The Problem of Knowledge

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If the expansion of the Federal Reserve’s balance sheet due to its swaps agreements with Europe is a trip-wire for inflation, consider it trippy. Bloomberg reports that, “The Federal Reserve’s balance sheet rose to $US2.34 trillion, the first increase in a month, as the central bank reopened liquidity swaps with foreign central banks. Assets increased by $US9.93 billion, or 0.4 per cent, in the week ended yesterday, the central bank said today in a statement. The balance sheet reached a record level of $US2.343 trillion April 14.”

The increase in liquidity swaps was US$9.21 billion in the last week. That’s presumably the money headed “over there” to Europe to reinforce the ECB’s efforts to prevent a wider “contagion” in European credit markets. The bigger the Fed’s balance sheet gets the more support you’ll probably see in the gold price.

Speaking of which, JP Morgan analyst Michael Jansen told clients in a note that, “The gold price is being driven by…the rising concern of the ‘exit strategy’ for central banks given that the ECB is the latest agency to join the (quantitative easing) bandwagon…Indeed, the perceived breach of the ECB’s independence…adds to the view that in the long-term monetary and fiscal authorities will be forced to choose between anaemic economic conditions or monetary-driven inflation.”

“Monetary-driven inflation” is, along with good old fashioned fear, behind this week’s move in gold and precious metals. It is easier for governments to lean on central banks to print money than it is to make politically unpopular (and socially destabilising spending cuts). Bond markets will try to hold European governments honest by punishing those that don’t commit to genuine spending cuts and deficit reduction.

But this not just an accounting debate or a fiscal policy debate. Europe’s post-war social contract is being forcibly rewritten by economic circumstances. Markets enjoyed a massive “short squeeze” rally with the announcement of the bailout. But how markets behave now is anyone’s guess.

Our guess is that austerity measures in Greece, Spain, Portugal, and probably Italy will prove so unpopular that governments who agree to them may find it hard to hold onto power. And then? Debt default remains a real possibility, and one not currently priced into equities, if you ask us.

But don’t take our word for it. Yesterday the Australian Mint said it sold more gold coins in the first two weeks of April than in the entire first quarter of the year. Nearly all the buying was coming from Europe. The mint told Reuters that it sold 243,500 ounces of gold coins and bars in the first two weeks of April compared to 205,000 in the first quarter.

Meanwhile, what about China? We concede that all of our information comes second hand, and not from any correspondents on the ground (although some of our colleagues are headed that way next week). In the meantime, there are signs that property prices are already falling in Beijing and some analysts are joining in the prediction of a major credit bubble that’s due for a popping.

Beijing commercial property prices may have fallen by nearly 31% in the last month, if we’re reading this article correctly. “The average transaction price of commercial residential properties in Beijing for the week ended May 9 fell 1,790 yuan per square meter or 9.6 percent week-on-week to 16,898 yuan per square meter, reports The Beijing News, citing statistics released by Beijing Real Estate Information Network. Compared with the week ended April 11, the average transaction price of commercial residential properties in Beijing plunged 31.43 percent or 7,744 yuan per square meter.”

That’s just one source and one market. But if it’s correct, that is…well…that is what it is, isn’t it?

But according to Hong Kong-based hedge fund analyst David Roche, it gets a lot worse. “We’ve got the beginnings of a credit-bubble collapse in China,” Roche told Marketwatch.com. Roche goes on to assert that the Chinese banking sector will face huge loan losses on bad loans made to local governments. And what does that mean for you?

Roche links a credit contraction in China with infrastructure spending, which he reckons accounted for 90% of China’s economic growth last year. So while housing is a clear bubble, Roche says the contraction of bank lending will remove infrastructure investment as one of the key pillars of Chinese growth. He says that’s negative for industrial commodities like iron ore and copper.

As if the news wasn’t bad enough for Aussie mining companies…

Of course no one knows for sure what will happen next. The fact that so many people are talking about a China bubble is itself a disturbing sign. Normally you don’t get that during a bubble, although claiming there is not a bubble in China because people are talking about it a fairly superficial way of dismissing the argument.

