Author: George Sutton

Fiat Money: Inconvertible paper money in support of which there is no reserve of specie. Governments issuing such money usually give it the quality of full legal tender.

Dictionary of Economics, 1961 by Sloan and Zurcher. Cover price was $1.95 of fiat money. No gold was used in the transaction.

The borrower shall be a slave to the lender.

Proverbs 22:7

The United States itself is the leader of a new, hard, materialistic civilization…. whose priests are the instalment-seller and the advertising expert.

The Economist, 1935.

What they implied, what I could not hear, was that the Republican Party, now in the grip of the Reagan forces, had abandoned the reality of the retail world in which politics had always been done: they had put emotion to work in the service of ideology. The politics of the nation had been given into the hands of the salesmen, and it was certain that the salesmen would win, for they had learned the secret of modern politics, which is that no one can refute the arguments of the heart.

From "A Nation of Salesmen: The Tyranny of the Market and the Subversion of Culture", by Earl Shorris, 1996.

Debt is said to invoke necessary discipline, simply because you have to pay it back, or risk foreclosure, or a credit downgrade which increases the cost of future debt. Private debt is said to be more disciplined than public debt because it requires you to earn income and profits to service your debt obligations, including interest payments. Public debt on the other hand usually results in governments raising taxes, or more debt, in the hope that inflation over time, or an election loss, will hide their profligate behaviour. The problem with governments, of course, is that they face the electorate on a regular basis which encourages unsustainable pre- election policy followed by the need to pay for it post-election. A lot of the cost of poor policy and poor policy execution is higher interest rates. Hence the ‘voodoo economics’ of which we speak is that Ecinya remains to be convinced that de-leveraging the private sector by leveraging the public sector is sound economic policy.

Australia has gone from a domestic budget surplus of just under 2% of GDP and zero debt to a domestic deficit of 3.6% and 19% govt debt to GDP ratio, respectively. The domestic deficit is a swing of $50 billion. Wow! Though these deficit numbers are relatively low and well short of the USA at 10% and 55% respectively, it still means that we are exposed to any downturn in the global economy and vulnerable to the unexpected, such as event risk and, say, an oil price spike. Australia has not done anything in relation to substantive industry policy (other than trade white papers that omit any reference to imports) for about two decades to mitigate our persistent trade deficit.

Rather the stimulus package (that ‘saved’ us from recession) and government policy on work-place ‘reform’ has entrenched us as a nation of chronic importers. Because of inflexible and unrealistic labour laws and high taxes on employment, Australia will produce about the same, but using less labour and thus creating more welfare recipients. An import is a job created abroad.

Ecinya Insights, "Our view of the year ahead", 12/1/2010.

Countries can reduce their private debt, reduce their public debt, or run a trade deficit, but not all three at the same time. If a country wants to see its government run a fiscal surplus (or small deficit) and at the same time its private citizens want to reduce their leverage (common desires throughout the developed world), it must run a trade surplus. That’s a simple accounting statement.

John Mauldin’s weekly blog "There’s a Slow Train Coming", 4/6/2010

Clearly the central bank of Zimbabwe has overdone it. But if the central bank of the USA has overdone it few seem aware of it. The secret is to give people more money, but not so much more that they realize all they’re getting is pieces of paper. Paper money may be a fraud, but it still represents purchasing power. When more units of it appear, people assume they have more purchasing power. And when they spend more the merchants think there is more demand and increase production. Pretty soon there is a boom.

Bill Bonner in 2007, author of "The New Empire of Debt", written in 2009 with Addison Wiggin.

 

Quotes above: The Core Messages (note old journalistic adage – ‘90% of the message is in the head-note’)

1. Definition of fiat money.
2. Even the bible speaks of debt, indicating that debt is hardly a new concept. In relation to the biblical quotation the Latin expresses it well : ipsa res loquitur: – "The matter speaks for itself"
3. The Economist speaking of the new age of consumption via the provision of credit to the consumer.
4. Governments take from certain sectors and give to others in the hope of buying votes, confessions of an advertising guru turned economic and social commentator.
5. Ecinya talking about the dangers of public debt, January 2010.
6. John Mauldin makes some very prescient, relatively obvious, points about sovereign finances.
7. The ‘Empire of Debt’ is obviously The United States of America.

 

THE FIAT MONEY SYSTEM

We live and work in a fiat money system. We produce goods and services and we are paid in cash or a cash equivalent, such as a direct credit to our bank account, we then withdraw the money as cash or pay it to a credit card company as our bills fall due. Companies borrow from investors via various forms of debt, but mostly from the banking system who provide credit from their borrowings with a central bank, or other banks, or the savings of depositors.

Paper currency is not new. It existed in 1716 in France, fell into disuse, and then re-emerged in 1791. Paper money found its way to America in 1862 when Abraham Lincoln passed the Legal Tender Act. The Federal Reserve System was put in place in 1913. After World War ll Germany became a massive printer of money. In 1934 President Roosevelt revalued gold from its official price of $20.67 to $35 to enable the printing of more paper money with the hope of lifting America out of The Great Depression. In 1944 The Bretton Woods Agreement was made to treat the dollar as a substitute for gold. At the official price of $1 for gold pegged at $35 an ounce, countries holding gold or US dollars could print money up to that limit. In 1971 President Nixon ended the gold standard, ending convertibility of dollars into gold.

Paper money has generally preceded outbreaks of rampant inflation as a large quantum of dollars chases a limited supply of desired goods and services.

 

INFLATION

There are three faces of inflation. Firstly, a general rise in the cost of goods and services. Secondly a rise in asset prices. Thirdly, a rise in the current account deficit as imports exceed exports via the trade balance as countries find it cheaper to import than to produce goods and services themselves. An easy example is the outsourcing of call-centre jobs to Bangalore and Malaysia etc. Another easy example is Wal-Mart where on a store visit our editor found that only the toy department stocked ‘made in America’ goods.

However, in a money printing environment such as that pursued by Alan Greenspan and then by Hank Paulson and Ben Bernanke, having too much money chasing too many goods and services is not an inflationary problem, because we have excess money supply chasing excess capacity. And this increased supply is mainly to do with the emergence of Asia where technological abilities, skill sets and an over-abundance of cheap labour enable goods and services to be produced cheaply for export to the idle and indolent west. And this is not a political statement, it is simply economic fact.

 

WHAT MAKES UP THE SHORTFALL?

In the good old days classical economics taught us that consumption and investment was funded from savings. But the phenomenon of excess consumption that began in the 30’s has survived with but occasional interruption, and over the past decade or so, with increased momentum. That process is a debt funded boom People consume today out of borrowings. In a real sense savings is spending forgone. The latest manifestation of this debt phenomenon is the transfer of debt from the private sector to the public sector. The private sector has de-leveraged and the public sector has re-leveraged.

 

BUT GOVERNMENTS HAVE NO MONEY!

Governments get their money from three principal sources – taxation, borrowings, and running a few public utility-type businesses. An example of businesses formerly run by governments would be Commonwealth Serum Laboratories (now CSL), Commonwealth Bank, and Telstra. Government budgets are just cash-flow statements – money in and money out. Little or no distinction is made between discretionary and recurring expenditures, and capital items. There is no Profit and Loss Statement, and there is not a Balance Sheet. If governments discourage private investment then the alternative is to increase our level of imports. This reduces job creation at home, increases unemployment, increases unemployment benefits and other forms of welfare (such as ‘free’ health). Pretty soon the budget surplus turns into a budget deficit.

But governments should run budget deficits at appropriate times PROVIDED the expenditures that contribute to that deficit are well targeted. What is happening though in the Western world is that fewer and fewer producers are servicing a growing number of welfare recipients. The Henry Tax Review recommended the creation of a super-welfare agency so that welfare could be properly monitored and controlled. The Australian (and American system) with active welfare states and activist Federal welfare leads to substantial abuse and waste.

So the fear and the problem is that over time we all veer towards being Greece where the government in effect had to borrow money to employ public servants who did very little. When we then impose ‘austerity’ there are riots and lootings, anger and mayhem.

 

WHY THEN PRINT MONEY?

Simple. Inflation is better than deflation, depression, or even a slow-down. Keynesian economics has reached its illogical conclusions, its zenith of idiocy. Fortunately in a fiat money system it will not matter until one day we finally reach the levels of our own misunderstandings and delusions. Even wars can be financed on credit provided China, a surplus country, is prepared to lend money to a deficit country like the United States of America.

 

IS THE ANSWER TO GO BACK TO THE GOLD STANDARD?

The answer is no. The economic debacle of the 30’s spelled the end of the gold standard. Modern economics has finally melded with modern politics. It is highly unlikely that an ounce of gold will be legal tender at Harvey Norman, Woolworths, David J or McDonalds. Our belief is that the fiat money system has travelled and prevailed for far to long to revert to the gold standard.

