The FASBI Flop

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  • What Bailout?
  • The Spillihp Curve
  • The FASBI Flop
  • It’s all about spending
  • & more

Gloom, or just Government?

Newspapers these days! It’s all just bad news. Between them, the Herald Sun and The Age had four front page news items a few mornings ago. Stories of war, corruption, harassment and we can’t remember the fourth one. But what struck home is that each of these stories was about the failures of government and its minions. Yes, not one smidgeon of anger directed at the free market. Truly heart warming.

What Bailout?

The Irish bailout is not a done deal. The Irish have to live up to several imposed changes if they are to get the money. And politicians are deserting the government’s efforts to impose those changes. Now the whole thing is descending into a game of chicken. Will the opposition oppose the budget, which carries out the required changes?

This little skirmish could really rout the markets. If people expect the bailout to go ahead, but the Irish put up a fight, things could go very fast from there. But why are the Irish not glad to get Europe’s cash? Well, some of the “proposals” are pretty harsh on the welfare state. And some are downright stupid.

Remember when people worried about bank bailouts resulting in even bigger “too big to fail” banks? Well, according to The Age, the Europeans are requiring “Ireland to merge banks as part of [the] bailout.” Yes, too big to fail was the problem, so let the solution be bigger banks.

Remarkably, the IMF has come up with some constructive bailout requirements: Cut the minimum wage and the dole. In other words, create jobs and free up workers. Although it probably doesn’t sound that way.

The German newspaper Der Spiegel has been doing what it can to help the Irish. Its piggybank, which has an Irish flag pasted on the side, featured at the Euro Finance Week in Frankfurt. The aim was to collect money for the Irish from the bankers attending. The raised sum wasn’t disclosed.

There are other reasons to be optimistic about Ireland’s future. “Irish Teenagers are some of the most politically aware in the world, according to a survey which places them seventh in a table of 36 countries.” That’s not the important part. This is: “However, the international survey on civic and citizenship education also found that almost half of teenagers surveyed did not trust the Government and more than half did not trust the media.”

So there you have it. A future market for the Daily Reckoning is flourishing on the Emerald Isle. You can be less enthusiastic about the likes of Portugal: “Portugal’s prime minister, José Sócrates, has echoed his Irish counterpart Brian Cowen in stating that his country needs no bail out.” How’s that for ominous?

The UK and Ireland’s austerity measures, let alone Greece’s, do not reduce public debt. They only reduce the deficit. In other words, those nations are still going in the wrong direction, only at a slower speed. Now, it may take a while to turn a big ship around, but until it’s heading the right way, it’s still the wrong way.

That should make anyone think twice about whether this half baked austerity effort will actually work. The cat is out of the bag and the outlook remains bleak. As governments borrow more, resources will remain stuck in the public sector, unavailable for job creating investments.

So why not simply default, as suggested in Bloomberg’s opinion column? The banks need bailouts, why not wipe them out completely by defaulting on the government bonds they hold? The Irish didn’t need to create a “bad bank”, they have plenty of them already. Then, once the dust settles, start again. It’s happened all through history and it happens in people’s personal lives all the time. Bankruptcy is not the end.

Of course, funding a welfare state if you are the defaulting type will be pretty difficult.

Inflation In China

Bernanke is having a tough time getting the stock market to inflate. But in China, prices are going up… except in the stock market of course.

One way to view this is that Bernanke is flooding the Chinese built foreign exchange dam until it cracks. And water is beginning to seep through at a rapid rate. Eventually, China will be forced to revalue its currency upwards to stop the inflation.

For now, the Chinese are putting up a pitiful fight. And directing it at their own people instead of the Fed (like everyone else is doing). Yes, it’s the old price controls and hoarding penalties rubbish again.

Even the local academics are onto the flaws: “They are just not addressing the fundamental problem at all.” One measure that might cause an interesting outcome is China’s raising of bank reserve requirements for the 5th time. It’s like pulling the tablecloth out, without sending dinner flying.

While all this is going on, the Chinese are making their beds elsewhere. By avoiding the US dollar as a go-between currency, China and Russia will be trading with each other on their terms. No more of these toilet paper dollars!

The FASBI Flop

“Fair-Value Fight in Finance Making Volcker Rue FASB Dissonance.” How’s that for a title! The shenanigans the article features is about the valuation method used by banks. Don’t skip this, it gets interesting.

The American accounting body (FASB) wants to apply “fair value” valuation to all financial assets, which basically means that assets are valued for what you can sell them. The international accounting body doesn’t want to apply that valuation method to all assets, for several reasons. If FASB gets its way and US banks have to value their assets at fair value, the US banking system risks swaying between solvency and insolvency on the whim of asset markets.

Why the American accounting body thinks this is a good idea is a mystery. Particularly when “U.S. home prices fell 3.2 percent in the third quarter”. And, “the new Basel III banking rules will leave the biggest U.S. banks short of between $100 billion and $150 billion in equity capital…”

Yes, the banks remain risk takers. But which ones? “90 per cent of the shortfall concentrated in the top six banks, the Financial Times said, citing research from Barclays Capital.” Too big to fail and not afraid to flaunt it.