But inquiring minds often disagree on the same set of objective facts. That’s what makes a market. Our colleague Dr. Alex Cowie has the full time resource beat here in St. Kilda. Alex is recommending precious metals producers as part of his general strategy, with a particular focus on the inflationary policies of central banks.

However the key debate the rest of this year is how to value the miners. And you have two massive elements of uncertainty now. One is the Rudd Resource Tax. The other is China’s growth. The only upside to all of this is that a great deal of uncertainty can distort valuations, which occasionally gives you a chance to buy something really cheap at a time when everyone else is petrified.

“You know,” a friend said to us the other night over a drink, “sometimes you come off like a know-it-all smart arse. It’s one thing for you to tell the Chinese they’re doing it all wrong and predict a crash. But you’re bagging out our Prime Minister and you’re not even in an Australian. To be honest it’s kind of aggravating and offensive.”

“Good,” we replied.

“How can you say that? Aren’t you worried you’re going to upset your readers? They won’t become customers if they’re angry with you.”

“That’s true. But you probably mis-understand what our business is. I don’t want a customer who’s easily offended by ideas. It’s my job to provoke thought. And you do that by presenting ideas, challenging conventional wisdom, and just thinking harder about things.”

Warming up to our task, and perhaps inspired by a sip of Maker’s Mark, we continued, “When I see someone say something idiotic – or, if you prefer – something I think is totally wrong, I feel compelled to point it out. You have to challenge that stuff when you see it, or else people start to believe it. And once they start to believe it without really thinking about it, the game is up. You become a servile, passive, brain-dead whip dogged to be kicked around and cuffed about the ears by the Welfare State. You’ll be lucky to get a bone.”

The discussion came up because of this quote by the Prime Minister earlier in the week on the radio. He said:

The core element of conservative economic management, in which I believe, is expanding the role of government in the economy when the private sector is in retreat.

Had we not done that we would have had a quarter of a million more Australians out of work, many small business [sic] collapsing.

Now that the economy globally is on a pathway to recovery it’s time for the role of government to retreat. That’s what conservative economic management is all about. That’s what I believe in.

You have to give the Prime Minister credit. He says what he believes. But what he believes is all wrong. And we wish he’d stop using the phrase “the business of government.” It’s an insult to businesspeople. Government is not a business. It does not take risks with its own capital to create value and jobs. The Prime Minister is not an entrepreneur.

He is, however, by his own admission, a manager. And in that respect, his hubris and his error are revealed. It is not “conservative economic management” for the government to massively intervene in the private sector. It is Socialism.

You might agree with it or believe in the moral rightness of that intervention, mind you. But let’s at least call things by their right names. It’s one of the surrealities of the modern world that things are often given names that are in direct opposition to what they actually are. Examples include the Democratic People’s Republic of Korea, which is neither Democratic nor a Republic, and Britain’s Liberal Democratic Party, which is neither Liberal nor Democratic either. We would add to the list Kevin Rudd as a “conservative economic manager” of the economy.

In any case, the Prime Minister’s error (shared by many members of the opposition who fail to rebuke him), is that he does not understand the inherent impossibility of managing a complex system like the economy. The second order error is probably just a disagreement about the government’s role in the economy. But you can’t have the second error without the first. And the first one is a fundamental question about the limits of human knowledge.

No human being, economist, and philosopher made this point more clearly than Friedrich Hayek. One of Hayek’s great achievements – picked up today we think by Nassim Taleb – is forming a clearer picture about the quality of knowledge and what we can say that we really know. What does that mean?

Hayek simply pointed out that in a complex system like an economy, no single person can have enough information or even know what information is required to correctly allocate and direct the use of society’s resources. To believe otherwise is to have an exalted sense of your own abilities as a micro-manager.

Hmmn.

Hayek’s critique of central planning – what he called the fatal conceit of socialism – was, and remains, the most sensible criticism of centralised economic authority. It can’t work because human action is too complex and unpredictable and ultimately unknowable in a strict cognitive sense. You cannot plan and organise for what you do not know and cannot understand.

Market prices, on the other hand, are the sum total of human action. Those prices contain information and help maintain the relationship between supply and demand. That is the essential triumph of a free market: it allows people to be free and choose their own path and, at the same time, manages the most efficient allocation of resources.