 

CONCLUSION

We do not yet know the limits of the debt-laden system. We do know that it takes more and more debt to get to a desired level of production and consumption, or lifestyle. We do know that people are better off in jobs than having nowhere to go, nothing to do. We also know that television and communications and education has increased the desire of the under-privileged to have a better life. In broad terms when you have trouble paying the interest bill each year then your debt limits have been reached. The alternative then is to sell assets. Will the Acropolis in Athens be sold to a group of Chinese developers and shipped back to Beijing as a tourist site and the now vacant Athenian land used to build a factory or a group of condos? Probably not. The answer over time will probably be that Greece remains a distressed asset and likely to default. It would be handy if they could leave the Euro, drop their prices, and attract more and more tourists to swim and sail in their pristine waters, listen to the music and be consumed by the dance.

I keep six honest serving men, They taught me all I knew. Their names are What and Why and When, and How and Where and Who.

Rudyard Kipling

There are those who do not know, and those who do not know they do not know. I belong to the former camp.

J K Galbraith

(1) It is unlikely that God’s plan for the universe includes making you rich. Success in the stockmarket requires effort, discipline and patience. (2) "Research" is to contemplate the possibility that, intuitively, you may not know the answers, and worse still, you may not even know the questions. Information insightfully interpreted will help avoid being caught in a position where you can lose a lot for reasons not understood. Try to avoid making the facts fit the theory, especially in relation to timing. Speculation is not investment.
Buffetology: Can we understand the business? Does it have a sustainable competitive advantage? Do we like the people? Are we getting it at the right price?

(10) In the medium and long term the stock market indices fluctuate around the upward trend in earnings per share.

Ecinya Investment Rules #1, #2 and #10.

(1) In many respects we, on our side of politics, still live with the attitude of capitalism being a system that will always exploit workers, and will always exploit consumers. But the truly equitable thing now is to say that the problem with capitalism is that there are not enough capitalists, and that the best social justice policy is to make the ownership tent as big as possible. (2) The miserable lot of the Third World’s poor results from a history of corrupt governments; it has nothing to do with Mc Donald’s or Coca Cola. The true enemy of the poor is the corruption of the state. Capitalism is actually part of the solution

Mark Latham former leader of the Labor party 10/10/2001 and 2/5/2001

We’re enjoying sluggish times, and not enjoying them very much.

George Bush Snr, 1992

The economic cycle in simple terms, is the process of moving from an excess of consumer and investment spending to stability, and then to deficit. New spending begins the next virtuous cycle. If income is pressured, so is spending. Lower taxes and lower interest rates drive the recovery phase.

The Ecinya pages 23/2/2001

THE ORIGINAL ESSAY WAS WRITTEN IN FEBRUARY 2009 and was re-produced on 1 September 2009 as it appeared to be more pertinent at that time when many (some of them self-serving) were exaggerating the ‘global financial crisis’, which now seems to have been not much of a crisis at all. All that was required was to simply throw large levels of fiscal and monetary stimulus at the problem. Keynes had done it before so that it was an old recipe. But it still seems to us that not enough current attention was being given to the basics – structural, systemic, and attitudinal – especially in America. The cult of ‘the free lunch’ had returned. The imbalances that provoked the ‘crash’ seem omni-present.

Australia is in relatively good shape, growing at circa 4% on a cum-stimulus basis and probably around 2.5% on a post-stimulus basis The underlying reason is our proximity to Asia where the Chinese economy is expected to achieve growth of 8.5%. But all of these figures are relative. In ‘normal’ circumstances the world should grow at around 3% per annum which means that world output doubles about every 24 years. Australia’s domestic economy enjoys high per capita GDP, a stable banking system, generally sound infrastructure, relatively full employment, a stable housing sector etc. But as a major trading nation we cannot expect immunity from the global economy.

Part of the original essay said:

"This has been written to attempt a brief articulation of a major concern that far from saving Australia from the ‘global financial crisis’ the actions, rhetoric and policies of the current Australian government are going to totally immerse us in it, or delay our recovery from it, or both. We are just 1% of the global economy. Time is needed to see where the stimulus packages of China, America and Europe will lead the world. Current local policy prescriptions seem to be pre-emptive, excessive, and poorly targeted."

"Ecinya has suggested that payroll tax relief, personal tax cuts being brought forward, and some relaxation of capital gains taxes for long-term residential property holders upon sale would provide sufficient short-term relief. We are totally opposed to the $950 per person hand-out which apparently will cost about $11 billion and we don’t understand the pre-occupation with direct infusions for commercial property as opposed to working through the banking system. We are strongly in favour of infrastructure spending, but the schools programme is blatantly political and can unfold more slowly than currently envisaged. Some of the ‘green’ programmes seem also to be politically inspired."

"On the rhetorical side we have suggested that ‘balanced free enterprise’ replace ‘capitalism’ and ‘socialism’; that ‘beneficial trade’ replace ‘free’ trade; and that the Chinese Communist Party change its name to the ‘China Central People’s Party’ to mitigate cheap shots from the west during its past 30 year transition and integration into the global economy."

Ecinya Insights article 1/9/2009

The principal contribution that monetary policy can make to economic well-being is to maintain low and stable inflation. I think it is true to say that if you wished to forecast the path of the Australian economy, and you were able to have foreknowledge of only one economic variable, the one you would choose would be the path of the world economy. That is not to say that we have no influence over our own destiny – we can make the situation better or worse than it would otherwise be – but we cannot escape the influence of the world business cycle and the other factors that feed off it.

Ian Macfarlane, former Governor of the Reserve bank, 14/6/2005

 

CONTEXT

Our global proxy, the SP500 is now 12% off its intermediate peak of 1217 reached on 23 April and the All Ordinaries index is 13% off its intermediate peak of 5024 reached on 15 April (our editor’s brother’s birthday who has lived in North America for nearly 40 years). Swans are flying everywhere and only the colour is confusing, some are white, others grey, and some are said to be black, but colour is often in the eye of the beholder. Prior to this retracement the SP500 was 53% off its March 2009 low and our market at the same date was 37% of that corresponding low. The current down-wave is now 22 days old with elevated downside momentum.

It is a time to go ‘placidly amidst the haste and noise’.

But just a bit of background. The IMF and OECD have upped their growth forecasts for the next year or so. These are the same people who were oblivious to the sub-prime fiasco, the depth of the Greek ‘crisis’ and the Euro currency ‘crisis’. We rate their prognostications at low levels. The Goldman Sachs story is alive and well and we expect further revelations and conjecture about their role in world markets and certain economies. The current rates of growth being achieved around the world are driven by stimulus and sustainability is an open question. US housing and commercial property is not ‘out of the woods’. There are stories circulating about downgrades of US government debt. The market technicals are weak, and gold, said to be a ‘safe haven’ is strong. The oil price is weak suggesting lower levels of global activity and this is even more pertinent as the northern hemisphere is entering its summer driving period. Commodity prices are volatile to the downside, currencies are volatile, the Gulf of Mexico oil spill is devastating.

The North Korea – South Korea ‘skirmish’ has just entered potential black swan territory. Black swans are random events as we all know.

The cacophony of the bears is now loud and the bulls are muted with technically driven zealots calling the "end is nigh".

At home our budget deficit and the resulting sovereign debt appears to have not achieved much at all of a lasting nature and the Federal government and the states (apart from Western Australia) have relatively empty wallets. A "responsible budget" means that you have depleted your coffers and cannot afford to buy votes. The Reserve Bank has responded to rising housing prices and poor fiscal settings (though they don’t mention the latter) by raising interest rates as the rest of the world generally has falling, or relatively low, interest rates as they fight various degrees of recession. Then just as interest rates are slowing down the economy, Mr Henry decides that it is a good idea to tax our best performing sector and our only sustainable growth state.

Question (Q): What to do? Answer (A): bring out the six serving men. Start finding questions to begin the search for answers.

 

WHAT

Q: What is happening? A: the glass is suddenly half empty, not half full. In depression the thesis is "Where is the glass?" Though we are far from depression, the ‘double-dip’ talk has re-entered the economic debate.

Q: What signals should we be watching for? A: All Ordinaries moving back towards 4500 in good context, the SP 500 moving back above 1110, takeovers occurring from the people not caught -out in the crash of 2007/ 2008. Plus a BIG BACK-FLIP on the Resources Super Tax.

Q: What will lower interest rates mean? A: That they are needed and that growth is slowing excessively. Retail sales look to us to be pressured with ‘sales’ everywhere, and not all are seasonal.

WHY

Q: Why is it happening now? A: Because the PIIGS problem is now in the open, there has been a change of government in the UK and they are preaching ‘austerity’. America is unwell.

WHEN

Q: When will it all be over? A: We do not know because many thought it was over anyway. But it seems to us that if the world is about to face higher taxes it needs to have low interest rates.

HOW

Q: How will growth emerge in a sustainable way? A: When housing recovers, when unemployment peaks (but watch for government employment making the stats look better than they are), when confidence returns. Calm is required.

WHERE

Q: Where should we focus our attention? A: The USA, China and Asia generally, the UK, Brazil and Australia.

