The mother-of-all bounces

Last November I posted on the mother-of-all-crashes Through a couple of graphs I detailed why the Australian and US sharemarkets were falling at a faster rate than the great sharemarket crashes of 1929. After the post, the Aussie market drifted sideways for a few months before falling even lower to below 3100 (March 09), for a total peak to trough fall of 55 per cent.

Now, a year on from that post, we have witnessed, perhaps, the mother-of-all (dead cat?) bounces, in an 8 month period from mid-March 2009 to mid-October 2009, the All Ords has rebounded some 56 per cent from the trough (see chart below).

Chart 1: All Ords - crash and bounce
The rise or fall of the All Ords is largely attributed to the big 4 Australian Banks and BHP. The big four banks account for 21.47% of the All Ords, while BHP accounts for 10.15%. If you compare the chart below (Financials Index) with chart 1, they are a mirror image of each other.

Chart 2: The Big 4 banks led the All Ords crash, and now the recovery. Notice the % fall and % rise similar proportions to Chart 1 (XAO)
No other area in the Australian economy has done as well as the Big 4 Australian Banks. They now have combined market capitalisations which exceed the pre-GFC crash. Through help of the Government, they have increased their monopolistic position in lending. For reasons unknown, the Australian Government and ACCC allowed Westpac to buy St George Bank (no. 5 bank), and Commonwealth Bank to buy BankWest. In early September 2009, the Australian Prudential Regulation Authority figures reported that the big four lenders captured almost 100 percent of the $7 billion in new mortgages written in July 2009, squeezing the small lenders out of the mortgage market. Before last year's funding freeze in global markets, the big four banks' share of new mortgages was running at about 60 per cent. Some day soon, just like in the US, we will be having the “too big to fail” debate in Australia. The Australian banks are sitting on the mother-of-all housing bubbles, which is staying upright for now due to unprecedented net migration and government stimulus intervention (see further below). Give it a couple of years, the Great Australian Housing Ponzi Scheme will eventually run out of buyers.

Like the Aussie market, most world markets have bounced, including the Dow Jones (US). As the following chart demonstrates the length and magnitude of this bear market bounce is unprecedented when compared to the Great Depression bear market rallies.

Chart 3: Depression-era bear market rallies (Dow Jones)
source: Chart of the Day

The three charts above give us a clue about the state of the world economy (and I would argue, the state of the US-centric monetary system). Extreme volatility is in full swing.

USD-AUD Exchange Rate

No better example of extreme volatility in the system is the USD-AUD exchange rate.

Chart 4: In 16 months the AUD has gone from almost parity with the USD, crashing 39%, and now rebounding 56% from the lows at 60 cents
So what has changed?

Nothing, nothing has changed. The fundamentals are still broken. The US is still trading insolvent and an aging population will ensure most Western Countries will pursue a path of monetisation (going into more debt) to pay for the welfare state. What has changed is two things:

Inflation and Timing

During the GFC we were constantly told of deflation (decreasing prices). However, during this time I argued that inflation was and will remain our greatest concern. In the middle of the GFC (June 08), Australia's money supply growth was at 23 percent (annualised), the highest rate since the mid 1970s. I ask.. is it any wonder that it appears Australia is such a buoyant economy right now? We inflated our way through the GFC. Another angle is that we populated our way through the GFC (see chart below). If you add more citizens to the economy, there is greater demand on food, housing and general consumption. Add Government "free" handouts, and the warm fuzzy experience we feel aobut our "resilient" economy was all-but inevitable. To the contrary, I believe this is making a bad situation worse, at least for the long run. The artificial wealth effect continues.

Chart 5: Inflate and populate out of financial crisis! Australia net migration since 1860. You would think there was a gold rush on...source: ABC News, Alan Kohler, 23 Sept 2009

The other difference at play here is timing. During the GFC, the All Ords, Dow Jones and even world trade (click to see charts) were declining at a faster rate than what they did during the 1929 crash. The rate of fall was just unsustainable. It's the law of the markets... or like bouncing a tennis ball. If you bounce it hard on the ground, its going to bounce back to some extend. In market terms, this is called a dead cat bounce (however some stocks fall and just don't bounce...). Timing is everything. For instance BHP was almost $50 per share prior to the GFC crash, than fell to $21 seven months later. Same company, and arguably the fundamentals of BHP were stronger than ever. The difference is market mood. Perceptions of value change over time.

Dow-Gold Ratio still falling

One of the key indicators I keep an eye on is the gold-dow ratio. When we price the world sharemarkets against gold, the downward trend is still well intact. Historically the Dow-Gold Ratio goes to below 1 when gold becomes very expensive relative to the sharemarket (Dow). There is still a long way to go... Gold is very cheap at US$1,100 oz!

Chart 6: What bounce?
source: Chart of the Day

Money can be made in all market conditions. Volatility in the markets in the last two years is telling us something is happening. Short-term it may appear that everything is back to normal. This couldn't be further from the truth. Measuring the share market and housing markets (and other debt-based markets) in terms of a tangible good (ie. gold) tells a very clear non-volatile storey. The long-term fundamentals have not changed, but arguably getting worse year by year, as Government and banks continue to fuel the fire with more fuel (inflation).

Cheers
Scott

(feel free to comment!)

Australia – selling our (fake and real) money to the world

Playing with toy money

If a child tried to pay for lollies at a tuck shop with notes from the Monopoly board game, the shop staff would know instantly that it was fake money... Yet in today’s society, we commonly accept and take for granted the polymer banknotes which we use every day as “money”. They are both just pieces of paper, so what’s the difference? They are both forms of currency, but accepted under entirely different circumstances. Paper money today, whether it be Australian Dollars or Zimbabwe Dollars are deemed valuable, only if the population believes it should represent value. We still believe a $50 Australian dollar note is worth $50 dollars – because that’s what the note tells us. However, we are aware that a $50 note today doesn’t buy as much as it did 10 years ago. Despite the knowledge that inflation is eating away at our purchasing power, we continue to be loyal to our currency. One day this will change, and it will be just monetary history repeating .

Fake (Fiat) vs Real Money

Part of the money problem today is that the definition of money has changed over the generations. Few people alive today were alive in the 1920s or 1930s when coins actually had silver in them, where your savings in the bank held its purchasing power, because our money was linked to gold. 100 Years ago, gold and silver were referred to as money, as it was the lifeblood to the monetary system. Today gold and silver are.... gold and silver, and banknotes and circulating coins are referred to as money. Another way to put it, gold and silver has and always will be real money, as it is a finite resource, while banknotes and circulating coins are merely currency. Currency is not money! It’s a fake, and more and more people will realise this over the coming decade as inflation dilutes our currency, while at the same time, increasing the value of real money (gold and silver).

Banknotes used to represent value

Historically banknotes were merely receipts for “real” money, that is, gold and silver. If you deposit 1 ounce of gold, you got a banknote (a receipt) which said it was redeemable for the amount written on it. In the US, its Constitution was written to include , that "No State shall...make any Thing but gold and silver Coin a Tender in Payment of Debts." Therefore, up until 1933, US banknotes held the words “Redeemable in gold on demand at the United States Treasury”. (confirming the role of the banknote as a receipt). In the Australian Constitution, Section 115 establishes the same principle, that “a state shall not coin money, nor make anything but gold or silver coin a legal tender in the payment of debts”.