It does this based on what people want as expressed through their own choices, not what government tells them they should or should not want. It produces this kind of peaceful and prosperous order – most of the time – without being organised by a smart man in an expensive suit serving on the public payroll.

But the basic idea simple. Individuals and firms know better how to plan their own future than the government. If you believe otherwise, you believe the government has the right and the obligation to make plans on behalf of people who are not fit to govern themselves. Proper names for that include: Nanny State, coercion, tyranny and more!

The Prime Minister is a planner and a world improver. That is the “business” he is in. And perhaps his motives are building a better world. But the way to do that is to sweep your own doorstep and tend your own garden, we’d submit. His belief about the proper role of government in the management in the economy is based on an overweening pride in the knowledge and skill of government ministers and career bureaucrats.

How else can you explain a piece of tax law like the Resource Rent Tax which effectively makes the government a silent partner in the profit and the losses of the resource industry without the consent of shareholders? Only a man who believed government had the right and the ability to insinuate itself into private business relationships would so pridefully propose a scheme like that.

That’s not to say that the government doesn’t have a role in civilised society. It most certainly does. Its role is to guarantee and enforce clear rules that establish and protect the ownership of private property and enforce contract, as well as punish people who take what is not theirs. The Law – transparent, providing equal justice, and impartially administered – is as important an institution to civilised society as the free market, which itself is could be described as a mechanism for communicating prices.

By those standards – which are, of course debatable – this government has done the exact opposite of conservative economic management. It has changed the rules in mid-stream, proposed to enforce them retroactively, and demanded equity in private enterprise without paying for it like the rest of us.

To be fair, that is “business” of a kind. Monkey business perhaps. Or “business” in the same way organising payments through the threat of violence is a “business.” Or less threateningly, it’s just meddlesome troublesome “business” that gets in the way of real people doing real business.

As the economist and thinker Henry George wrote, “It is not the business of government to make men virtuous or religious, or to preserve the fool from the consequences of his own folly. Government should be repressive no further than is necessary to secure liberty by protecting the equal rights of each from aggression on the part of others, and the moment governmental prohibitions extend beyond this line they are in danger of defeating the very ends they are intended to serve.”

The world is complicated enough. Europe’s sovereign debt crisis will eventually migrate its way to America and the super cycle in fiat money will end in either a debt deflation or massive inflation or both. Real wealth will be destroyed. Meanwhile, China faces a property and credit bubble of its own.

These are big enough worries for Australia without having to worry that its own government is unwittingly sabotaging the country’s success. Sound economic management would have been to leave well enough alone. But that is not what the government has done. And it’s going to reap the whirlwind, both in the markets and, perhaps, at the polls.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Good on you Dan. It is an excellent written article.
    We have the Goverment we deserve. Given the chance people and Companies will prefer to pay no confiscatory taxes at all.
    Who has the authority/knowledge to say how much tax is fair at
    any given time?

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  2. “Europe’s sovereign debt crisis will eventually migrate its way to America and the super cycle in fiat money will end in either a debt deflation or massive inflation or both. Real wealth will be destroyed.”

    The order does not matter, but I think both will occur… knowing when to be in or out of the market is the tricky question. Stay out for the collapse first and ride the inflation wave… Stay in for some more uptrend in markets and get out when it collapses..

    Stillgotshoeson
    May 14, 2010
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  3. We agree wholeheartedly shoes.

    And George the market does give signals on investment spend and gross taxes paid, but getting the balance right is alchemy. One thing you don’t do is radical change, and if it looks like a duck and it quacks, it is a duck. Or a wombat … And Rudd is still a bureaucrat, he plays political theatre the same as all bureaucrats, with a hearty direspect for both democracy and markets.

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  4. Dan,

    Your reference to Australian Mint is actually the Austrian Mint, fat finger keying?

    http://www.bloomberg.com/apps/news?pid=20601012&sid=afxIg_jX35T0

    “May 12 (Bloomberg) — Muenze Oesterreich AG, the Austrian mint that makes the best-selling gold coin in Europe and Japan, said sales jumped in recent weeks on concern that Greece’s fiscal crisis will hurt the euro. Buyers have purchased 243,500 ounces of gold since April 26, compared with 205,300 ounces in the first quarter, Vienna- based Marketing Director Kerry Tattersall said by telephone today. Bullion climbed to a record $1,245.07 an ounce today and reached all-time highs in other currencies.”

