s focus on the suggestion of abolishing central banks.

Last week featured a discussion of how banks are the most regulated businesses in the world. They cannot control the price they provide their goods/services at (the interest rate), nor can they control how much they sell (the money supply). Both of these are controlled by the central banks. (See lasts week’s edition for a more detailed explanation).

Deregulation is meaningless if you can’t even control price and quantity, so blaming the crisis on regulatory reform or greed is just ignorant. Only the central bank has enough influence to cause a crisis in the banking system. A free market doesn’t stuff up that badly.

Ponder for a moment a world without a central bank manipulating interest rates and without a financial services regulator implementing regulations. What do we get? Well, historically speaking, we get the safest banking system possible.

Don’t believe it?

Check out these podcasts on Free Banking and the Austrian Business Cycle. For a more current example of how transactions occur safely, but out of the government’s sight, check out Hawala Banking. You just gotta love the free market at work – because it works.

Fear the Boom and Bust

For those of you who don’t like podcasts, but want an understanding of the crisis, I suggest the following rap video. It is more informative than any economics lecture I have ever been to.

Part of the rap is about the Austrian Business cycle theory, which explains how the crisis we are in comes about and how it plays out. “Blame low interest rates” says the chorus.

Here are the key verses:

“The place you should study isn’t the bust
It’s the boom that should make you feel leery, that’s the thrust
Of my theory, the capital structure is key
Malinvestments wreck the economy

“The boom gets started with an expansion of credit
The Fed sets rates low, are you starting to get it?
That new money is confused for real loanable funds
But it’s just inflation that’s driving the ones

“Who invest in new projects like housing construction
The boom plants the seeds for its future destruction
The savings aren’t real, consumption’s up too
And the grasping for resources reveals there’s too few

“So the boom turns to bust as the interest rates rise
With the costs of production, price signals were lies
The boom was a binge that’s a matter of fact
Now its devalued capital that makes up the slack.”

If this sounds familiar, have a look at the Albert Edwards quote above. Mr Edwards comes up with the same argument almost 100 years later than the Austrian School of Economics.

It’s the “expansion of credit” that signals the onset of another bubble, or “fig-leaf of continued prosperity.” If you don’t see that expansion of credit happen here in Australia, then we may be heading for trouble instead of another fake recovery. We will keep you posted on that.

Mainstream Reckoning II

According to The Telegraph, Société Générale isn’t just talking the talk:

“Société Générale has advised clients to be ready for a possible ‘global economic collapse’ over the next two years, mapping a strategy of defensive investments to avoid wealth destruction.”

So it’s official now. You should be concerned. Alan Kohler is now doing some reckoning in the Business Spectator.

“In general, what we are seeing is not just a Mediterranean muddle – it is the beginning of the great global fiscal stimulus reckoning… In other words, the entire western world is insolvent and each country is facing its own day of reckoning – starting, appropriately enough, in Greece, the place where western civilization itself began.”

The article carried the same title as a book written a colleague of ours in 1992.

“In The Great Reckoning, Lord Rees-Mogg and I [James Davidson] warned that the coming fall in real estate would cost trillions as the ill-considered guarantees kicked in, on Freddie, Fannie and other guarantees that proved to be AIG-style Credit Default Swaps on real estate.”

Noting the date, it would seem Jim is worth listening to. What is his latest claim? Nothing less than an upcoming “Little Ice Age”. He even coined a term to describe the evidence cited by the global warming camp. You’ll find it just below.

Statistical Falsies

No, the subtitle is not meant to read “Statistical Fallacies”. The word “Falsies” refers to the un-biological content sometimes found in bras. Statistical falsies are proving just as disappointing to the global warming camp. I find myself on thin ice here, so let’s get back to the point.

On the real climate change front, the former Chairman of the IPCC has made an intriguing point about the amassing “errors” made by its “scientists”. If, as the IPCC claims, these “errors” are innocent, then why do they all overstate the impact of climate change? Innocent errors would imply a mixture of results, while it seems the fallacious claims of IPCC cited material all point to global warming.