The Constitution is our legal and political rule book (in this instance in Australia, Section 115 is the rule for monetary policy), but despite this, in 1971 the principle of backing a currency with real money was removed, when President Nixon removed the gold window for US Dollars, thus making the US Dollar and all other currencies in the world completely fiat (money declared by a government to be legal tender). In other words, between 1946 and 1971, any nation could hand in their US Dollars (receipts) and buy gold from the US for US$35 dollars a troy ounce.

Because the US printed extra dollars to pay for a negative trade balance and increasing inflation, other countries (particularly France, Switzerland and Great Britain) began to convert/redeem their US Dollar reserves with US gold. Thus the US had no choice but to abandon the system in order to preserve its gold. However, following this change, the US Dollar remained the world reserve currency, despite there no longer a requirement to link the Dollar to gold. Thus an endless money tree was born – and now around 70 per cent of the world’s currencies are denominated in US Dollars (with half of these Dollars residing outside the US).

Private bankers control our monetary system – not Governments

After explaining this brief history, there is one critical element which has not been covered. Since 1913, the Federal Reserve has been responsible for issuing currency in the United States. The Federal Reserve is a non-Government, private corporation which has private shareholders. It was established by private European bankers from families such as the Rothchilds, and Warburgs. These private banking families still remain shareholders of the US Federal Reserve, and thus have direct control over world monetary policy – through the US Dollar, and through the debt based Fractional Reserve Banking system. If the US Government can issue bonds, why does it need a private banking consortium to issue currency for the people? (I will go into greater depth another time).

Likewise in Australia, Australia’s banknotes and coins are issued in the same was that US Dollars are issued in the United States. For one year in 1910, Australia’s notes and coins (Pounds) were controlled by the people, under the Treasury Department. By 1911, the Commonwealth Bank was given powers to issue banknotes (however this was not made law until 14 December 1920 through the Notes Issue Board), and given central banking powers in 1945. The convertibility of Australian banknotes into gold effectively ended during World War I. In 1959, the central banking powers held by the Commonwealth Bank were transferred to the new Reserve Bank of Australia (RBA). Like the recently created Future Fund, the RBA is not a Government Department, but an independent statutory authority. Essentially the RBA make decisions on monetary policy (how much money (or inflation) to print) – just like the Federal Reserve has the power to influence the US Dollar (and economy through interest rates) in anyway it sees fit.

So why do we have confidence in paper money such as Australian Dollars today? Why do we allow bankers to control our money (by inflating it continually year in year out, largely through fractional reserve banking). Aren’t we just using Monopoly (Central Bank controlled) money?

So now that we know Australia no longer backs its Dollars with gold, what has the RBA done with our gold?

The Australian Government sold "our" gold

In early 1997 the Reserve Bank of Australia held nearly 250 tonnes of gold bullion reserves. By July 1997, the RBA sold 167 tonnes, reducing its holdings from 247 to 80 tonnes (selling some 6 million troy ounces). That 167 tonnes of sold gold is now worth an extra US$4.2 billion more 12 yrs later. What will it be worth in 10 years time? More importantly, what sort of purchasing power will that gold have in 10 years time (remember, there is a huge difference between price and purchasing power!) It’s ok for the RBA to make such a mistake though?

The RBA, the bankers, sold our gold (our money) near the bottom of the commodity cycle so it could leverage its balance sheet to speculate in fake money (currencies).

It’s even in the RBA’s charter that:

'It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank ... are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:
(a) the stability of the currency of Australia;
(b) the maintenance of full employment in Australia; and
(c) the economic prosperity and welfare of the people of Australia.'

I would argue that the RBA, and all other central banks around the world are:

A) Increasing the instability of the currency
B) Creating fake job opportunities through the current monetary system (eg. How many jobs rely on an inflation society – superannation, sharemarket, house prices inflating. ie. Bankers, accountants, lawyers...)
C) Decreasing the economic prosperity and welfare of the people of Australia (through the debt-based fractional reserve banking system to ensure businesses and individual become enslaved to the banks)

Anyway, its ok for Australia, we are naturally endowed in gold. We have enough gold in the ground to replenish and to restore to a more sound monetary system in the future – right? Only if our politicians, and everyone else learn basic monetary history. We are conditioned at school, amongst other things, to be savers, not investors - to rely on debt to buy “assets”. It is not a coincidence Australia is now a consumption/services economy today (and why we are willing to sell our gold dirt cheap).

Taking this one step further, from a different angle, lets examine what Australia, as a country does with its real and fake money. The great paradox is that Australia is well endowed in both real and fake money. We are a major gold producer/exporter (real money) and a significant producer and innovator of banknotes (fiat money).

1. Fiat Money

Note Printing Australia (NPA) - a wholly owned subsidiary of the Reserve Bank of Australia, prints the banknotes for Australia, New Zealand and a handful of other countries. In 2008, it exported 182 million (fiat) banknotes.

Securency International – 50 per cent owned by the Reserve Bank of Australia, prints the polymer substrate for banknotes which is used by 27 countries around the world. In 2008, it supplied polymer substrate to 13 countries. The company now has substrate manufacturing plants in Mexico to supply Latin America.

Both NPA and Securency achieved similar profits in 2008 to 2007.

So it appears Australia has been a world leader in the evolution of currencies, and has done modestly out of exporting banknotes (receipts) and banknote technology.

Let's compare to Australia's recent achievements selling real money.

2. Real Money

Lets now examine Australia’s production and export of real money – specifically gold.
For anyone who may not be aware, Australia and the world is currently experiencing a major bull market in gold and silver. With the explosion of Government and private debt, it is inevitable that more and more people will flock to real money, as opposed to printed money. We are currently halfway through a normal commodities cycle (which started in 1999). I feel this will be no ordinary cycle,but a once in a lifetime opportunity for a large wealth transfer to those who hold real money (particularly silver).

Until more recently, Australia, like South Africa, has had declining gold production for the past couple of decades. China became the world’s largest gold producer in 2007, but Australia should resume number 2 spot in 2009. If we compare the Australian Government’s view of gold to that of China, we get two completely different views. Australia is short-sighted, we see gold as a commodity export earner only, to fuel our consumption/services economy. On the other hand, the Chinese central Government is slowly accumulating gold and is buying most of its domestic production (oddly enough, an Australian company, Sino Gold is China’s largest gold producer). China is about to overtake India as the world’s largest buyer of gold.

Recent trade statistics supports this view. In 2008, Australia exported $14.3 billion worth of gold (up 27% on 2007), of which nearly 40 per cent was exported to India. Australia is also a major importer of gold, importing nearly $9.7 billion (up 59% on 2007), reflecting Australia’s niche capability in refining gold dore’ bars. Most of this gold is then re-exported.

This then leads into: AGR Matthey. This company (40% owned by the Perth Mint) refines about 60 percent of Australia’s annual mined gold. AGR Matthey refines the dore bars into 99.9% gold bars.

Now, the most interesting part of this post.

The Perth Mint - is one of only about six bullion mints in the world (partly owned by WA Govt). It is a top 50 export earner for Australia, with over 90% of its products exported overseas. It is Australia’s largest gold refiner (under the name Gold Corporation) and refines about 60 per cent of Australia’s annual gold production.

The Perth Mint recently released its annual report for 2008-09.