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  5. LONDON, May 14 (Reuters) – Gold rose back above $1,240 an ounce in Europe on Friday, close to this week’s record highs, as investors bought the metal to protect against sovereign risk in the euro zone and instability in the foreign exchange markets.

    The European market seems not to have faith in the bailout…
    I still think China plays more on our short term prospects than the Euro.. if China keeps afloat we should still see some support for our market, China falls over, added to the Euro and US worries then deflation is assured. The market here will capitulate to a new low. The sub 3000 that I am expecting.

    Stillgotshoeson
    May 14, 2010
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  6. …if his holiness says that the shroud of turin is genuine, then i believe it is…if scientists say the shroud is from the 11th century, even i believe this…would i then believe that jesus lived one thousand years ago, and not the usual two…perhaps…so what could have been the purpose of peter’s church form 0 to 1100 “AD” if 0 through 1100 AD even existed, or is that too a “fake”, a book entry, time created “out of thin air”, the “dark ages” that seemed to have slipped though the cracks of historical accountancy…i wonder…it seems to me that the vatican and the federal reserve are distant sisters…i mean, wasn’t the federal reserve created a century in advance of a global currency…while the vatican was created 1000 years in advance of our global saviour…

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  7. Not sure I agree – the idea that price changes effectively clears markets generally is soft thinking. The evidence of ‘asset bubbles’ tends to reinforce that fact that markets based on assets fail to clear effectively and neo-classical economics has no sensible explanation in the face of debt creation. Markets no matter how you define them are subject to influence and distortion (regulatory requirements) and price signals in some markets are poor signals for investors, especially if the market is being manipulated – take ‘rapid’ computer trading in stocks for instance. Better to take a pragmatic view of the world rather than a dogmatic one that says all government is bad so end all government. Sure, you cannot set yourself up to ‘see all’ and control all spending decisions via a socialist utopia nor should you assume that all individuals in a more ‘liberal’ economy with more decision choice have all the information to hand to make the correct choice (in their own interest).

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  8. I cant see how it would be possible to have damaging assett bubbles/price distortions in the absence of central planning with a mismanaged unbacked currency and the inevitable (as human nature is unchanging) cheap credit and monetary inflation that follow. One example may be inflation after Spain plundered the gold and silver from the New World long ago but not likely to happen very often.

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  9. Again we see Westpac preference shares rising +0.72 as common shares are down 5.18%. same happened during last mini panic risk event across all 4 pillars preference shares

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  10. It takes a US 6K filing to expose Westpac http://www.asx.com.au/asx/statistics/announcements.do?by=asxCode&asxCode=WBC&timeframe=D&period=T

    And beyond growing their residential property market beyond their ability to get at wholesale funds to roll it all over they have now issued an explicit increased risk warning on their post merger commercial property lending portfolio.

    No wonder the market went after them, but we should go after APRA, CAMAC, ASIC (incl Gonksi’s ASX before it), and the AASB on the woefull Australian regulatory & accounting record. One where we only get to read disclosures when posted for US compliance purposes. We are swarming with those compromised and the cronies.

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  11. At 31 Mar 2010 45% of Westpac offshore wholesale funding has a maturity of less than one year! Repo assets with the RBA have gone from $18b to $80b in 1 year. All good in Australian bankster land, says so in the statement, “our access to wholesale funding markets has been strong”. As strong as the brains that got us into this mess.

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  12. “It is not the business of government to make men virtuous or religious, or to preserve the fool from the consequences of his own folly. Government should be repressive no further than is necessary to secure liberty by protecting the equal rights of each from aggression on the part of others, and the moment governmental prohibitions extend beyond this line they are in danger of defeating the very ends they are intended to serve.”

    Well, that libertarian quote from Henry George has sure been doing the rounds. Here are some more excepts from the same chapter of SOCIAL PROBLEMS (http://www.schalkenbach.org/library/george.henry/sp17.html), to show you where his libertarian premises led him. Enjoy!