WHO

Q: Who was responsible? A: Ronald Reagan, Alan Greenspan, George Bush II, Dick Cheney, Hank Paulson, Moody’s, S&P, Fannie and Freddie, Goldman Sachs, Bear Stearns, Lehman Brothers, Merrill Lynch, AIG, Morgan Stanley, various UK and European banks.

 

FINALLY

The global financial crash occurred in the northern hemisphere and the only real damage to Australia related to the banks access to capital. The government guarantee was good and necessary policy. The spending was, in an overall sense, bad policy badly implemented. The problem now is that the market weakness will/ is finding its way into Australian households. Anecdotal and observable evidence suggests the local economy is slowing appreciably.

It is the ninth year of inconclusive battle on the plains of Troy, where the Greeks are beseiging the city of King Priam. The gods are intimately involved with the belligerents as a result of jealousies generated ten years earlier when Paris, Prince of Troy, offended Hera and Athena by giving the golden apple as the award of beauty to Aphrodite, goddess of love. Not playing fair (as the Olympians, molded by men, were not disposed to), she had promised him, if he gave her the prize, the most beautiful woman in the world as his bride. This led as everyone knows, to Paris’s abduction of Helen, wife of Menelaus, King of Sparta, and the forming of a federation under his brother, the Greek overlord, to enforce her return.

War followed when Troy refused………………………..

Heavy with wine, the Trojans sleep. Sinon creeps from the hall and opens the trap door of the Horse to release Odysseus and his companions…… They sped through the city to open the remaining gates while Sinon signals to the ships with a flaming torch. In ferocious triumph when the forces are joined, the Greeks fall upon the sleeping foe, slaughtering right and left, burning houses, looting treasure, raping the women. Greeks die too as the Trojans wield their swords, but the advantage has been gained by the invaders.

The episode of the Wooden Horse exemplifies the pursuit of policy contrary to self-interest. The Trojans, having resisted for so long, celebrate the retreat of their foe and glory in the gift of The Horse celebrating to excess. Barbara Tuchman, ‘The March of Folly – From Troy to Vietnam’, 1984.

Gary D Cohn, president of Goldman Sachs, went to Athens to pitch complex products to defer debt. Such deals let Greece continue deficit spending, like a consumer with a second mortgage. Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning.

The New York Times 13/2/2010.

It’s amazing really that on average a derivatives trader earns more than a wheat farmer. I guess that’s where the expression ‘Man does not live by bread alone’ came from.

In conversation with Maximus (an Ecinya confidant), who has been both a wheat farmer and CEO of several derivatives departments, on 13/5/2010.

"We have a simple thesis" said Eisman: "There is going to be a calamity and whenever there is a calamity, Merrill [Lynch] is there." When it came time to bankrupt Orange County with bad advice, Merrill was there. When the internet went bust Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. That was Eisman’s logic: the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in the neighbourhood. Merrill Lynch was the little fat kid assigned to the least pleasant roles, just happy to be part of things. He assumed Merrill had taken its assigned place at the end of the chain [and was ripe for shorting].

Michael Lewis, ‘The Big Short: Inside the Doomsday Machine’, 2010 (page175)

What is it with you wogs? You always want to pay in cash.

Daryl Kerrigan, the family patriarch, talking to his neighbour, Costas Kilias, as each are facing resumption of their properties along with others in the street that has become a community. From the film ‘The Castle’ starring Michael Katon with Anne Tenney as his loving wife.

It’s a slow day in a dusty little Australian town. The sun is beating down and the streets are deserted. Times are tough, everybody is in debt, and everybody lives on credit. On this particular day, a rich tourist from down south, driving through town, stops at the local motel and lays a $100 bill on the desk saying he wants to inspect the rooms upstairs in order to pick one to spend the night in. He gives him keys to a few rooms and as soon as the man walks upstairs, the owner grabs the $100 bill and runs next door to pay his debt to the butcher. The butcher takes the $100 and runs down the street to repay his debt to the pig farmer. The pig farmer takes the $100 and heads off to pay his bill at the supplier of feed and fuel. The guy at the Farmer’s Co-op takes the $100 and runs to pay his drinks bill at the local pub. The publican slips the money along to the local prostitute drinking at the bar, who has also been facing hard times and has had to offer him ‘services’ on credit. The hooker rushes to the motel and pays off her room bill to the motel owner with the $100. The motel proprietor then places the $100 back on the counter so the rich traveller will not suspect anything. At that moment the traveller comes down the stairs, picks up the $100 bill, states that the rooms are not satisfactory, pockets the money, and leaves town.

No one produced anything. No one earned anything. However, the whole town is now out of debt and looking to the future with a lot more optimism.

Supplied last week by Prince Geoffrey (an Ecinya confidant) discovering how a fiat money system works in a closed economy.

When the discussion turned to taxes, Reagan’s fist came down squarely on the table. "I don’t want to hear any more talk about taxes" he insisted. "The problem is deficit spending!" It is difficult to politely correct the President of the United States when he has blatantly contradicted himself. The $800 billion worth of deficits were the result of spending he didn’t want to cut.

David A Stockman, ‘The Triumph of politics: Why the Reagan revolution failed’, 1986.

Quotes above: The Core Messages (note old journalistic adage – ‘90% of the message is in the head-note’)

1. Troy: Enduring fable of government folly
2. Goldman Sachs: Bad advice to Greece worsens the situation significantly.
3. Derivatives traders: Overpaid and counter, or unproductive actions, often tantamount to fraud.
4. Fat boy: Merrills not ethical or smart, now taken over by Bank of America, an icon becomes a victim of its own folly.
5. Daryl Kerrigan: There is a cultural aspect to the cash economy.
6. Country town: How a fiat money system works in a closed economy.
7. Reagan: The source of America’s current calamities, a very poor fiscal President, often cited as an example of good fiscal policy.

 

GREECE IN PERSPECTIVE

Greece accounts for about 0.5% of global GDP, Australia 1.2%, the PIIGS (Portugal, Ireland, Italy, Greece and Spain combined) account for about 5.8%. China accounts for 12.8% and the United States of America 21%. It must seem bewildering to many that Greece could account for the unfolding calamity that occupies most of our TV space, air-waves, daily newspapers and the hyperbole of our Prime Minister and his Treasurer. As an addendum to the ‘Global Financial Crisis’ politicians in Armani suits can proclaim their brilliance and embark on bold adventures, all of which, if they fail, you get to pay for.

Beware of Greeks bearing gifts – the enduring legacy of the Trojan Horse.

 

LET’S KEEP IT SIMPLE

Greece has a simple economic system. Very few people work for a taxable wage; very few people pay taxes, and the biggest earners (remember Aristotle Onassis) pay low taxes relative to their income and have assets abroad, generally hidden. The people in the cities are mainly involved in tourism, construction, or work for the government. Apparently, around 25-30% work for the government. Because welfare is high and taxes are low the government has, in effect, borrowed heavily to meet their payroll and welfare commitments. All systems can survive a great deal of folly while conditions are favourable.

As the government ran out of money they decided not to tell the voters nor the European Commission. Rather they borrowed more money in the hope that things would get better before they got worse. Many of you may remember that old Irish sage, Murphy, who said: "If it can go wrong, it will." But our editor has met very few people who are aware of the old Scottish sage, McPherson, who said: "That Murphy, bless him, is an incorrigible optimist."

But when things get difficult, you call in a financial engineer and try to buy some time. His fees are seldom cheap. So Goldman Sachs turns up and creates a derivative that takes the large debts off the Greek balance sheet and they comply with their European fiscal obligations. Then people realise that all is not well and the Greek government has to seek a hand-out from others who are encouraged to look favourably on the proposals because their citizens savings are now at risk. Will a bail-out increase or reduce the chances of recovery?

The Trojan Horse is alive and well.

However, the now awakened populace revolt. They plunder, burn cars and buildings, and even kill some fellow citizens that are in the same boat as themselves. This could be fairly described as counter-productive behaviour. Living in a paradise, a fool’s paradise suddenly is revealed.

 

TOWARDS THE SOLUTION

When the global financial crisis was well advanced and we were trying to work out how it might unfold, in 2008 we purchased the Churchill speeches from World War II to determine how a real fiscal crisis unfolded, rather than the exaggerated cacophony we were hearing from people who didn’t know it was in the making anyway, such as the Bush administration, Mr Greenspan, Mr Bernanke, and the IMF, to name a few.

We then revisited Bill Bonners’ book ‘Empire of Debt’ (2007) and played the Churchill tapes over and over whilst driving in the car. Thus we were able to see ‘the beginning of the end’ in our March 2009 ‘Bounce’ paper and then later stated in our 2010 Overview Paper that the recovery would be complex. Messrs Bonner and Wiggin said: "Clearly, the central bank of Zimbabwee has overdone it. But if the central bank of the USA has overdone it few seem aware of it.  The secret is to give people more money, but not so much more that they realize all they’re getting is pieces of paper. Paper money may be a fraud, but it still represents purchasing power. When more units of it appear, people assume they have more purchasing power. And when they spend more, the merchants think there is more demand & increase production. Pretty soon there is a boom."