The growth in volume and profit is quite staggering for only one year. The Perth Mint is selling real money to the world, and making very handsome currency profits.

- A ten fold pre-tax profit increase to $38 million (up from original forecast of $4.9 million).
- Sales of coins, bars and medallions up 50 percent to 2.7 million units.

What I find most interesting is the growth in metal volumes. Here are my calculations based on their recent annual reports.

Graph 1:
To me, silver is the clear stand out in growth.

Analysing further:
- Averaging 100% volume growth per annum over the last 5 years.
- The 229 tonnes of silver produced in 2008-09 equates to 7.36 million troy ounces of silver (vs. 4.5 million in 2007-08).
- Excluding the last couple of years of silver product production, 229 tonnes is more than all the Perth Mint silver coin production for a 20 year period from 1987.

Clearly silver is exploding in growth, but only about 1 in 100 people would know this. But why?

Silver's price is biscuits compared to gold, and yet silver is 4 to 5 times rarer in gold today! This is because silver is still heavily manipulated by two US based banks on the NY COMEX exchange. No other investment opportunity I have studied comes close to the potential of silver. This may seem uncharacteristic to overstate such a claim, but do not take my word, study and draw your own conclusions. To determine if gold and silver are going to be good long-term investments will largely depend on your 10-20 year outlook for the world economy and for inflation. It's better to do a bit of study than to put it into the too hard box. I believe big inflation, political and social instability is almost all but inevitable because the current debt-based monetary system is broken. It’s just monetary history repeating. All past fiat currencies have collapsed to their true value - zero. There are times when fiat currencies, and debt are king (post WWII to 1999), and there are periods when real money is king, and is the only form of accepted money (other than barter). Don’t take my word for it. Like any investment, it is important we do our own due diligence. We must embrace individualism and always look outside the box (tv screen).

This post is starting to hit the crux to the reasoning behind why I first set up this blog. Understanding basic monetary history and having an awareness of current monetary events are vital if we are to shed some light on where the world economy is heading to in the next decade.

Best,
Scott

Concluding thought:
A few weeks ago I visited the Perth Mint, and one thing I found most intriguing is that it’s large gold bar collection is owned by N M Rothschild & Sons (of London). The same, famous banking dynasty which set-up the first central bank, the Bank of England, and later the Federal Reserve in the US. More on central banking soon...

Free-market fundamentalism bails out Rudd's social democracy

(Post currently being edited)

A string of recent news headlines in the last couple of weeks rings alarm bells, about the way the Australian Government is now utilising the free market to implement its political and economic agenda.

On 24 August 2009, the Government announced it would strip market supervision powers from the Australian Securities Exchange (ASX) and transfer the powers to a Government agency, the Australian Securities and Investment Commission (ASIC).

This follows a sequence of Big Brother policies ("The Government needs to watch you") policies. FuelWatch, FoodWacth, and "ATM Watch" (stimulus packages) and of course pushes to censor the Internet (ala China). This also follows Prime Minister Rudd's 7,000 word essay where he blamed the neo-liberals and the free market for the global financial crisis. Lets revisit one snipet:

“Neo-liberalism and the free-market fundamentalism it has produced has been revealed as little more than personal greed dressed up as an economic philosophy. And, ironically, it now falls to social democracy to prevent liberal capitalism from cannibalising itself.”

September 2009 - and how "ironic" it is to see the free market bailing out the Australian Government.

On 17 Sept 2009, it was reported that the Reserve Bank of Australia (RBA) paid a record dividend to the Federal Government of $5.23 billion for the 2008/09 financial year, up from $1.4 billion in the previous year, largely from currency trading - due a severe decline in the Australian Dollar and the subsequent rebound as Chart 1 illustrates. An extra $4 bn or so to help fill in the budget black hole..

Chart 1: History of the Australian Dollar since float.
Source: ABC News - 15 September 2009

Result #1 - Free market helps Government reduce its record debt.


Has the Government been involved in insider trading?

As I've mentioned, the Australian Government announced it will take market supervision powers and give it to the bureaucracy to watch the misbehaving free market. Minister Bowen said this course of action was required due to concerns of conflict of interest.

However, a couple of weeks later...

On 22 August 2009 it was reported that the Future Fund offloaded a 1/3 stake in Telstra.

On 15 September 2009, the Australian Government announced Telstra should voluntarily split into two arms if it wishes to participate in its $43 billion national broadband network.

The first question that comes to mind. Did the Future Fund conduct insider trading? Did the Australian Government give the FF a heads up? The Australian Government does have a conflict of interest to see the Future Fund increase its net worth... The more money in the Future Fund, the greater the ability the Government has to meet its future liabilities (to pay superannuation liabilities of the Public Service).

Clearly the FF and the Government knew it had to offload as many Telstra shares before it dropped this bombshell.

Result #2 - The Australian Government distrusts the free market buy stripping the ASX of its supervision powers - yet it now appears (highly plausible)

Where is the accountability? Few media outlets have been asking the obvious questions...

But wait...

Earlier this year, the Australian Government announced it wanted to establish a $4 billion commercial property fund with the Big 4 Banks. However, this didn't pass through parliament. Solution? Use the Future Fund!

On 2 September 2009, it was revealed that the FF board approved moves to aggressively bid on shopping centres in Australia and Britain to the tune of $800 million. This follows a number of listed property trusts (or REITs) which almost collapsed in the market free fall last year, including Centro Properties. This is one way the Government can try to keep the property bubble going.

All this should come as no surprise though. After all, the Future Fund board is dominated by a group of prominent bankers (Commonwealth Bank, Suncorp, Rothschild Australia, JP Morgan). Sure these executives have vast experience in the capital markets and this is why they are on the board, but this group are also friends of the banking executives whom tried to buddy up with the Rudd Government to create a $4 billion commercial property fund - they too have a conflict of interest to ensure the property bubble keeps inflating.

So it looks very plausible that Free-market fundamentalism is bailing out the Rudd Government's "social democracy". If you can't get parliament to pass your economic and political agenda, just utilise the free market to do it for you. Kick in one motion, take with the

More soon,
Scott

The Houdini Economy

I believe there are many, many parallels in the world economy today, to that of previous economic depressions. We need only to look at past history. However, historian's all have different accounts and points of view. Is historical information based on objective analysis, primary evidence or a biased second hand account?

Is the economic events of today so different to that of the past? We are constantly told we are living through the worst economic downturn since the Great Depression; then we are told Australia has a resilient economy and that we are weathering the storm. Surely it can't happen to us?

"But we live in a modern, innovative, high-tech society today!"

In the 1920s America - the "Roaring Twenties", the sharemarket was booming, the humble car was built for the masses (T-Model Fords), and the population was extremely opportunistic. The population had never felt so wealthy, the horse and buggy were essentially gone from urban areas and the economy had never been more innovative. It seemed the good times would always last.

And today? We live in the so-called "new economy". A modern, innovative, high tech economy. We have never felt wealthier. We expect the good times to always get better. The next 20 years will be better then the last 20 years.

These are two different points in history - but the same human traits of economic complacency are well and truly alive today. There is usually a large economic depression every 75 years - the average life span of a human. Is it a coincidence economic lessons repeat? Is it a coincidence that each generation since the 'silent' generation (of the 1920s and 30s) has progressively had worse money habits than their parents generation? Everything used to be bought within our means, today its on credit, and we have little incentive to save for a raining day.