    The primary purpose and end of government being to secure the natural rights and equal liberty of each, all businesses that involve monopoly are within the necessary province of governmental regulation, and businesses that are in their nature complete monopolies become properly functions of the state. As society develops, the state must assume these functions, in their nature cooperative, in order to secure the equal rights and liberty of all…

    It is not the business of government to direct the employment of labor and capital, and to foster certain industries at the expense of other industries; and the attempt to do so leads to all the waste, loss and corruption due to protective tariffs.

    [17] On the other hand, it is the business of government to issue money…

    In rude stages of social development… the making and improvement of highways have been left to individuals, who, to recompense themselves, have been permitted to exact tolls… But the great inconveniences of this system, and the heavy taxes which, in spite of attempted regulation, are under it levied upon production, have led, as social advance went on, to the assumption of the making and maintenance of highroads as a governmental duty…

    Either government must manage the railroads, or the railroads must manage the government. There is no escape…

    I do not think the postal department of the government, with its extensive ramifications and its numerous employees, begins to be as important a factor in our politics, or exerts so corrupting an influence, as would a private corporation carrying on this business, and which would be constantly tempted or forced into politics to procure favorable or prevent unfavorable legislation…

    The inefficiency, extravagance and corruption which we commonly attribute to governmental management are mostly in those departments which do not come under the public eye… But let the mails go astray or the postman fail in his rounds, and there is at once an outcry. The post-office department is managed with greater efficiency than any other department of the National Government, because it comes close to the people. To say the very least, it is managed as efficiently as any private company could manage such a vast business, and I think, on the whole, as economically…

    [34] Like these businesses — perhaps even more so — the railroad business comes directly under the notice of the people. It so immediately concerns the interests, the convenience and the safety of the great body, that under public management it would compel that close and quick attention that secures efficiency…

    All I have said of the railroad applies, of course, to the telegraph, the telephone, the supplying of cities with gas, water, heat and electricity — in short to all businesses which are in their nature monopolies…

    [39] Businesses that are in their nature monopolies are properly functions of the state. The state must control or assume them, in self-defense, and for the protection of the equal rights of citizens. But beyond this, the field in which the state may operate beneficially as the executive of the great cooperative association, into which it is the tendency of true civilization to blend society, will widen with the improvement of government and the growth of public spirit.

    [40] We have already made an important step in this direction in our public-school system… with such happy results that in no State where the public-school system has obtained would any proposition to abolish it get respectful consideration. In spite of the corruption of our politics, our public schools are, on the whole, much better than private schools… In some of our States the books used by the children are supplied at public expense, being considered school property, which the pupil receives on entering the school or class, and returns when leaving. In most of them, however, the pupils, unless their parents cannot afford the outlay, are required to furnish their own books. Experience has shown the former system to be much the better, not only because, when books are furnished to all, there is no temptation of those who can afford to purchase books falsely to plead indigence, and no humiliation on the part of those who cannot; but because the number of books required is much less, and they can be purchased at cheaper rates. This not only effects a large economy in the aggregate expenditure, but lessens an important corruptive influence. For the strife of the great school-book publishers to get their books adopted in the public schools, in which most of them make no scruple of resorting to bribery wherever they can, has done much to degrade the character of school boards. This corruptive influence can only be fully done away with by manufacturing school-books at public expense, as has been in a number of the States proposed.

    [41] The public-library system, which, beginning in the public-spirited city of Boston, is steadily making its way over the country, and under which both reading and lending libraries are maintained at public expense for the free use of the public, is another instance of the successful extension of the cooperative functions of government. So are the public parks and recreation grounds which we are beginning to establish.

    Not only is it possible to go much further in the direction of thus providing, at public expense, for the public health, education and recreation, and for public encouragement of science and invention, but if we can simplify and purify government it will become possible for society in its various sub-divisions to obtain in many other ways, but in much larger degree, those advantages for its members that voluntary cooperative societies seek to obtain…

    In succeeding chapters I propose to show how, by recognizing in practicable method the equal and unalienable rights of men to the soil of their country, government may be greatly simplified, and corrupting influences destroyed…

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  13. BROKEN LINK

    I keep forgetting the bug that combines closing parentheses with URLs. Here’s that link again: http://www.schalkenbach.org/library/george.henry/sp17.html .