We added our own foot-note in January 2009 as we developed our thesis: "Fiscal stimulus should work based on historical precedent and barring a serious war, but some of it will be well & truly wasted."

We also added another Ecinya note at the same time to our working reference document, which said: "History never precisely repeats, but it certainly rhymes" (Mark Twain). The last bubble/ crash was the tech/telco crash when the S&P went from 1527 to 776 & made a final bottom in March 2003 at 800, just as the first shot was fired in Iraq. The recovery/ boom to 2007 then started and was sustained by the housing credit bubble led by Bubbles Greenspan. Top to bottom in 2000-03 was 751 trading days (2.6 years including weekends). Using that last crash as a template takes us through to about September 2010. My guess is that this quicker crash will be followed by a quicker recovery in the USA than last time, and also in Australia if commodities recover (though past dizzy heights will not  re-occur). This crash began at SP1565. REMEMBER THIS IS A ‘MADE IN AMERICA’ (GLOBAL) RECESSION.

When called to the Greek rescue, Goldmans Sach’s should have said: ‘Look, I suggest you fess up and we can underwrite some bonds for you at a reasonable price and interest rate. If you wait for the walls to tumble, it will be much more expensive later on, perhaps even terminal.’

 

THE SOLUTION

The solution is America. If it can get its house in order, the world will follow. Perhaps an early option would be taking the world’s top 50 derivatives traders to Christmas Island and then selling the island to the International Monetary Fund. But that is a story for another day. Derivatives are now the synthetic tail wagging the real dog, and the dog is visiting the veterinary surgeon on a daily basis. Hedges properly used can be constructive. Improper use is very destructive. Beware of Trojan Horses. Beware of Greeks, or bankers, bearing gifts. Exercise caution.

 

WHAT DOES A GRECIAN EARN?

Not very much at the moment, and not enough to pay off his debts in a timely manner.

One day perhaps someone will be interested enough to trace the point at which the journey into fog began. There can be no respect for the truth without respect for the language. Only when language is alive does truth have a chance. As the powerful in legend turn the weak or the vanquished into stone, they turn us into stone through language. This is the essential function of a cliche, and of cant and jargon; to neutralise expression and ‘vanish memory’. They are dead words. They will not do for truth.

"Death Sentence – The Decay of Public Language" by Don Watson, 2003.

A billion here, a billion there, and pretty soon you’re talking about real money.

Senator Everett Dirksen on fiscal policy, circa 1963.

There are many who believe that George Bush [insert Kevin Rudd] is a liar, a President [Prime Minister] who knowingly and deliberately twists facts for political gain. But lying would indicate an understanding of what is desired, what is possible, and how best to get there. A more plausible explanation is that words have no meaning for this President [Prime Minister] beyond the immediate moment, and so he believes that his mere utterances of the phrases makes them real. It is a terrifying possibiity.

Seymour Hersh "Chain of Command, the road from 9/11 to Abu Ghraib", 2004. The insertions are Ecinya’s. Mr Rudd is more akin to George Bush and distant from John Howard’s good attributes

Mr Walsh, who remade the national economy in the 1980s with Bob Hawke and Paul Keating, is regarded as a tough and uncompromising economic reformer but one who never forgot Labor’s working-class roots. He slammed Kevin Rudd’s reform credentials and style of governing. "The Prime Minister is an economic illiterate," he told The Australian; "an economic illiterate and an egomaniac. He won’t take any hard decisions. He’s capricious. He sees himself as some sort of Platonic philosopher king."

As reported in The Australian 18 November, 2009

The trip had been flawless and successful. It was a pity that among all the good news the ABC’s Jim Middleton reported that on the flight from Pusan to Beijing, in a conversation about Mabo and the premiers, Prime Minister Keating made unflattering remarks about Wayne Goss and called his adviser, Kevin Rudd, a ‘menace’.

"Recollections of a Bleeding Heart: A portrait of Paul Keating PM" by Don Watson, 2002

When the legislative changes for the GST were back in the House of Representatives on 30 June 1999, a little known Queensland Opposition backbencher, Kevin Rudd, told the Paliament: "When the history of this Parliament, this nation and this century is written, 30 June 1999 will be recorded as a day of fundamental injustice – an injustice which is real, an injustice which is not simply conjured up by the fleeting rhetoric of politicians. It will be recorded as the day when the social compact that has governed this nation for the last 100 years was torn up. It will be recorded as the day when the nation’s taxation system moved from progressivity to regressivity. It will be recorded as the day when the Parliament of the country said to the poor of the country that they could all go and take a running jump."

From "The Costello Memoirs", 2008. Hyperbole in magnificent dimesion from out current PM just as he seeks to remove 33% of the States’ GST for his ‘health-care revolution’.

This model, not good luck, is the reason Australia has enjoyed a fifteen year expansion…. It is defined by a floating exchange rate that operates as a shock absorber, a credible medium-term inflation target that governs interest rate policy at the discretion of an independent central bank, a shift towards a more decentralised wage-fixing system, and a permanent budget surplus strategy set at about 1 to 1.5 per cent of GDP.

Paul Kelly, The Australian, May 2006.

The central issues in tax reform, therefore, are slated for the third term at the earliest. And governments are hardly famous for third-term courage. This is a cautious approach. Rudd Labor offers no road map, no broad principles, no statement of intent on future reforms. The juxtaposition between the sweeping nature of Ken Henry’s 138 recommendations and Labor’s caution is conspicuous. Second, with Australia having escaped a recession, Labor’s new focus is to target the resources sector for a revenue redistribution. This is its chief tax priority. This decision will define Rudd Labor. Its presentation is critical yet the government is unsure whether to depict its tax as an economic reform or a populist "soak the corporate rich" mantra.

Paul Kelly, The Australian, 5 May, 2010.

 

An Apology to Mr Ken Henry

The Prime Minister, Kevin Rudd, has a penchant for apologising in a grandiose way for things that have nothing to do with him personally such as ‘The Stolen Generation’. When confronted with the possibility of apologising for entirely scrapping the Insulation Programme, Mr Combet was given the task while Kevin went to Tasmania, no doubt to wear another hard-hat. Thus it is up to Ecinya to apologise on behalf of the taxpayers of Australia for the trivialising and disdain heaped upon the several years of blood, sweat and tears that produced the 3 volume "Australia’s future tax system" report dated December, 2009.

We have little, or no, doubt that Mr Henry and his colleagues would have wished to present the balanced alternative of including the GST in the tax reform proposals, but he has had the satisfaction of seeing the debate escalate, and though Mr Rudd did not intend this to happen in a way counter-productive to his desire to remain Prime Minister, he has certainly reduced his chances. The very excellent Henry Report has been rendered anorexic by Mr Rudd. Not all anorexic victims die, praise the lord.

Mr Henry and colleagues, we apologise.

 

PROLOGUE ON LEADERSHIP

Tax reform will fail because there is no leadership on the issue.

A sub-optimal Prime Minister carrying a litany of fiscal disasters on his curriculum vitae cannot be trusted to formulate proper tax policy nor to implement his misguided efforts in a near-enough-to-viable way. At Mr Rudd’s current level of fiscal recklessness Australia will gravitate towards the parlous state of fiscal folly currently in view in parts of Europe and the United States of America. You cannot run policy through the prism of a PM’s ego. Australia has tried that before, and failed. All countries that try it fail.

Prosperity is the tide that carries us all to fulfillment of our material and social goals and aspirations. You cannot be anti-business and pro-jobs.

Mr Rudd uses weasel words like "working families" without definition, prefaces his remarks about "long-term sustainability" and "Australia’s national interest while I am Prime Minister" whilst being engaged in short-term waste and miscallocation of resources. He was elected, not ordained, yet continues to give interviews outside of his church. Presumably Jesus Christ has given prior approval. He talks in platitudes of ‘stronger, fairer and simpler’ as layers of bureaucracy and complexity are added to an already stressed tax and fiscal expenditure system. In 11 years of absolute and relative prosperity John Howard ‘did not meet the challenges of government’ according to Mr Rudd. Boy oh boy, does this guy have a self-esteem problem.

In terms of primevil salesmanship, immediately upon Mr Rudd becoming Prime Minister, the neo-conservatives were responsible for our manifest fiscal and social folly. Now it is the turn of ‘the greedy miners’ where years of toil, often speculative exploration, overcoming extraction, production and transport difficulties and having to sell into often volatile and cyclical markets. But expertise and positioning over time count for nought. Mining companies re-capitalise themselves in the good times to sustain development in the bad times. Many developments do not produce a viable return for years and years.

In looking at the rhetoric coming from Mr Rudd on the tax "reform" package, the paras immediately above and Kevin’s quoted response to the GST in 1999, it seems certain that even when the PM is putting on his trousers each day it is an historic event. The nonsense never ends!