My personal favourite of those “errors” was the claim that Himalayan Glaciers would disappear by 2035. Evidence suggests they got their numbers muddled. 2305 is more like it. Sadly, the data still suggests they will disappear… Just as they have in other places around the world since before man first rudely released the greenhouse gas methane.

The Great American Liquidation Sale

Dan Denning’s predictions of China’s attitude toward US government bonds have gone from being scoffed at, to reality. He reports in the Daily Reckoning that “foreign holdings of U.S. Treasury securities fell by $53 billion December. China reduced its holdings by $34.2 billion. The end game is beginning in the Chimerican relations.”

CNBC manages to paint a much brighter picture with the title “Foreign Demand for US Treasurys Takes Record Fall”.

One wonders what could happen to the banks, who hold vast reserves of US treasuries to sure up their capital structures. “U.S. Treasury and agency debt makes up about 60% of the world’s banking reserves” says Porter Stansberry. Banks are on shaky ground as it is (real estate). Dan Denning named this a “double collateral whammy”.

Could banks survive a big hit to US Treasury prices?

Of course they could, just not by themselves. They have learned the government will come to the rescue – if the size of their bets are big enough to cause instability to the wider economy.

But then again, the legendary Paul Volcker has other ideas:

“If a big non-bank institution gets in trouble and threatens the whole system, there ought to be some authority that can step in, take over that organization and liquidate it or merge it — not save it… It’s called euthanasia, not a rescue.”

As Mr Volcker is President Obama’s economic advisor, his proposal is worth paying attention to. Except that a fall in treasury prices would spell trouble for just about all banks at once, so it would be more like genocide than euthanasia.

Acronym Update

Thanks to the readers who have submitted their alternative acronyms for debt ravaged nations. Unfortunately, I assumed it was a task that could be safely left to sophisticated and mature Daily Reckoning readers, so I didn’t do any pondering myself. The endless variations of the following should have been predictable: “PIIGSUSUK (PIGS-U-SUK).”

Although adopting this acronym would allow bacon references going forward, it does not have a nice ring to it.

Strangely enough, the PIIGS matter has become quite an issue. No, not the debt, just the name. Particularly enjoyable was the specific attempt to point out the acronym in a Bloomberg article.

“With all of the issues the EU had with the PIGS, one would think we would see a continued flight to quality,” said Thomas L. di Galoma, head of U.S. rates trading at Guggenheim Partners LLC, a New York-based brokerage for institutional investors. He used an abbreviation for Portugal, Ireland, Greece and Spain.

Did he now! Golly gosh.

Meanwhile, a big thanks to David G. for submitting the best new acronym for debt ravaged nations:

BIGPISA = BRITAN, IRELAND, GREECE, PORTUGAL, ITALY, SPAIN, AMERICA

Those nations certainly look like they are leaning towards a collapse.

Also, thanks to James for sending this in:

I quote from the instructions [of Monopoly]: ‘The Bank never “goes broke”. If the bank runs out of money, the Banker may issue as much more as may be needed by writing on any ordinary paper.”

Ah the irony.

Nickolai Hubble
The Daily Reckoning Week in Review

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A Weak Week?

Stock markets around the world got the jitters, stumbled and then face planted. And that was just the first two days. Will the mud stick, or will the market get up and go-go-go from here on?

Why not ask Bill Bonner?

“We’ve had our bounce. Now, we’ll take the long slide down to the ultimate, final, this-is-where-it-stops end.”

Personally, I don’t think sliding is quite the right word. Indexes don’t slide around, they get pushed and shoved all over the place.

The strange thing about indices is that they only include the better performing companies. Most indicies have requirements for size or other factors before a company is included. If a company’s share price falls enough, it is often deemed too small to be included in the index any longer. Thus, the underperformers aren’t included in the index over time. The markets call this survivorship bias.

I call it fraud.

That’s because the “buy and hold” strategy the mainstream advocates is based on index returns over time. Buying and holding a diversified portfolio won’t necessarily get you the index returns, not that they are favourable in the first case.

If you diversify to the extent that the mainstream suggests, chances are that you will pick a lemon. It would only take one such lemon to make the whole portfolio sour. Meanwhile the index could happily continue on its way up, having dropped the lemon from its basket of companies.