Houdini economy

** The big difference between 1929 and today, I believe, is the acceptance of mis-information by the general public and an acceptance to think the monetary system will always work. We live in the so called "Information Age", yet our diluted statistics mean we live in a Houdini economy. It's all smoke and mirrors. Government's have an interest to keeping the public unaware about what is really happening in the economy - to maintain political and social stability (in the short run).

However, comparing today to the past has become distorted because economists, Governments, and the media think they are comparing apples to apples. Today, statistics are treated as gospel. We believe that the stats on the nightly news are accurate, objective and unbiased. Why are we not learning from recent events? Many of the economists and bankers who got it wrong, are still in positions of power and influence. Central banks are being given expanded powers (particularly the Fed Reserve), rather than face increased accountability.

More often than not, an economic number today will be grossly diluted to that of 75 years ago. For example, the unemployment rate, or level of inflation are grossly misunderstated today.

For instance why is unemployment so low at the moment? In the 1930s it got to 32 per cent in Australia! Yet it is still around 5 per cent today, despite a recession and economic turmoil worldwide.

Answer: The ABS counts people as been employed if they are working just 1 hour per week.

But as the following chart shows, the number of hours worked has been falling gradually in the last 15 years. For starters there are a lot more part time jobs. It's good for people who want to work less, but its bad for recording what the real unemployment rate should be.

Chart 1:
Source: Kohler, ABC News

Getting back on topic - lets compare further to the last Great Depression:

1929 to 1932- the greatest sharemarket crash in history put the world into a Great Depression. In 3 years the market fell 89 per cent.

Current sharemarket crash? Depends on your measuring stick, namely, the monetary system has changed. 1929 money was backed by gold. Today it is backed by an exponential curve of debt.

If we use the Dow/Gold Ratio (which is what the 1929 sharemarket crash was recorded against), then the current bear market we have today really started in 1999 (not 2007). So far from top to bottom of the bear market the Dow Jones has fallen 84 percent measured against gold (the old monetary unit).

Perhaps we are already in economic depression but we just aren't awake to it?

As the following chart shows, the inflated US Dollars of today have diluted the impact of what is really happening. From 1999 to 2007 the Dow Jones rose in nominal terms, while the old monetary system was showing the economy was sick (and crashing), now both these measuring sticks are showing the US and world economy is continuing to tank.

Chart 2: Dow Jones over last 100 years
Wow - look at the 1929 crash! It's huge. What this chart fails to show is that important change of the monetary rule book in 1971 (when the gold link was removed).

The following chart puts the 1929 crash, and today's sharemarket crash into a better perspective (apples vs apples).

Chart 3: 100 yeas Dow/Gold Ratio.
Source: Steve Hickel, gold-eagle.com

The last dip in Dow/Gold Ratio:

Notice has taken at least 32 years to reach a new peak in the Dow/Gold Ratio in the last two downturns. In the last downturn there was stagflation in the 1970s, a change of the monetary rulebook in 1971, a commodity price peak in 1982, and an increase in social security outlays of Governments among other things. There was no great depression, but inflation was accepted and new bubbles came along to occupy everyone's money. The key last time is that there remained confidence in the new fiat monetary system. I believe this time round will be different.

Clearly there is a huge difference between Chart 2 and Chart 3. Chart 2 is an inflation drive chart. Chart 2 characters a true free market which goes from undervalued to overvalued and back over time. (Change the monetary system (methodology), and you will change the shapes of the charts!)

Steel industry today vs 1920s

Lets compare 1920s and today even further...

In the 1920s, there was a huge boom in the United States steel industry. 15 per cent of steel was used in automotive manufacturing. By 1928 there was over 21 million cars, enough for 1 in every 6 Americans. When the Great Depression hit however, by the mid 1930s over 50 per cent of the United States steel capacity stood idle.

Today there is vast amounts of steel capacity standing idle also. Lets compare.

Kingdom of Rust

According to latest research from Macquarie Bank, there is some 362 million tonnes per annum of unutilised steel capacity in the world.

Chart 3: Today, around 25 per cent of the world's steel capacity is sitting idle.
Source: Macarthur Coal Presentation - 17 June 2009

To put this into perspective, this is equivalent to:
- every single steel mill in Europe, Japan and Korea shutting down OR/
- ¾ of China’s steel production closing down.

With all this recent iron ore hype in the Australian sharemarket (in the last couple of months), just stop for one moment and envisage 3 out of every 4 steel mills in China closing down. Only the lowest cost (lowest debt) iron ore, coking coal, steel producers could survive a sustained turn down. Clearly there is too much capacity worldwide. This is not unique to just the steel/iron ore industries. The capacity for most goods today is built on the premise that the current monetary system will continue to work, that the world economy will continue to expand at a rapid rate, and that our tolerance of debt will continue to expand.

All this extra capacity will have to be removed from the system. Many companies will continue to go under. This is only natural. In the boom times too much competition led to cheaper cars and airfares, and even steel was pre-fabricated in China and exported back to Australia! There needs to be a giant shake-out across industry worldwide. Give it a few years..

Baltic Dry Index

Much of the gains on the Australian Securities Exchange (ASX) in recent months have been on the back of a bounce in commodity prices (ie. A fall in the US Dollar), and increased shipping movements out of China for Australian iron ore and coal. This has also lifted the Baltic Dry Index (BDI), which had a major crash in 2008. The BDI is a daily number published by the Baltic Exchange – it tracks world wide international shipping prices for dry bulk cargoes such as iron ore. It shot up in the boom years, and crashed big time last year as the following chart demonstrates.

Chart 4: Baltic Dry Index crashed 94 percent when the resources boom bust, its now rebounded on growing Chinese iron stockpiles.
Source: Bloomberg

The following chart from Alan Kohler pictures an interesting relationship between the BDI and movements in the Australian and US Dollar. Positive movements in commodity prices (particular in US terms) and the BDI - is a positive force for the Australian sharemarket.

Chart 5: Baltic vs AUD
Source: Kohler, ABC News

I believe its now time for the BDI to fall sharply once again. The third quarter of the calendar year is traditionally the worse for commodity prices (from my experience, particularly in base metals). Apparently about 10 per cent of the world Capesize ships (the largest) are sitting of Chinese ports, unable to unload their iron ore. The two largest iron ore terminals in China are said to be close to full capacity. Now that the 2009/10 iron ore benchmark prices have been finalised (with Japan and Korea), my bet is the Chinese have done most of their shopping for this year, and will try to manipulate the market in the short-run to really hammer down prices come next year.

World Trade

Ok, so i've talked about the BDI - what about world trade as a whole?

The following chart from Alan Kohler paints a bleak picture for world trade. It uses a base of 100 for the peak in world trade (some 12 months ago). Already we have gone from a massive boom, and the big bust continues at a greater magnitude than the 1929 trade bust. Just like the 1920s America – there is significant overcapacity in the world. Trade flows are stalling.

Chart 6: World trade has fallen off a cliff much higher then the Great Depression slump.Source: Kohler, ABC News

Covering up debt - back to the suitcase method

We all know what hiding bad debts can do... Subprime mortgage-backed securities, bundled together, given a AAA rating and sold overseas to unknowing investors worldwide. This grand scheme worked for a while... now it appears the humble suitcase is back in vogue to move Government debt around.