 

ECINYA’S TAX REFORM PACKAGE

• Extend the Federal parliamentary term to a maximum of 4 years and a minimum of 3.5 years to give policy time to work (or to be modified, abandoned, or fine-tuned).
• Abolish direct donations to political parties by pooling them into a fund with a formula for distribution to retard the growth of crony capitalism and crony socialism.
• Expand the GST to food which will be a big tax, and compensate "the losers" such as pensioners and genuine welfare recipients.
• Capital gains on the sale of residential properties to be treated as ordinary income on a long-term sliding scale basis, say 7-9 years.
• Abolish payroll tax collected by the states via a compensation system and many of the other taxes proposed to be abolished by Henry.
• Increase the tax free threshold and change personal and company tax rates as dramatically as is sensible.
• Have a target rate of total taxes to total GDP similar to the inflation targetting system e.g. 20% in good times.
• Introduce tax breaks on certain forms of savings particularly for younger people specifically saving to acquire a home.
• Have an exceptionally modest federal royalty tax on mining, say about 5% exceeded slightly by the mining royalties currently collected by the states.

 

KEN HENRY’S TAX REFORM PACKAGE

The key recommendations are set out below and we use the same numbers in our cross-reference commentary. We have ignored the 133 (non-key at this stage) recommendations not taken up by Mr Rudd and his Treasurer.

1. Impose a 40% "resources rent tax" on the mining sector.
2. Cut the company tax rate from 30% to 25%
3. Flatten personal tax rates, increase the personal tax-free threshold from $6,000 to $25,000
4. Replace state-based taxes such as payroll tax and stamp duty with broader consumption taxes including land tax on the family home.
5. Curb negative gearing.
6. Combine all family tax benefits into a single means-tested payment.
7. Taxes on interest earned from savings be slashed by 40%
8. Remove the medicare levy.
9. Restore fuel indexation.
10. Introduce traffic congestion charges.

ECINYA COMMENT

1. Emphatically disagree.
2. Agree.
3. Agree.
4. Emphatically agree.
5. Disagree; in fact capital gains tax on residential investment properties sold should be phased out over a holding period of say 7 to 9 years e.g. gain 100% taxable year 1, 90% year 2, 50 % taxable year 5 etc. No deduction for taxable losses (?)
6. Emphatically agree.
7. Emphatically agree, except for land tax on the family home.
8. Don’t know.
9. Don’t know, but do not like indexing anything….. CPI numbers are too rubbery.
10. Agree.

Mr SWAN’S KEY CHANGES (our comments are in brackets)

1. Impose a 40%"resource super-profits" tax on the mining sector from 2012-13 (expedient rubbish).
2. Raise the compulsory superannuation rate from 9 to 12% by 2019-20 (agree)
3. Cut the company tax rate from 30% to 28% by 2014-15, two years earlier for small business (Agree, let’s hope that the definition of small business is not the same as for the wrongful dismissal laws. Lot of potential silliness here.)
4. Create a $700m infrastructure fund to help build state infrastructure from 2012-13. ( Disagree: Unwieldy, complex, hopefully the Building Education Revevolution and National Broadband are not the templates.)
5. Continue to allow workers approaching retirement to top up their super by $50,000 a year. (Agree)

 

To talk about economics requires more and more, that one write about politics.

Paul Krugman "The Great Unravelling" 2003.

It can fairly be said that the chain of catastrophic bets made over the past decade by a few hundred bankers may well turn out to be the greatest non-violent crime against humanity in history. They’ve brought the world’s economy to its knees, lost tens of millions of people their jobs and homes, and trashed the retirement plans of a generation, and they could drive an estimated 200 million people worldwide into dire poverty. In other words, never before have so few done so much to so many. And has there been even one major, voluntary resignation by an American financial executive? One sincere apology? One jail sentence? Why the American public hasn’t taken to the streets in revolt is a mystery that can be linked to our inherent belief in the virtues of capitalism.

Graydon Carter Editor Vanity Fair, June 2009 issue. The magazine is an excellent source of economic and political material. Reproduced from Ecinya’s first new web-site issue of 28 July 2009. Please note we have been publishing now for 10 years.

 

Firm predictions are out of the question. The future depends on the policy responses the financial crisis will provoke. But we can identify the problems and analyse the policy options. We can also make some firm predictions about what the next era will NOT look like. The post-World War ll period of credit expansion will not be followed by an equally long period of credit contraction. Boom-bust processes are asymmetric (not identical) in shape: a long, gradually accelerating boom is followed by a short and sharp bust. Consequently, most of the credit contraction can be expected to occur in the near term.

The Bush administration shows no understanding of the predicament in which it finds itself. Eventually, the US government will have to use taxpayer’s money to arrest the decline in house prices. Until it does, the decline will be self-reinforcing, with people walking away from homes in which they have negative equity and more and more financial institutions becoming insolvent. The Bush administration resists using taxpayer’s money because of its market fundamentalist ideology and its reluctance to yield power to Congress. It has left the conduct of policy largely to the Federal Reserve. This has put too much of a burden on an institution designed to deal with liquidity, not solvency, problems.

George Soros "The New Paradigm for Financial Markets. The Credit Crisis of 2008 and what it means." Reproduced from Ecinya’s first new web-site issue of 28 July 2009. Please note we have been publishing now for 10 years.

 

In just that week, the Party of No’s intransigent campaign of obstruction and obfuscation went belly up. The Obama White House moved to get its act together with an alacrity lacking in its health care campaign, abruptly adding Thursday’s New York speech to the president’s schedule. The bipartisan Financial Crisis Inquiry Commission at last issued it first supoena — to Moody’s, one of the rating agencies that for a fat fee slapped triple AAA ratings on the toxic garbage Goldman packaged and sold to benighted suckers on the other end of a huge bet placed by a favored client, the hedge fund player John Paulson.

Salutary as this rush of events is, it still adds up so far to just one small step for mankind. We don’t yet know how many loopholes lobbyists will slip into the bill-in-progress. We don’t yet know the outcome of the S.E.C. case, let alone what other much-needed legal pursuit of Wall Street may follow it. And we still don’t know what, if any, true correction lies ahead for the financial sector’s runaway casino culture — much of it legal — that turned a subprime-mortgage bubble in a handful of overheated American states into an international economic meltdown.

Frank Rich, The New York Times, 25 April, 2010. ‘The Party of No’ is the Republicans.

 

The US mortgage bond market was huge, bigger than the market for US Treasury notes and bonds. The entire economy was premised on its stability, and its stability in turn depended on housing prices continuing to rise. "It is ludicrous to believe that asset bubbles can only be recognized in hindsight" Michael Burry wrote. "There are specific identifiers that are entirely recognizable during the bubble’s inflation. One hallmark of mania is the rapid rise in the incidence and complexity of fraud…. The FBI reports mortgage-related fraud is up fivefold since 2000." Bad behaviour was no longer on the fringes of an otherwise sound economy; it was its central feature. "The salient point about the modern vintage of housing-related fraud is its integral place within our nation’s institutions," he added.

From page 55 Michael Lewis’s book "The Big Short, 2010. Michael Burry was a hedge fund manager exploiting the chasm that mortgage bonds was to become.

 

Success breeds excess: America has come to believe that its profligate behaviour in relation to energy consumption, poor wages in many areas of its economy, unfunded pension liabilities, a second class education system for many of its residents, the same in health, corporate welfare, tax shelters for those who can afford them, and excess of legal mantra over common sense and good sense, rampant debt creation largely involving other people’s savings, excessive speculation via derivatives and other exotic financial instruments, poor public and private accounting, has led to a country seemingly out of control and exposed to regular crises, few of which are anticipated and after the event, the response is shambolic.

The Ecinya pages 13 January, 2006.

 

Lawrence J Kotlikoff

Mr Kotlikoff is professor of Economics at Boston University and his Curriculum Vitae can be found via Google.com.

Last week (21/4/2010) Charles Babington, Associated Press Writer, reported as follows: "President Obama suggested Wednesday that a new value-added tax on Americans is still on the table, seeming to show more openness to the idea than his aides have expressed in recent days. before deciding what revenue options are best for dealing with the deficit and the economy, Obama said in an interview with CNBC, "I want a better picture of what our options are."

This report brings into focus the essay from Lawrence Kotlikoff which appeared in The Federal Reserve Bank of St Louis Review July/ August edition 2006. The essay was titled " Is the United States Bankrupt?"

His paper concluded that countries can go broke, that the United States was going broke, that remaining open to foreign investment can help stave off bankruptcy, but that radical reform of US financial institutions was essential to securing the nation’s economic future. The paper offered three policies to eliminate the nation’s enormous fiscal gap and avert bankruptcy:

• A national retail Sales Tax
• Personalized Social Security
• A globally budgeted universal healthcare system.

It is interesting to Ecinya that Australia has all three of Kotlikoff’s measures in place today, not necessarily operating with a sustainable degree of perfection, but close enough. They are called:

• The goods and services tax
• The superannuation guarantee levy
• A universal healthcare system run by the state governments.