Practice makes Perfect

We now know that world governments are perfectly comfortable with their “whatever it takes” attitude. Nobody else is. The humorous aspect to this is watching fund managers trying to work out where to park your/their money. Every country has a government willing to greet funds with open arms and an interest payment. More and more of those governments are in trouble though.

There has been much hype over ratings downgrades and increasing insurance costs on government bonds. What people are discovering is that there isn’t anyone to bailout a government. Well, at least not with real money. Central banks have an infinite supply of funny money waiting to be created from thin air, but we will get to that in a moment.

Did you really think that the risks inherent in the economy simply vanish when the government takes them on? Nope, they’re still there. In fact, you the taxpayer has taken them on.

Strangely enough, the government of choice when it comes to parking your money during dangerous times is the American one. Whenever markets tank, the American dollar and its government’s bonds seem to surge. Daily Reckoning readers know we consider this to be absurd. The American government is probably worse off than many countries in the long run.

So why does the “flight to dollars” commence each time world equity markets take a step backwards in their weird dance routine? Well, it’s all got to do with liquidity.

“The secondary market for U.S. Treasury securities is the most liquid secondary market in the world. The spread between bid and offer prices is usually considerably narrower than other securities, making most Treasury issues easy to purchase and sell. [Emphasis added]”

When you don’t know what to do, you try to keep your options open. Treasuries earn small amounts of interest, but are easily convertible to money, even in the large quantities that some funds deal in. This gives even the biggest investor the flexibility to move fast. The thing is that these government bonds probably aren’t worth holding on to for very long.

This leads to an incredible opportunity for investors. It’s “a no brainer” to sell short Treasuries says Nassim Taleb on Bloomberg. “Every single human being should have that trade.” Nassim’s ability to forecast the crisis made him and his book “The Black Swan” a household name.

The list of people who agree with him is enormous and includes some big players. But that makes me nervous. If everyone agrees, why has nothing dramatic happened? The answer we venture is that investors don’t want to get caught out investing outside of the US, just in case the flight to the dollar occurs again.

However, consider that Bernanke and his fellow counterfeiters have put in some good practice at manipulating markets. They can engineer quite a rally through their policy tools. So how does this play out?

Simply put, the Fed can support bond and other asset prices all day long, but only at the expense of the value of the US dollar. It can print money to buy US government bonds and other assets, but more money means that money is worth less – that’s inflation.

The illustrious forecaster of the financial crisis, Peter Schiff, is often misunderstood. I recall a video where he refused to give his prediction for how far stock markets would fall. After much coaxing from the TV host, an answer was finally given, much to the confusion of those watching.

The answer was that the Dow (the index commonly quoted) will be worth “1 ounce of gold”. This implies a significant fall in the Dow, or rise in the price of gold. What Schiff means is exactly my point above. The Dow could go anywhere if the value of the dollar changes as well. If the Dow rises by 50%, but the value of the dollar falls by 90%, you still have a whopping loss.

So, why one ounce of gold?

As gold is considered the only real money that has withstood the test of time, it is a better asset to measure the Dow against than any paper currency. Any change in the value of the dollar should occur in the value of gold, thus offsetting the instability of the dollar.

Of course, the value of gold isn’t just influenced by inflation, but it remains the asset which has outlasted many other paper currencies. An ounce of gold could buy you a snazzy outfit in Roman times and can still do the same in Rome today. Its value remains. Meanwhile, the Zimbabwe dollar and the Reichsmark don’t buy much at all.

Schiff may not only be right in his prediction for the Dow, but he has made it in a way that only savvy investors can understand.

The Ouzo Effect

Another possible kick in the shins for those shorting US government bonds, or the US dollar itself, would be a full blown sovereign debt crisis striking in Europe before the US, creating rally in the “safe” USA.

Nouriel Roubini, another predictor of world economic problems, has been vocal about the possibility of problems in Europe. In fact, he sees the potential for a serious shakeup of European economies: “Down the line, not this year or two years from now, we could have a breakup of the [European] monetary union.”