Here is a rather amusing article. If this were true... the US/Japanese Governments are running out of places to hide their debt!!

Suitcase With $134 Billion Puts Dollar on Edge

Two Japanese men are detained in Italy after allegedly attempting to take $134 billion worth of U.S. bonds over the border into Switzerland. ..

The trillions of dollars of debt the U.S. will issue in the next couple of years needs buyers. Attracting them will require making sure that existing ones aren’t losing faith in the U.S.’s ability to control the dollar. ..

Think about it: These two guys were carrying the gross domestic product of New Zealand or enough for three Beijing Olympics. If economies were for sale, the men could buy Slovakia and Croatia and have plenty left over for Mongolia or Cambodia. ..

Let’s assume for a moment that these U.S. bonds are real. That would make a mockery of Japanese Finance Minister Kaoru Yosano’s “absolutely unshakable” confidence in the credibility of the U.S. dollar. ..

Bad news can only be covered up for so long. Question everything!

Scott

GM goes, Rio snubs, and the PM shrugs ("technically")

You gotta admire how bad the rhetoric coming out of Canberra is getting these days. We were told in the led up to the last election by the now Prime Minister, that he was an “economic conservative” (18 months later we have over $314 billion in projected debt).

In the recent budget we were told that the Government will go into a “temporary deficit”. Translated, “temporary” works out to be until at least 2021. Twelve years of spiralling deficits is not temporary.

Now Australia is “technically” not in recession. Technically New South Wales should have won the State of Origin on Wednesday.... Enough of the rhetoric. Actions speak louder than words. And there will be political consequences for ignoring sustainable economics. It’s not just in Australia, expect more political and social disconnect with politicians and the voting constituents in the next few years. For now we get to watch the UK Government tear each other to shreads.

Also in an eventful week:

- General Motors enters Chapter 11 bankruptcy

Well another "officially" it happened moment... but lets be realistic. GM isn't being liquidated - just restructured. Yes, it should have been restructured years ago, but despite the leftist media - its failure to not reinvent itself to produce "green" cars instead of "gas guzzlers" had nothing to do with GM's downfall. GM's balance sheet was choking with unfunded liabilities (indeed it is just a mirror of the greater problems facing the US Government). As I stated (in my first post this year), between 1993 and 2007 GM spent much more paying pensions and retiree health care ($103 bn)than it did in dividends ($13 bn) to its shareholders! The company should have went under years ago. Economics 101 - your balance sheet must be sustainable. Unions once again kicked themselves in the foot - pension/health care plans which were agreed upon as early as the 1950s have come back to bite their children's, children. The Western World must learn to stop over-consuming (on debt) and demanding higher and higher wages (source of inflation). Perhaps with a more stable monetary system, union demands would be reigned in (wishful thinking?)

Now that GM is in Chapter 11, its plan is to cut its liabilities... 150,000 current and future employees will get a cut to their pensions, health benefits and life insurance. That's right - the new majority owner, the US Government will continue to bail GM out. It's only thrown hundreds of billions at the car industry for decades - why stop now?

Restructuring GM will not bring it back to its former glory. The world economy will determine its future. Like GM, the US Economy has been trading insolvent - its liabilities are completely unsustainable (over US$65 trillion). China and India have growing automotive industries, which are innovative, competitive and forward-looking. There is an oversupply of auto makers (Australia alone has around 60 different brands of vehicles to choose from!), and the free market will force mass consolidation in the coming decades, much like what has occured in aerospace and defence in the last couple of decades.


- BHP and RIO announce Pilbra Joint Venture

Great news for Australia, bad news for China and steel mills. BHP is the master at striking great deals, and this looks to be another one. Iron ore prices should be higher now that the producers can maintain their bargaining power over their customers. Bad luck China, expect them to buy some smaller producers. Odds are Murchison Metals (MMX.ax) will be taken very shortly, perhaps Andrew Forrest will sell down more of FMG if China puts a few billion down to expand it’s production in a significant way.

- Australia avoids official recession (for now)

The buzz word for the world economy right now is “green shoots” – economic recovery is in site! Markets do not move in straight lines. The duration and magnitude of economic recessions vary greatly and do not move in straight lines. We are still on par with the 1929 crash (see chart 2 and 3 from this previous post). The fundamental problems of the broken world monetary system remain. The United States is still insolvent. As Kenneth Rogoff discussed on Thursday (Australian Financial Review),

“global trade and current account imbalances needed to be reined in to reduce the chance of a severe financial crisis. The US and China are not solely responsible for these imbalances, but their relationship is certainly at the centre of it”

“The US consumer, whose gluttony helped fuel growth throughout the world for more than a decade, seems finally set to go on a diet. In addition to tighter credit, falling home prices and high unemployment will continue to put a crimp on US consumer spending.”

These two paragraphs sum up the situation quite nicely. The monetary system is broken, the China-US trade imbalance is broken. The musical chairs
has stopped, and for now Australia is lucky to have

Property Researcher slams Rudd Bank

As discussed briefly on my blog, the Commonwealth Government is seeking to proceed with its Australian Business Investment Partnership (ABIP), a $30 billion financing fund (in conjunction with the Big 4 banks) to help the commercial property market stay up right. In other words, an anti asset-deflation device. Rudd thinks he can take on the free market and win.

This is some of what DTZ Research stated in the Australian Financial Review on 1 June 2009:

“the government’s ability to improve market fundamentals is limited”

“it has the potential to affect the feasibility of development projects”

Further “Ruddbank could distort market forces that would eventually cause the property market to recover in any case.”

DTZ warned that providing “funds via ABIP to restart projects that have stalled has the potential to not only flood a failing market, but prolong its recovery.”

Further, (DTZ) argued that falling values were a natural market mechanism for dealing with an oversupplied market and declining demand.

Lastly, “Intervention by providing a funding solution, and not addressing the core problem, can only lead to further issues.”

Two programs worth watching:

Million Dollar Traders – SBS 7:30pm Tuesdays

Eight ordinary people are given a million dollars, a fortnight of intensive training and two months to run their own hedge fund.



The Ascent of Money – ABC 8:30pm Thursdays

Harvard professor Niall Ferguson examines the long history of money, credit, and banking. In it he predicts a financial crisis as a result of the world economy and in particular the United States using too much credit.



Charting exercise - short term resistance/support

The following is a short-term (5 day) chart analysis I drew up during the week on SLR – Silver Lake Resources. The analysis shows how resistance/support lines (as well as candlesticks) can give a good insight into the short-term direction of some stocks.

Chart 1: SLR 5-day

Cheers,
Scott

There isn’t enough silver to go around

To date I haven’t posted much on gold and silver, a subject I intend to spend more time on in the near future (particularly on gold companies in Australia).

The following is extracts from one of the best silver articles I have read to date, from well-known silver commentator, Ted Butler. I encourage all to read the full article titled, A Presidential Bombshell.

Here is a quick summary of some of the points made in Ted’s article.

In the United States:
- In 1959, the US Treasury Department held approximately 2.1 billion ounces in silver bullion inventories plus 1.3 billion ounces in circulating coinage, for a total of 3.4 billion ounces of silver.
- By 1971, the Treasury held only 170 million ounces of silver bullion and most silver coins were removed by investors from circulating coinage and eventually melted into bullion.
- In only 12 years, the US Government transferred 94 percent of its holdings to the private sector (over 3.2 billion ounces).
- The US Government became a net buyer of silver again in 2001 to mint American Silver Eagles.