The Spillihp Curve

As many of the world’s governments are being clobbered towards fiscal sanity by bond markets, central bankers continue to clutch at straws. The Phillips curve turned out to be rubbish, so now they have decided to try it backwards. No longer do jobs create inflation, as Kiwi economist William Phillips claimed. Now inflation creates jobs. Neither is correct, of course.

Bernanke’s theory, which he calls “the wealth effect” instead of Spillihp Curve, seems to be failing on all counts (as the Phillips Curve did in the 1970’s stagflation). Under the wealth effect, QE is intended to drive up prices to make people feel wealthy enough to buy things. The fact that they have to buy more expensive things is beyond his understanding.

As the Phillips Curve failed to grasp, the Spillhp Curve doesn’t consider the monetary side to inflation. And that is where the action is taking place:

“The 30-day correlation coefficient measuring how often the Standard & Poor’s 500 Index moves in tandem with 10-year Treasury yields fell… Stocks and debt are ending a lockstep relationship that began in July 2007 and lasted through the worst recession since the 1930s.”

Demonstrating their belief in the Spillihps curve, Bloomberg calls this development greed beats fear. They think people are moving from safe treasuries to risky stocks. Another possibility is that it signals inflation expectations are moving forward. This is because equities rise during inflation, while bonds fall. The safe and risky assets switch spots.

To summarise, Bernanke is like the character in the movie Caddyshack who uses a gasoline truck as cover as he sets off his explosives. Safe?

It’s all about spending

Keynesians continue to celebrate and lament the mixed messages the American consumer sends them. They see spending as the source of wealth. Keep things chugging and churning, no matter the cost.

But is wealth really how much you can spend, regardless of how you get the money? That fallacy gave you consumer borrowing, as opposed to borrowing for investment. Simply viewing aggregate demand as the driver of the economy is the sure fire way of misunderstanding what gives you demand in the first place.

Consider Robinson Crusoe, alone on his island. How much he demands is irrelevant and infinite. It is his productive power that gives him wealth. Even when you introduce Friday, Crusoe’s neighbour, it is still easy to understand that it is the more productive of the two who will be wealthier. Continue to add island residents and nothing changes. However, if you add a second island, the analysis takes on an additional consideration.

This was beautifully demonstrated by the Spanish many years ago. They discovered and brought back South American gold, which was subsequently spent on all sorts of things. Did this spending make them wealthy? It certainly made them feel wealthy.

But the real growth in wealth took place elsewhere: In England, where Spain’s spending brought on the industrial revolution. It was the producing Brits that were left the world’s dominant power. But they failed to learn the lesson of their prosperity. Unable to discover a second El Dorado to mislead them as it had for the Spanish, they eventually went about creating the world’s most sophisticated government bond market to finance their empire. Did it make them feel wealthy? Yes. Did it make them truly so? Nope, this time it was the Americans who became wealthy as they provided the productive power needed to satisfy Britain’s hollow aggregate demand.

Do you see a pattern? Need the next paragraph be written, with America’s empire crumbling and Asia rising?

Artificial aggregate demand is the source of economic instability. It is dangerous, not beneficial.

Two faced Keynesians

This two tier economy talk has us a little confuzzled. (Confusion relating to the fuzziness of Keynesian economic theories.) Treasury Secretary Ken Henry is a big expert on the topic, which is why he warned a bunch of Senators on the matter recently.

But if the free market can cause such turmoil, isn’t the government’s stimulus spending of the very same nature? Using Keynes’ own example, if the government were to pay people to dig holes and fill them back up again, why wouldn’t that cause a two speed economy? One in the hole digging industry and one in private.

Then again, there is already a two tier economy in that sense. Consider the difference between public sector average income and private sector average income. The difference can’t all be because the public “servants” have to be compensated for living in Canberra.

In America the difference is even more dramatic. But that is to be expected in a bastion of free markets…

Adding a whole new dimension to the American situation is the “revelation” that “a one-parent family of three making $14,500 a year (minimum wage) has more disposable income than a family making $60,000 a year.” And that excludes benefits from Supplemental Security Income disability checks.”

The details are quite remarkable. But the result isn’t, especially if you visit the country.

Follow the money

We can’t finish this weekend’s DR without a discussion of the naked body scanners which are causing such uproar in the US. (They are on their way here too.) But rather than launching into the libertarian rant you expect, consider the economic argument.

“Driving is much more dangerous than flying, as you are far more likely to be killed in an automobile accident mile-for-mile than you are in an airplane,” says economist Steven Horwitz of St. Lawrence University. “The result will be that the new TSA procedures will kill more Americans on the highway.”

Yes, the law of unintended consequences strikes again. But it gets better. From The 5 Minute Forecast:

“According to Congressman Ron Paul, the former Secretary of Homeland Security, Michael Chertoff, is making millions selling the backscatter X-ray scanners to his former agency.

“Indeed, the week after the Christmas day “underbomber” incident, Chertoff was all over TV posing as an “expert,” advocating that more scanners be installed at airports, but never disclosing that his firm consults for the companies that make the scanners.

“Meanwhile, it turns out one of Chertoff’s clients accompanied President Obama on his recent trip to India. He was one of several CEOs who tagged along to drum up $10 billion in Indian business for politically connected American companies.

The laws of politics strike again.

Self sustaining recovery

Oh, by the way, all this is what the media classes as a “self sustaining recovery“. Never mind the $600 billion set to ripple through the economy and government deficits set to hit … oh never mind.

Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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