If the UK weren’t in as much, or more trouble this would bring delight to their faces. “Sound as a pound” is a favourite saying of one of my friends. Unfortunately, the PIIGS acronym may have to get a lot longer very soon.

“The problems currently faced by peripheral Europe could be a dress rehearsal for what the US and UK may face further down the road” said Jim Reid, a strategist at Deutsche Bank.

We would like to invite readers to submit their suggestion for a new acronym to include the US, UK and any other debt ravaged nations. Sadly, this will mean we won’t get to use a bacon analogy going forward.

But your former Daily Reckoning Week in Review editor, Dr Alex Cowie, has pointed out something better than bacon. It’s called the “Ouzo effect”.

“This is where we see contagion [from Greece] pass across to the other European countries with bad balance sheets like Portugal, Italy and Spain, the so-called ‘PIGS’. If this situation plays out slowly, and investors get little reassurance from the ‘PIGS’, then high risk assets such as mining equities may offer even better buying opportunities in coming weeks.”

For the record, Ouzo is a brilliant Greek alcoholic beverage. I would recommend it over mining stocks any day.

The Business of Banking

The Australian government has announced the withdrawal of the wholesale funding guarantee it has provided for some time now. In other words, the banks are going to be on their own… More or less… To some extent…

Let me ask you a simple question. If you were a butcher, baker or candlestick maker and the government decided how many fillet mignon, cupcakes or candles you could sell, how would you feel? What if the government then decided at what price you could sell those items?

Any person operating under those constraints deserves your utmost sympathy, right? It sounds like something out of Stalin’s Russia and Mao’s China.

There is, in fact, a huge industry in Australia operating under those very constraints. The price it sells its goods/services at and the amount it can sell are largely set by the government. In fact, the industry operates much the same way around the world, under the same or similar crippling circumstances.

Strangely enough, that very same industry has been accused of rampant greedy capitalism and profiteering. Even more surprising is that the regulation applied to the industry isn’t even decided on by the government. A private institution, unaccountable to government makes the rules.

What is the industry I’m on about?

You are probably thinking to yourself, “This plonker thinks I didn’t read the sub-heading he wrote himself just a few lines ago.”

That’s right, I’m on about the banks. And not about any new regulations either. I’m talking about business as usual.

Banks sell money in the form of loans. Their price is the interest paid. The regulator known as the central bank sets both the supply of money and the interest rate. Banks can theoretically diverge from this, but competition effectively keeps them pinned down to whatever the central bank deems as appropriate.

In my opinion, there is no industry in the world more regulated than banking. Everyone else I can think of can control the price they sell at and how much they can offer to sell.

Of all the people!

After almost bringing the world economy to its knees and relying on government support to survive, the banks, credit ratings agencies and economists are back to telling the politicians they are stupid. Poor old Barnaby Joyce. Apparently he was being irresponsible by warning of too much debt. Hahaha. It’s so ironic in so many ways.

The Labor party considers itself to represent the Aussie battler. Yet the Australian points out that “Swan [is] to resist [a] low-income wage breakout.” This comes after the same newspaper reported in 2008 that “Wayne Swan will make it a “top priority” in his first budget to protect low- and middle-income earners, after a study revealed the lowest-paid fared well under his predecessor, Peter Costello.” Maybe being a top priority of the government isn’t so great.

Meanwhile, the guy who was supposed to warn us of instability in financial markets before his promotion to Treasury Secretary, Tim Geithner, has made himself look ridiculous. Again. He said the U.S. government “will never” lose its triple A credit rating. It is well known that one does not grow up to face reality without leaving “Never Never Land”.

China’s military has other ideas for the US government’s borrowing plans, after being poked in the eye by the sale of US arms to Taiwan.

“Just like two people rowing a boat, if the United States first throws the strokes into chaos, then so must we…. attack by oblique means and stealthy feints… For example, we could sanction them using economic means, such as dumping some U.S. government bonds.”

The Chinese government holds about US$ 790 billion of those bonds and a further US$1.95 trillion in US dollar reserves…

Nickolai Hubble
The Daily Reckoning Week in Review

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