Silver per-capita

In the United States:
- In 1959, there was almost 19 ounces of silver for every person in the United States.
- Today the U.S. has no government reserves of silver.

Worldwide:
- in 1959 there were about 9 billion ounces of silver bullion in the world, with a population of 3 billion, there was a per-capita amount of 3 ounces for each of the world’s citizens.
- Today, there is a per-capita amount of silver of 0.15 of an ounce per person (1 billion ounces divided by 6.8 billion population).
- By way of comparison, the per-capita amount of gold bullion equivalent in the world has remained remarkably stable at around three-quarters of an ounce per person, for more than 100 years.

So if you hold just one 1-ounce silver bullion coin today, consider yourself wealthy. Likewise if you hold just 1 ounce of gold.

Further in Ted’s commentary on May 11, he quoted a speech from President Lyndon Johnson which was made on July 23, 1965. This is what President Johnson said:

"Now, all of you know these changes are necessary for a very simple reason--silver is a scarce material. Our uses of silver are growing as our population and our economy grows. The hard fact is that silver consumption is now more than double new silver production each year. So, in the face of this worldwide shortage of silver, and our rapidly growing need for coins, the only really prudent course was to reduce our dependence upon silver for making our coins.
If we had not done so, we would have risked chronic coin shortages in the very near future.
Some have asked whether our silver coins will disappear. The answer is very definitely-no.
Our present silver coins won't disappear and they won't even become rarities. We estimate that there are now 12 billion--I repeat, more than 12 billion silver dimes and quarters and half dollars that are now outstanding. We will make another billion before we halt production. And they will be used side-by-side with our new coins.
Since the life of a silver coin is about 25 years, we expect our traditional silver coins to be with us in large numbers for a long, long time.
If anybody has any idea of hoarding our silver coins, let me say this. Treasury has a lot of silver on hand, and it can be, and it will be used to keep the price of silver in line with its value in our present silver coin. There will be no profit in holding them out of circulation for the value of their silver content."

Silver is rare. It's so rare, 99 out of 100 people wouldn't know about it. It’s a finite store of value with no debt or liability attached to it. Unlike gold it is also an industrial metal as well as a monetary metal. In 1959 President Johnson used the word’s “world shortage” and “silver is a scare material”. Less than 15 years after those worlds the price of silver rose from US$1.29 to more than US$50 in 1982. In 1959 there was 9 times more silver and 3.8 billion extra people than today! – so why don’t we hear stories of silver’s extreme rarity today? We only get a handful of gold reports on the news, and it will always be referred to in USD terms. Apparently the world is flat, not round.

Silver has become so rare for the first time in human monetary history there is more than four to five times more silver above ground than gold. Even more amazing is that silver has been manipulated so much by Governments, and commercial banks that it remains dramatically undervalued compared to gold. The silver market in dollar terms is one of the smallest and easiest commodity markets to manipulate. Total above ground silver is currently worth US$12 billion at current prices compared to almost US$4 trillion for gold. Keep in mind there is about 1 billion ounces of silver, and 4 to 5 billion ounces of gold. Something is not right here.

Gold-Silver Ratio

The historical gold/silver ratio (over many centuries) was around 15 to 1. The primary reason is that silver was around 15 times more abundant in the earth's crust than gold. Today the gold silver ratio is 80 to 1, almost double the average for the last 200 years of 33, and the average of 20th century average of 47.

Chart 1: Gold Silver Ratio over last 200 years
With available silver more rare than gold, silver has considerable gains to record. Gold will do very well, but silver should provide exceptional returns within the next decade. Another way to put it, the purchasing power of silver should rise greater than the purchasing power of gold. Some analysts believe silver will get to a gold/silver ratio of 1:1 within our lifetime. I think this is highly plausible and not out of the question.

Something has been keeping the silver price down for many years... It's Government, Central Bank and Commercial Bank manipulation... I will go into more depth another time, in the meantime Ted Butler's weekly commentary website is worth a bookmark.

- Scott

House Price Expectations – May 2009

The latest Westpac–Melbourne Institute Sentiment Survey asked an extra question this month on consumer expectations for house prices over the next 12 months.

All in all, across all categories consumers are currently balanced between those expecting a fall in price, those expecting a rise, and those who think prices will stay around the current levels.

What is most interesting from the survey:

Chart 1:
By State:
- Consumers in NSW and Vic were notably more bullish on prices with a net 6.9% and 2.1% expecting prices to rise respectively.
- Conversely the Resource rich states of Queensland and Western Australia were the most pessimistic. WA had the highest proportion of 'extreme' pessimists with 9.4% of respondents picking a decline of 10%+.


Chart 2:By household income:
- Those on low incomes ($21 to $30K p.a) were the most optimistic of house price increases, while those with an annual income of $81 000–$90 000 were the most pessimistic.


Chart 3:
By Age Group:
- Generation X and Y continue to be the most optimistic age group (those aged 18 to 34 in the survey) expecting house prices to rise.
- Those aged 45 to 54 on balance expect house prices to decline in the next 12 months.

Concluding statement from survey:

“Despite record low interest rates and rising rental yields, demand from investors has remained subdued to date. Price expectations appear to have been the crucial 'missing ingredient' with potential buyers in this segment still clearly very wary about the potential for significant price declines.”

What can be drawn from this?

This closing statement (above) from the Westpac–Melbourne Institute survey is spot on. I have been arguing about this “missing ingredient” for some time. It is the elephant in the room which many would-be home buyers have not been taking into consideration. More importantly, I would go further and say that purchasing power expectations is the missing ingredient with potential home buyers. I expect both price and purchasing power (relative to other investments) to continue to decrease for Australian houses.

Unsurprisingly the younger generations are those who continue to be most optimistic about future house prices. After all, we are the generation which has been offered free home owner grants on a platter from the Federal and State Governments. Most of us under 35 are too young to remember the last recession in the early 90s. Why would we expect the future to be worse? We have been conditioned to believe the economy will always get bigger and better.

The Baby Boomer generation, those who have a lot more of the property, have more buying power than the younger generations (due to nearing their working life as opposed to starting) and are more pessimistic about house prices. This should be of considerable concern. This demographic has a lot more financial leverage than the X & Y generations. When sellers outnumber buyers (just on demographics) there is a long-term problem for properties and business prices.

I also discussed previously on my blog in more depth on the great Australian housing bubble (see here). I stated that the resource states would be the first to really feel housing price pain. I used the example of a person earning over $100,000 per annum driving a truck at a fly-in fly-out iron ore mine in Western Australia. This person took on a large mortgage in inner Perth on the expectations that they would continue to work in the $100K job for many years to come. As expected, just like the mining bust, Perth is now out in front leading the housing crash (in both actual house price falls and future price fall expectatiosn). Over the longer term, I believe Canberra will be the last capital city to experience the worst of the falls due to it’s reliance on Government jobs, rather than business-oriented jobs, which is what the economy really needs. It is by no means immune. All house prices have a common denominator - debt.

- Scott

Accounting for deadwood

One of Australia’s great ponzi schemes is toppling. In the last two months, the two largest Managed Investment Schemes (MIS) have entered administration; Timbercorp (23 April 2009) and Great Southern Plantations (15 May 2009). Fortunately these companies have been allowed to fail. The market is accounting for deadwood in the system.