It is interesting to note that America has just one leg in place of the Kotlikoff three-legged stool and even that leg was constructed against a background of extreme angst and controversy, and has not yet begun.

 

WHY CONTINUE TO FOCUS ON AMERICA??

US gross domestic product is about US$14.8 trillion and this translates into GDP per capita of US$43,180. China’s GDP is about US$9.8 trillion and this equates to $7,350 of GDP per capita. Let us assume for the sake of argument that the USA’s GDP does not change over the next 8 years and China’s GDP continues to expand at 9% per annum. Let us further assume that China’s population stays at its current figure of 1,339 million. On these bizarre assumptions China’s GDP would rise to US$19.7 trillion and per capita GDP would rise to $US14,705, equivalent to 34% of America’s current per capita GDP per capita. It does not take much imagination to see that the world wants and needs a robust and efficient and growing United States of America.

 

BACK TO KOTLIKOFF

The GST (the national sales tax) came about in Australia because it was first proposed by the Labor Party under Paul Keating, Bob Hawke and Peter Walsh, acting on advice received from Treasury. But Hawkie decided he could not sell it to a sufficient mass of voters that would get him re-elected so he abandoned it. Mr Keating as the appointed chief salesman (later fall-guy) said he was not at all miffed, but subsequently went to the backbench and from that vantage point rolled good old Bob and became Prime Minister. The Liberal Party could see an opening during all of this so they elected John Hewson as leader who tried to sell the concept of a GST, but failed miserably, and Keating was elected Prime Minister in his own right (‘The sweetest victory of all’). Along came John Howard, sold the GST to the electorate, and the defeated Paul Keating moved to the Eastern suburbs of Sydney to join Mr Hewson in sniping at Mr Howard for the next 11 years.

What is the message? The GST saved Australia because it was sensible policy and facilitated better spending decisions, lower company and personal tax rates, fostered lower interest rates, and about 11 years of further economic expansion was added to the Hawke- Keating years, assisted,of course, by the rise of China and other emerging nations. As Keynes said: "Fundamental change does not occur quickly."

President Obama is coming to town. It will be interesting to see whether, or not, and presuming the Banking and Financial sector reforms currently going through Congress are passed, that towards the end of the year and going into next year the next major reform in America is a national sales tax. Let us hope he gets to meet John Howard to discuss the matter. Let us hope that some of his economic advisers know what is going on in Australia that might be relevant to their own country. One can only hope.

 

THE PHILADELPHIA FED APPEARS TO HAVE JOINED THE KOTLIKOFF CHORUS

Even with a GST Mr Rudd has dug a great big hole which we are in the process of falling into by declaring "We are all Keynesians now" and spending vast amounts of money on over-funded projects which either have failed or are in the process of failing or are doomed to failure beyond the next election. These of course are the emissions trading scheme debate, the $900 hand-outs and the national home insulation roll-out, the Building Education revolution, and last week the "new" health system. In relation to the latter many health professionals don’t appear to know how it will work, how it is supposed to work, who will be responsible for it working, and what it might cost. The same questions appear to apply to the proposed $43 billion national broad band network concept (is it a plan?)

We have found an edited transcription of remarks given at the Philadelphia Fed’s policy forum "Policy lessons from the Economic and Financial Crisis of December 4, 2009 by N Gregory Mankiw (an Harvard Professor) titled "Questions about Fiscal Policy: Implications from the Financial Crisis 2008-2009". It appears that the St Louis Fed is also involved in this paper’s creation.

Mankiw believes in Keynesian theory but not without reservations and suggests that enhanced government spending can inadvertently drive up interest rates and taxes. He poses a number of questions:

• Can governments spend large amounts of money quickly and wisely?
• Are the relevant multipliers that are applied to Keynesian spending correct as opposed to the multipliers that pertain to lowering tax rates? He says the Keynesian conclusions are questionable.
• Do tax rates influence work and savings incentives?
• Will healthcare legislation reduce healthcare spending?
• Is the VAT coming?

 

SHORT TERM FEARS AND RIDDLES

• The IMF has said global growth has returned to circa 4%. They didn’t know about the GFC until it slapped the entire world in the wallet. Thus we should treat their pronouncements and actions with some scepticism. Currently, their Greece solution seems to be fluid in context of rubbery Greek numbers on the depth of the ‘crisis’ and the political reality of potential solutions.
• What has emerged with Goldman Sachs thus far looks like the the first cockroach, meaning that more are sure to exist. (Michael Lewis’s book throws up a lot of questions)
• The new GDP numbers for most of the developed world have been achieved via massive fiscal and monetary stimulation so that unqualified comparisons seem misleading. Australia has moved pre-emptively on interest rates and that seems good policy in context of sub-optimal fiscal policy outcome.
• US housing is still cum the housing credit and better weather for construction.
• Can the US continue to borrow abroad at current interest rate levels? Watch 10 year bond yields.
• The Henry tax review is likely to be substantial nonsense.
• The All Ordinaries index looks weak vis the SP500.
• The SP500 looks stretched and vulnerable.
• The Shanghai index looks to be rolling over.
• The copper price looks like the Shanghai index.
• British politics looks to be complicated leading into the election.
• America believes it is a capitalist country and wants to debate socialism under Obama and capitalism under anyone else. Congress seems to be fighting old wars on dogma and confusing and disappointing main-street.

 

Don’t you see that the whole aim of Newspeak is to narrow the range of thought?

George Orwell, 1984

A powerful agent is the right word.

Mark Twain

No nation was ever ruined by trade.

Benjamin Franklin

President Bush left for Canada today to attend a trade summit. Reportedly, the trade summit got off to an awkward start when the president pulled out his baseball cards.

Conan O’Brien

ECINYA SUBMISSION: MORTIMER TRADE ENQUIRY

The following is a submission made by the Ecinya editor to the Mortimer Trade Enquiry in 2008. The enquiry was undertaken to assist the development of an integrated trade policy that would “drive productivity growth, enhance international competitiveness and improve export performance”. The ideas introduced, including an increased role for government and the importance of containing the trade deficit remain central to future growth, and as the economy shows signs of a possible recovery it is timely to review these issues.

 

1 April 2008

David

This is meant to be extremely broad brush, more in the nature of a conceptual framework rather than specific in terms of direction or solutions.

1.     The major aim of this submission is to introduce two Ecinya concepts to the debate: The expression ‘beneficial trade’ should replace ‘free trade’. The expression ‘balanced free enterprise’ should replace ‘capitalism’.

2.     Words do have a precise meaning. How can we speak of bilateral trade agreements on one hand, and ‘free trade’ on the other. Better that we look for a new expression and ‘beneficial trade’ might be the descriptive answer.

3.     It is clear that there is a role for government in relation to matters economic. The days are past when unfettered capitalism was a useful description of the way developed economies work, or a reliable framework for poorer economies to attain sustainable prosperity. The recent exotic debt implosion and the previous dot com bubble/bust are contemporary examples where capitalism has clearly failed. In each of these busts the government was found wanting. It is axiomatic that ‘socialism’ has failed, but the welfare state is far from dead. The challenge for free enterprise economies is to define the limits of government involvement, and the scope and manner of intervention.

4.     Prosperity is the tide that carries us all to realisation of our material and social aspirations and trade is an aspect of the attainment of prosperity. It is axiomatic that an effective trade policy requires a strong and balanced domestic economy. ‘Balance’ requires a viable and progressive tax system. It is obviously outside the scope of your enquiry, but one cannot but feel that while-ever we exempt food from GST we cannot achieve real tax reform that delivers reward for merit and also provides an appropriate social safety net within an efficient and targeted welfare system.

5.     The government sponsoring a trade enquiry is sufficient evidence that government aim to play a substantive and positive role in commerce. Government expenditures as a share of GDP is probably the clearest statement of all.

6.     Why trade at all? University economics tells us that overall living standards can be raised via trade. The theory was the comparative advantage would lead to the appropriate scale, best productivity outcomes, and the lowest price within a defined quality. But we now know that the expansion of education over the past 25 years or so has meant that knowledge and skills has enabled relatively poor countries to produce the goods and services that were the exclusive domain of the developed countries.

7.     “Globalisation” is the broad expression used to partly describe how the theory of ‘comparative advantage’ has become obsolete. Yet one cannot but feel that ‘globalisation’ was the American response to its inability to control the American manufacturing unions and so jobs were exported as American companies found it easier and cheaper to manufacture abroad. The longer-term and perhaps inevitable result has been the rise of Japan, followed by Taiwan and South Korea, and now China. European trade with Asia has also expanded rapidly over the past few years which is probably a belated recognition that an inept welfare system and union power has cooked the European manufacturing goose.

8.     America’s response to the demise of local manufacturing, using the advantage of being the world’s reserve currency, was to become a ‘service economy’, a nation of bankers. However, having lost the will to manufacture, America then lost the skills. Ultimately, we now have many, many products that are produced abroad that are of comparable quality – form pianos to barbeques, from television sets to cars etc. The problem ultimately becomes that a nation that produces little has to import a lot. Having lost the desire to produce, you then lose the capacity to produce on a competitive basis. Consumers, who had manufacturing jobs, end up with few jobs, and/or declining incomes, and consumption has to be propped up by lower interest rates. So you end up with the worst of all possible worlds – low employment growth, declining incomes (except for bankers), an indebted consumer, and an intractable current account deficit mainly brought about by the trade deficit.