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  14. Well politicians and bureaucrats always try to justify their existence (and status) by being seen to be doing something – socially, financially, whatever. Few in numbers at the start, they tend to add value during the formation of a civilised society. But as a society peaks these unproductive people become too numerous and meddlesome. Rather than building, they now distort the system with their avalanche of policies, rules, directives. The meddling is increasingly linked with propaganda, double-speak and no serious debate or (in our case) investigative journalism. Society as a whole seems to tow whatever the party line is. Ugly to see once strong democracies decline into this.

    The developed worlds dramatic financial meddling may now be at its limit. The world will rebalance. Over indebted fiat currencies must devalue relative to creditor nations. The standard of living in debtor nations must decline relative to creditor nations. I also suspect we are currently consuming the capital of the earth (thus degrading it), to sustain unsustainable lifestyles. We can keep this up for a while, given the developing world still has large tracts of the surface of their countries to fully exploit for human use. But medium term, Id guess world GDP has to reduce. If it doesnt, we will end up living on an ecologically bland planet – essentially just a big farm pock marked by urban centres.

    This financial tustle and ongoing ecological decline appear the likely outcome to me. Wouldnt it be a breath of fresh air to see a central politician frame the debate so simply as I have, recognise our partial impotence in the face of what must happen, yet attempt to genuinely lead the world into managing this process as best we can. Not on this planet I fear.

    No-ledge
    May 18, 2010
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  15. NoLedge, you have your politician in Bolivian President Chavez, who recently held an alternative Copenhagen…. but no, he’s a socialist, but no, the peasants are calling him a capitalist….. still, I hold to the idea that diversity is a good thing.
    may be better than this Thatcheristic utopian view. (trickle down and competition My A**e).
    I hope that common sense prevails, else I am praying to the aliens (the good ones that presumably need to be good to go much further than our dangerous level of “progress”).
    Real wealth might be destoyed, but I am willing to go into it boots and all IF the bullshit wealth (the other 800%) goes down with it, and stays that way… the reality probably boils down to military power.
    My utopian view is sufficient (but not dangerously excessive) technology that is much, much more distributed (chiefly energy), democritising the economy (from the bottom up), high tech (materials conversion, recycling etc) and connected (informationally). The trick is the power… too much “rogue” power cannot be a good thing. (kids with nukes). State power monopolies suck, its called History.
    Its a long shot, but my only hope (for humanity in the long run (< 100 years)… thats it, only 2 glasses so Ill stop there.

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  16. peterg, you mean Chavez is the VENEZUELAN President, right?

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  17. Bolivarian, Bolivian… get ’em mixed up myself after two glasses. Ran round and round a tree once, after I’d been drinking… and ended up as a pool of melted butter… .

    Biker Pete
    May 19, 2010
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  18. Half a trillion of bets vaporised in Europe by the Germans, got that one right anyway

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  19. I see the AUD broke down Ross. Bears probably to run away with it now.

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  20. Well Lachlan using the AUD as my meter was the long held view on equities and I just stuck with it. The thing is if you factor the scale of foreign equity in the market, and look at the timing as reflected in the RBA’s increase in the equity side of nett foreign liabilities, and consider that a very big chunk of it is margin lent money out of the USD, then you come to that conclusion based on a money flow basis (collateral calls / forced deleveraging back in USD’s)

    I am in cash but for my reduced dozen and have abandoned ASX index trades. I have hopes for VTA despite the market not being impressed on the funding side and my having dim view of the management captive corp set that they belong to. The CAD-AUD cross is doing what I thought it would during the risk event, I took my pennies on the NZD-AUD cross at a fair time and will play again on that one when I see that the RBA has to get into murky mode to bail out its mates. I might not have done my Mt Gibson at the optimum time and missed 15% of upside but at today’s price I’m already 22% ahead of getting caught long. It is a great company and I will be back there.

    So I revert to my 08 plan, get invested long into selective foreign currency earning equities but otherwise be in cash and looking at NTA value and the inflation & currency dive meter that threatens that cash. This time hope those that need offshore funding have borrowed in that sovereign currency rather than relied on an AUD funded balance sheet.

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  21. Hope we get a report on Rand Paul’s win in Kentucky, some are reporting a wacky acknowledgement speech but I am hoping that is just “tea bagger” spin.

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