The MIS industry prospered over the last decade purely as more investment flows came into the companies each year by paying high short-term returns at the expense of long-term balance sheet sustainability (from future profits).

In many ways, the MIS industry is akin to the Babcock and Brown or Allco Finance model. Take low yielding assets that have a long investment time frame, sell the assets to investors on the sharemarket, inflate the yield numbers over the short term, and skim large amounts of fees off the top. This model worked brilliantly when the economy (and the money supply/credit/debt) grew consistently and individuals looked for investments to expand their wealth. Now the debt model is broken and the MIS industry has been exposed as a complete fraud.

However, the real fuel on the fire was the lure of a tax break. The tax rules on MIS schemes in the 1990s early 2000s made it ideal for investors who wanted both an investment and a way to minimize tax. In a way it was a voluntary savings scheme (similar to Superannuation), the scheme mangers were almost guaranteed to get a growing number of buyers for their schemes each year.

Like all ponzi schemes, the system starts to show huge cracks when the liquidity of buyers starts drying up.

The first major crack was an ATO crackdown in February 2007, which prevented non-forestry MIS (such as almonds, olives) from receiving upfront tax deductions. The increased uncertainty created from this no doubt have a significant impact on the financial sustainability of the MIS industry.

The second crack was under delivering investors. When the first timber projects were harvested, yields were well down on what investors were told a decade earlier. The assets (the trees) were considerably less valuable.

Third, both Great Southern and Timbercorp took on substantial debts to keep the schemes going. Taking on large debts (with less investor equity) in the boom times worked (ala B&B model). As we know with the Global Financial Crisis (GFC), debt-based models are no longer sustainable and companies are now rushing to raise equity at any cost. The MIS could no longer raise any credible equity or debt and the great ponzi scheme has been felled.

It turns out Timbercorp and Great Southern became the biggest of the MIS schemes because they were the best at selling schemes (with the tax break lure). As it turns out, they weren’t in the business of making fat profits via harvesting – ie. what investors were led to believe.

As an example of the largess of the industry, Great Southern spent $62.3 million on commissions, marketing and promotion of its products in the year to September 2008.

However, despite the commissions, fees, tax breaks and other incentives, lets not forget that the agriculture and forestry industry, like any investment, has risk.
The risk/reward relationship changed for the MIS industry substantially over the last 10 years. Risks were overlooked in the earlier years because of the lure of the tax break. Without the tax break, it is now known that TIM and GTP were high risk/low (no) reward investments.

Further, Agriculture and forestry is susceptible to serve weather conditions, particularly drought. This has no doubt impacted on expected yields and expected future profits. The 62,000 investors caught left holding worthless paper when the music stopped, like any investor, have to take personal responsibility for their investments. The financial/investment industry has its fair share of bad advisors who give bad advice on bad investments. Economists also don't have a crystal ball about he future on tax changes, climate influences etc. Investing is also about timing and discipline. Every investor must have an exit strategy for when things start to go wrong. As we now know the investment world no longer tolerates high debt companies. For instance, Timbercorp had debt gearing of 62.4 per cent in 2007. The charts of both Great Southern and Timbercorp show investors have been deserting the companies for the last 3 to 4 years.

All up over $10 billion in investment flows went into the MIS industry over the last decade, with and estimated $4.7 billion in tax breaks received.

As the following graphic details, Timbercorp fell with over $900 million in debts, while Great Southern owes around $700 million.

Chart 1: Total invested in MIS in last decade
source: Financial Review, 19/05/2009, page 61

Chart 2: Timbercorp’s investmentssource: Timbercorp website

Chart 3: Great Southern’s investmentssource: Great Southern website


Deflation to hit rural property prices

I’ve discussed a number of times that I believe there were continue to be deleveraging of debt across Australia and the world. All types of property in Australia are at high, immediate asset-deflation risk (commercial, industrial, residential and rural properties).

The collapse of the two largest MIS schemes should have a significant impact on rural land prices across Australia. During the last decade, MIS has been criticised by many rural communities for pushing up land prices (due to their investor and bank backed purchasing power) and accelerating the decline of many rural communities. Traditional farmers could not compete on land purchases, and many of the best grazing properties were turned into hardwood plantations.

Now with the collapse of Great Southern and Timbercorp there is talk of an immanent fire sale. Great Southern has 240,000 hectares, while Timbercorp has 120,000 hectares of property. Just like a bank taking back a default home mortgage, they will not be interested in holding onto all this surplus property. It will be dumped onto the market for whatever price they can get. We now have a reverse outcome to the last decade. The buying force of a the MIS industry pushed prices up dramatically, are now crossing over to the seller side. When administrators/banks are the sellers, lookout below… Severe asset-deflation is coming. The only hope is if a major foreign investor showed up to buy most of the assets.

Debt will continue to be the downfall for many individuals, businesses, and even Governments. Timing and discipline is key. We are no longer in a debt cycle.

- Scott

But house prices are supposed to always go up…

The latest ABS quarterly House Price Index (March 2009) for established houses show continued falls in five of Australia’s eight capital cities.

• The average decline across the eight cities for the 12 months till March 09 was – 6.7 per cent.
• The House Price Index has now fallen for the past four consecutive quarters.
• On an annual basis, only Darwin and Hobart prices have increased in price.
• Perth continues to be the worst performing market with a quarterly fall of – 3.6 per cent, with an annual fall of – 10.1 per cent.

Chart 1: Year on year and quarterly established house prices by capital city
The following graph gives a better picture of what has been happening to Australian house prices in the last 5 years.

Chart 2: Year on year Australian established House Prices
Source: ABS

But housing prices are always supposed to go up… right?
They said, "Buy now, or be priced out... FOREVER"

Cheers
Scott

The Inflation vs. Deflation Debate

There are a lot of articles going around about whether the world economy is facing Inflation or Deflation. Here is my take on the situation.

It’s asset-deflation

Deleveraging of financial assets worldwide has been driving short-term deflationary pressures on world money supply. I label this as asset-deflation or debt-deflation. Deflation has a snowballing effect. It comprises of:

a) Illiquidity. When buyers hit the sidelines on expectations that prices will fall lower in the future.

b) Spreads Widen. With buyers drying up, the difference between what the nearest buyer is willing to pay and what the seller expects to get paid widens. For example, someone may believe their house is worth $500K, but the nearest buyer is now at $400K, causing a spread of $100K. In other words, the house is only worth what the nearest buyer is willing to pay!

c) Many sellers exit the market at almost any cost. In a rising market, buyers out bid each other to acquire an asset. In a deflation environment, many sellers are forced into a position to sell to the nearest buyer (even though it may be vastly under what they believe their asset is worth). There doesn’t need to be many sellers in an illiquid market to make prices fall sharply (just like a lack of buyers). For example, if someone forecloses on their mortgage, the bank will offload the property back onto the market and get what ever it can. As unemployment rises, mortgage default rises, the quantity of surplus properties in bank hands rises. This causes more asset-deflation.

Baby Boomers

More so in the future, demographics will be a major influence on asset-deflation. The Baby Boomer generations is the largest living generation in the United States, Australia and many Western economies. As they move into retirement at the end of their working life, many will sell down their properties, businesses, and shares (held in the Superannuation accounts). However the following generations will be unable to match this selling pressure as they are starting our/half way into their working life. This factor alone will ensure the next 20 years will be vastly different to the last 20 years for financial (DEBT) driven assets.