9.     TRADE IS NOT A ONE WAY STREET: Too often when we have a trade enquiry all we talk about is exports. But IMPORTS are just as important. In looking at the trade balance we need to look at the question of import replacement. What industries do we wish to maintain our skills in? Should we maintain a basic capacity in almost everything? Why should we import olive oil and jam when we can grow our own inputs and put them in a can or jar? Why create a job in China at the expense of losing all of our jobs in that product category in Australia? What goods are we not producing, when with some investment, we could produce them? Perhaps all of these questions can be asked and solutions addressed within the concept of ‘beneficial trade’.

10. Beneficial trade means that we will import from, and export to, countries where it is beneficial to us. China buys our resources in large quantities, we buy their manufactured goods. Brazil exports iron ore to China why should we buy their farm produce when we can grow our own? We grow olives and can produce olive oil, why buy Italian olive oil in such quantities? We buy enough of their suits anyway.

11. Running a persistently high trade deficit means that we are consuming more than we are producing. This cannot last forever. It is bad longer-term policy. We need a local manufacturing policy that works, and dove-tails with our export capacities and aspirations.

12. ‘Beneficial’ might mean politically beneficial in some instances e.g. to assist a poor or emerging country to become more viable we will develop a trade relationship. We have no doubt that China has benefited from trade to such an extent that democracy is less than two decades away. As living standards rise the demand for democracy grows.

13. SO THE OVER-ARCHING QUESTIONS become: How much trade OUT do we want? How much trade IN do we want? What good and services should it be? Who with? What investment do we need now in order to get it in the right balance later? If it cannot be now, when can it be? Why trade with that country in that commodity when we can trade with another? Where are our good relationships?

14. Once upon a time in economics the real economy (the production of goods and services) used to drive the symbol economy (money and credit). That has now changed and money and credit seem to be the primary driver. But it may be swinging back with the fast reducing role being played by the US given their entrenched economic problems – twin deficits, wars over time and budget, oil prices, health, education, infrastructure. The multi-nationals are a big factor in trade flows. A dividend paid to a foreigner producing locally, is the same as an import as regards the current account deficit. Hence the role of foreign investment is another aspect of a beneficial trade policy.

15. As Rudyard Kipling said: “I keep six honest serving men, They taught me all I knew, Their names are What and Why and When, And How and Where and Who.”

16. Or as Ecinya once put it – “Research is to contemplate the possibility that intuitively you may not know the answers, and worse still, you may not even know the questions.”

1. It is unlikely that God’s plan for the universe includes making you rich. Success in the stockmarket requires effort, discipline and patience. 90% of success is having the discipline to be consistent.

2. "Research" is to contemplate the possibility that, intuitively, you may not know the answers, and worse still, you may not even know the questions. Information insightfully interpreted will help avoid being caught in a position where you can lose a lot for reasons not understood. Try to avoid making the facts fit the theory, especially in relation to timing. Speculation is not investment.
Buffetology: Can we understand the business? Does it have a sustainable competitive advantage? Do we like the people? Are we getting it at the right price?

3. Trust falling interest rates to begin a new bull market. Bull markets are driven by liquidity. It takes a lot of bad news to reverse a bull market, and a lot of good news to reverse a bear market. Calculate and analyse ‘trend’ very carefully.

4. Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria. BUY when others are despondently selling. SELL when others are greedily buying. When too many people are doing the same thing the market will adjust. Bull markets are driven by liquidity.

7. Human behaviour cannot be predicted. Distrust anyone who claims to know the future. Chaos is not dangerous until it begins to look orderly. Beware the historian’s trap, beware the chartist’s illusion.

A selection from the Ecinya Investment Rules, formulated July 1997.

I keep six honest serving men, They taught me all I knew. Their names are What and Why and When, And How and Where and Who.

Rudyard Kipling.

Even Karl Marx had to be right occasionally. When he observed that capitalism contained the seeds of its own destruction, he had at least a talking point.

Boom and bust are customarily depicted as the extreme points in the regular operations of the business cycle, the comfortable conclusion being that we need not and cannot do anything about them. There are two grounds for challenging this belief. The first is that recessions do not treat all companies equally. Businesses do not collapse through any iron rules of an economic cycle but because of the greed and folly of the people who run them. Well-run companies survive the most vicious economic downturns but badly run companies don’t.The second ground for challenge is that if the business cycle is working the way it is supposed to then we had better do something to change it, because the damage being done is becoming intolerable.

Trevor Sykes "Two Centuries of Panic – a history of corporate collapses in Australia", 1998.

There are market players and value players, both in stocks and commodities. The market player relies on his knowledge of price movements in the market as a whole to make money. The value player looks for buy-and-hold opportunities in specific stocks or commodities that are likely to appreciate over time. Most consistently successful pros are both, but more the former than the latter.

Victor Sperandeo , "Trader Vic- methods of a Wall Street master", 1991.

This is not a black-and-white business.

The ‘secret’ is the shorter your time frame of trading, the less money you will make.

A perfect system or approach does not exist. Never has, never will.

Life is a judgement call, but that call is based on having data and systems to make life work better. So it is with trading. I need a systemic approach to get me in and out of trades, I need absolute stops, and I sure as heck need precise entry rules.

The first rule of life is to survive; the second rule is that all rules can be broken if that supports the first rule. In trading, always use stops.

Larry Williams "Long-term Secrets to Short-Term Trading", 1999.

 

BUY and HOLD

In seeking outperformance within reasonable risk parameters that do NOT define you as a ‘speculator’, Ecinya believes that it is necessary to trade around the edges. The buy-and-hold strategy works well in prolonged upturns, but does not prepare you for the (inevitable) downturn. Thus developing trading strategies is the pathway to outperformance. This is the approach that the Cactus Fund takes, though we do have two other unpublished portfolios that are essentially passive. Also if you are a regular reader of the Ecinya pages you will have noticed that we recently abandoned a published portfolio called ‘Bamboo’ after just 14 weeks of operation as we were of the opinion that the markets had gotten too far ahead of themselves in terms of the SP500, our global proxy, and the XAO, our local benchmark reference point.

The stock-market has changed a lot. On-line brokers have reduced the cost of doing business. Participation and knowledge has increased exponentially. Hedge funds are active and volatility has increased as a result. Overseas fund managers are comfortable with our market and about 60% of the market turnover comes from overseas brokers with all of the American majors having large local operations. DIY superannuation is common. Compulsory superannuation under-pins the market.

 

HOW, AS AN INVESTOR, DO I LEARN TO OCCASIONALLY TRADE?

1. Always make a note as to WHY you bought a stock in the first place. Have an idea or concept of price and of value.
2. THINK in terms of essentials – Rudyard Kipling might assist here. Always have a macro perspective.
3. Experiment with charts, toss them around, add indicators, access help menus to assist your comprehension of them.
4. Develop some trading and investment rules. Under the tab THINK we have four contributors who might assist in this.
5. Record and measure your investment performance, document some benchmarks.
6. Learn to read quickly, don’t expect to have perfect knowledge in an imperfect world. Watch the language.
7. Enjoy your successes, learn from your failures, but do not expect to fail otherwise you will.
8. Read Victor Sperandoe’s book (Methods of a Wall Street Master) if you read no other. After you finish it put it away then invest and trade, read your notes and read the book again. After about 5 readings you will learn to appreciate its value.
9. Read the Ecinya pages. If you have a query send us an email or a response.
10. Have some fun; golf and the market are essentially mind games.

Commentary on the above –

1. Memory is often self-serving and/ or unreliable. Even if the diary note is "Bill Bloggs said to buy it", at least you know you have not developed an opinion of your own. But a better note would be "Bill said he had bought it, i looked at it, I looked at a chart and felt good about the economy in broad terms, so I bought it. The things I liked about the stock were…." . In our Stock Recommendations our entry price is derived from our valuation models. We set the entry price at 90% of our ‘fair value’, one year hence. We do not want to buy stocks that are over-priced, or even fully priced. The Ecinya valuation models operate at both a macro and micro level. The macro incorporates a view on current and future interest rates, confidence, and the current stock-market. The macro inputs apply to our entire stock universe. At the micro level we have a rating matrix for operational and corporate credibility, excess growth potential, x-factors and gearing levels. The sum of the macro and micro gives us a ‘fair value price-earnings-ratio’ for each stock. We determine the EPS from Aegis Equities Research, consensus numbers, our view of company guidance, Huntleys, and our own formulated view on the company’s earnings profile. We read many annual reports, stock-market announcements etc. We have a wide range of confidants who have views on a wide range of industries. Our models give us a target price 6 months hence, 12 months hence and 18 months hence. Essentially, our models are really all about the macro and micro mathematics.