Asset-deflation should be embraced

Prices have been lifted artificially high for too long, and now the market forces are accounting for misallocation of capital.

Governments, central banks, commercial banks and individuals fear asset-deflation. This is why the Australian Government is guaranteeing deposits, the States debt, forming a Rudd-bank (commercial property fund). The aim of the Federal Reserve (and central banks worldwide) is to ensure property has soft landing so people feel wealthy again. They now want to prevent massive asset bubbles from bursting as it will destroy the artificial wealth effect.

artificial wealth effect - the general population get angry when food prices, rent prices continually inflate (because of an expanding money supply), but also dislike when the sharemarket and property values fall in price (again, due to an expanding money supply). We can’t have it both ways.

Historically property prices are said to double every seven years. What is never mentioned is how much the money supply has grown every seven years, or how our purchasing power has decreased every seven years. For example, if you buy a property for $100K in 1988 and sell it for another house in the surrounding suburb, you would have to pay around $100k for a similar house. Come forward to 1998, that same house is now worth $200K, but if it were sold, you would still have to buy a similar house in that area for around $200K. House prices have doubled in this 10 year example, but overall purchasing power decreased as the M3 money supply more than doubled. This is an artificial wealth effect.

A couple more points. The 1970s and 1980s were ideal times to acquire and invest in property and the sharemarket. The market was in a Debt-cycle. From 1982 to 1999, commodities were largely lousy investment and lost purchasing power. The two cycles have an inverse relationship. We currently remain halfway through an average commodity cycle. The purchasing power gains will continue to occur for gold, silver and most commodities, while the purchasing power of investing in the sharemarket and property will continue to decrease.


By design the system must inflate

The monetary system is designed to inflate over time and reduce our purchasing power. The system is mathematically designed on an exponential growth curve.
These factors include: fractional reserve banking, mandatory savings scheme, government monetary/fiscal power.


i) fractional reserve banking.
Every time someone signs a new mortgage or a new bank loan, new money is created right there and then. Fractional reserve banking is at the heart of the flaws in today’s monetary system. By design, all debts can never be repaid. Exponential credit (debt) is guaranteed. Therefore many nations, businesses, individuals will remain in spirally debts and bankruptcies.

“The most powerful force in the universe is compound interest” - Albert Einstein

ii) mandatory savings scheme (Superannuation)
Superannuation, Government Funds (such as the Future Fund) artificially inflate asset prices over time as they provide excess liquidity to the market and a guaranteed source of continual investment. By design, these schemes also need asset prices to inflate in price.

iii) Government monetary and fiscal power
The reason we have such extreme volatility in the economy is that Governments central banks, commercial banks try to re-inflate bubbles whenever market forces try to account for bad debts through asset-deflation. Central banks (through monetary policy) around the world are currently lowering interest rates in a desperate attempt to manipulate investor decisions, to draw more financially able investors into the asset-deflation black hole. Central banks/Governments aren’t lowering interest rates so people buy more food or enter the rent market. The monetary framework today is all about saving the PRICE of financial assets (debt).

Through fiscal policy, Governments are giving financial incentives (free handouts - free as in using taxpayer money…), such as the first home owner grant to artificially keep house prices high. In the future (its already happening…), these insentives will be funded by Government-debt.

These actions ensure the longer-term money supply will inflate over time and that debts will become increasingly unsustainable.

iii) a) the US Government is insolvent

The US Government currently has a national debt of US$11.2 trillion. Right now the US Government is spending almost. In 2008, the interest repayments on the national debt is US$431 billion (around 14 percent of the annual budget). When you add future liabilities (of an aging 80 million US baby boomers) such as Medicare, Medicaid and social security – debt liabilities total over US$65 trillion.

The US Government cannot escape its debt situation without borrowing more debt. The Government will never consider reducing Medicare or pension liabilities. The result – more money has to be created, and purchasing power must continue to decrease.


Cause and Effect

Economics is all about cause and effect. Unfortunately many (including our current PM) do not understand both elements.

Fractional reserve banking, mandatory savings scheme and Government monetary and fiscal power are all causes. The consequence is Inflation (loss of purchasing power).

Likewise, many journalists continue to ignore the root causes of deflation, but are fixated on reporting the effects of (asset) deflation. For instance, many are now writing up articles about how wages are falling across many Western economies. Wages just don't fall on their own. Wages are falling as a consequence of something else happening. That is, businesses are collapsing due to DEBT, the drying up of liquidity in markets (including debt markets) and as a result, demand is collapsing. Consequently, as the number of unemployed rise, wages come under pressure as they should.


The CP”lie” – is money supply deflating?

Another mechanism now entrenched in today’s monetary system is the constant dilution (manipulation) of Government statistics. Unfortunately Governments and media are now fixed on the Consumer Price Index (CPI or CP-“lie”). It’s the intention of Governments (and thus the media) that it is possible to sell the idea of deflation through manipulated statistics (particularly CPI).

Currently in Australia, the official CPI rate is 2.5 per cent.


Australia’s money supply is still inflating

In the year to March 2009, Australia's money supply:

Broadmoney 12.4 per cent;
M3 increased by 15.1 per cent;
M1 increased by 8.1 per cent.

There is no deflation in the money supply numbers. It's all on the RBA website. It's the media's fixation on CPI that a drastically diluted scenario is continued to be created. We will never hear what real inflation is doing through the mainstream media.

Chart 1: Exponential curves keep expanding
source: Wikipedia

Chart 2: A chart from my second post last year.
The above chart shows the annual grow rates of Australia's M3 money supply. It's not a conincidence that both the sharemarket and property market continued to bubble in the last couple of years (as M3 grew at a faster rate). Expect M3 volatility like the 1970s over the next couple of years (at least).


Japan’s decade of deflation?

Money supply has consistently increased in Japan during the last couple of decades whilst it has experienced deflationary pressures. Asset prices (property, sharemarket remain well below the bubble levels of the 1980s). As the following chart shows, the inflator mechanisms of fractional reserve banking, monetary and fiscal policy etc have meant that Japan's money supply has continued to grow even those asset prices are still subdued.

Chart 3: But the money supply is still growing?
source: Wikipedia

Japan has already been through much of what the Western World is now facing: significant asset-deflation. (Obviously there were other issues going on such as the zombie banks, several stimulus measures etc which I will go into more depth another time).

Summary:

Assets worldwide are being deleveraged and revalued by the market. Asset-delfation is healthy and should be embraced by Governments, banks and individuals worldwide. The market is accounting for excess money and debt in the system.

In Australia the current CPI is 2.5 per cent p.a., banks are offering around 4 per cent interest for savings. Official M3 data shows overall money supply inflation is 15 per cent p.a.
- Aren’t our savings going dramatically backwards in the bank?
- The RBA shouldn’t be reducing interest rates!

Ultimately when it comes down to the inflation/deflation debate, ask yourself this:

* Will the Australian Dollar (or other fiat currency) increase or decrease its purchasing power in the next couple of years? (in this "deflationary" environment). How much stuff will it buy in the future compared to today. This is the crux of the issue.

Remember there is a huge difference between price and value.

- Scott