2. In Kipling terms, apart from WHY, other questions might be: WHAT does the company do? HOW well do they perform? WHERE do they operate from? WHO runs the company? In relation to Kipling’s wisdom we have always found the ‘WHEN’ question the most vexing of all, and the ‘WHO’ question as being one that can be mostly ignored except for smaller companies where directors are often after a quick buck. We DO NOT rate management, and instead assume that management is self-serving, engaged in self delusion, obfuscation, or outright lies. Over many years our editor has met just one trustworthy company that does not spin, or engage in market and self-deception. Bankers are often the biggest spinners of all, especially US central bankers.

In relation to having a macro perspective we read books, we subscribe to various web-sites and magazines. The Dismal Scientist is an expansive and expensive web-site that provides global data on a daily basis. We build macro-economic models from these sources, looking for trend and absolutes. Data is hardly ever meaningful until you have accumulated a lot of it and attempted to make the macro data fit with the market cycle and the micro stock views. The fit is never easy, but the data analysis causes you to determine confirmation or divergence. Timing is always the problem. In relation to the national economy we generally pay particular attention to ANZ Economics and Westpac Economics as we have timely access to these publications and have developed a view as to the reliability of their conclusions.

3. We always look at a chart and have developed a set of principles around which we can analyse and interpret charts. Charts are described by Carl Swenlin as "a wind-sock, not a crystal ball". Our interpretive principles involve measures like moving averages, price channels, bollinger bands, trend lines, support and resistance levels, momentum etc. What we are looking for is confirmation, or divergence, from our calculated fundamentals. If our model says a stock should be going up and it is going down, it is generally clear that the market is either mistaken, or knows something we do not know. Can we find the question? Can we find the answer? The market is not always right; there are frequent divergences between price and value. We also consult with a gifted chartist whom we call ‘Compass’ and we seek his views on a regular and on-going basis. We read various chartist web-sites, mainly in relation to our global proxy, the S&P 500, as well as charts on commodities and currencies. Larry Williams says; "Charts do not make the market, the market makes the chart." "History repeats, but not with precision."

4. Knowing that you know what you are attempting to do is important. Verbal thoughts are not worth the paper they are written on.

5. Our benchmarks are – absolute and positive returns overall; outperform the All Ordinaries by at least 400 basis points (if the XAO is up 10% then we want to be up 14%).

6. 90% of the message is in the head-notes. A quick read of the headnotes can ‘put you in the picture’. Are the head-notes positive or negative? We use a tick when we understand something we are reading and agree with, a cross when we understand and disagree, and a question mark when we are uncertain as to understanding or agreement, or disagreement. In reading company announcements and annual reports watch the language. Language is important in corporate communications. So much of it is truly dreadful, and in such quantity we can only believe it is aimed at encouraging you not to read any of it. We are especially wary of euphemistic expressions like ‘robust’, ‘solid’, ‘challenging’, ‘values’, ‘governance’, ‘key performance indicators’, ‘benchmarks’ , ‘stakeholders’, etc. We are cognisant and a devotee of the ideas of Don Watson expressed in his book ‘Death Sentence: The Decay of Public Language.’ We do not like annual reports obviously written by public relations ‘experts’. Recently, we were greatly amused by the theme of the Transpacific annual report ‘365 days of progress’ following a year in which the company had to restructure, dilute shareholders, and experience a share price fall from about $10 to near $1. Also watching David Jones run full-page ads about how they were a better investment than Myer pre-float, without even mentioning their track record on EPS growth, was truly disappointing. How did responsible directors approve of such rubbish? We believe that David Jones should have received a warning from ASIC on the content of these ads. Also the Myer prospectus seemed to imply that Jenifer Hawkins was a good reason to buy shares in their over-priced float, simply because she is beautiful.

7. Losses come with the territory. Being wrong is not a sign of weakness or failure, but staying wrong is.

8. Just do it it!! Everyone we have recommended read this book have thanked us immensely.

9. Our aim is to keep ourselves thinking and to get you to think as well. You can even profit from our errors.

10. Mae West said: "You only live once, but if you do it right, once is enough".

 

OVERVIEW

ECINYA operates on multiple levels and these may be referred to in the familiar terms of ‘top down’ and ‘bottom up’. However, it is essential that they meet in the middle as a formulated and structured basis for action. The market is so dynamic that our convictions, though firm, are changed by new information, challenged by new questions, and thwarted or rewarded by subsequent events -nearly all of which are outside our control and influence. All we are in charge of, really, is ourselves. The process of Think, Act, Review springs from our deliberations.

In the About Ecinya section we say: "ECINYA is an acronym for Exercise Caution In Your Affairs and is meant to remind both you, and us, that in order to get rich quickly you should endeavour to get rich slowly, as all endeavours require appropriate management of risk, and time. The stock-market from time to time appears to be an easy endeavour, but neither the economic cycle or market cycle is dead, and profits won on one adventure can disappear in the next. Folly can easily follow triumph. Those that tell you the market is easy, ‘either do not know, or do not know that they do not know’ (J K Galbraith).

Ultimately, success in the stock-market comes down to you, for no matter how much we know, the future is difficult to predict, both in relation to time and dimension. No one cares as much about your money as you do and Ecinya encourages you to develop sources that can assist you to take advantage of many sources of information. In looking at source material be mindful of confirmations and divergences of opinion. The aim of the Ecinya pages is to help you to build a set of thought processes to assist you to successfully invest, and occasionally trade. It is considered that occasional trading can enhance performance.

In defining the Ecinya approach, which is almost exclusively fundamental, our proximate matrix is 35% fundamental company, 25% the global economy, 20% the national economy, 13% technical analysis, and 7% quantitative analysis."

OPPORTUNITIES

Opportunities come in various forms. Stocks may be over-sold. A market turning point may be in prospect. ‘Fallen angels’ may represent an opportunity – Toll Holdings fits this bill. New management or new investors may have come on board. Digestion problems may have occurred as companies have paid too much for an acquisition or the integration process has not gone well. Recognising takeovers can be lucrative. Turning points represent major opportunities and do not come all that often as they occur at peaks and at troughs. In March 2009 we identified a potential turning point and documented it in our Insight article "March 2009, a retrospective". Part of that article said:

 

"MAJOR REASONS FOR OPTIMISM

There is currently no hard evidence that the bottoming process is complete in market terms and there is accelerating evidence that the local and global economies are performing ever-more poorly. BUT the market bounce will lead  the economic bounce.

The combination of lower interest rates and stimulus packages will work. The vexatious question is WHEN.  The market itself should tell us.  The bottom is a process, not an event. So expect bounces, retracements…. then at some time, consolidation…. and later a faltering advance as the good news begins to overtake the bad.

Plenty of things can go wrong.

Black swans are now in vogue and flying everywhere (disequilibrium). White swans are the norm (equilibrium) and the periods of sustainable growth over the course of history have exceeded periods of severe, or soft, recession. One recession in a long period of growth (though some of it was fraudulent) does not seem unreasonable.

Using our ancient acronym of ICE – Interest rates, Confidence and Earnings we can currently say : Interest rates are going down, Confidence will return only when global confidence has a bounce, and soon the EARNINGS focus in Australia should be on fiscal year ended 30 June 2010. IF analysts behave as they have in the past, earnings forecasts will be wound back excessively as this reporting season passes.

ANECDOTAL EVIDENCE IS IMPORTANT IN ANY TRANSITION FROM EARNINGS DECLINE TO EARNINGS RECOVERY. MARKETS DON’T RECOVER FROM A SINGLE CATHARTIC EVENT, BUT FROM AN ACCUMULATION OF DATA AND A GRADUAL RE-BUILDING OF CONFIDENCE.

The world economy is still running at around $US70 trillion compared with $60 trillion in 2006. The BIG thing that has happened is the implosion in the American banking system and the flow-on impact to the real economy – “From Wall Street to Main Street.”

ECINYA’S theme for 2007 was “A year of living dangerously within a framework of cheerful paranoia” – there was an expectation that Mr Market wanted to take some of our profits. In January 2008 the theme in our Overview was “A tale of two halves and the long good bye to two half-wits”….. Messrs Greenspan and Bush.

BUT the downturn evolved slowly in 2008 and then the US banking implosion, and its still unfolding disclosures, hit with sudden force and this completely negated prospects for early recovery. Direction was well anticipated, dimension was not.

Remember that we live in a fiat money system. 

Bill Bonner (2007) expressed it well, with just a tinge of cynicism : "Clearly, the central bank of Zimbabwe has overdone it. But if the central bank of the USA has overdone it, few seem aware of it. The secret is to give people more money, but not so much more that they realize all they’re getting is pieces of paper. Paper money may be a fraud, but it still represents purchasing power. When more units of it appear, people assume they have more purchasing power. And when they spend more, the merchants think there is more demand and increase production – hiring workers and ordering machinery. Pretty soon there is a boom."

Ecinya comment: Stimulus should work, but some of it will be well and truly wasted.