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So act that you use humanity, whether in your own person or in the person of any other, always at the same time as an end, never merely as a means - Immanuel Kant's Formula of Humanity

Friday, September 9, 2011

Recent Market Movements : what it means

There has been and continues to be a shaky share market all over the world for the past three months. There has been high volatility and there is a sense of what can be simply referred to lack of confidence among the global business community. The market basically reflects reality most of the time, if not all of the time. So why is that now?

There are many significant things that are guiding the market uncertainty. Primary among them is what is being referred as sovereign debt crisis. In the financial crisis of 2008, even that was a debt crisis (remember?), but it was in big corporations. The huge corporations mostly in investment banking had took too many leverage and were overwhelmed with debt. The investments made against the US housing market went bust and the institutions were on the brink of failure. The US government stepped in and bailed out the institutions with tax payer money(read newly printed money). On this side of Atlantic the Euro and the UK did similar acts to shore up their own banks. At that time it was believed it was a wise decision. The recent market itchiness is really a consequence of those bail outs. It just turned out the banks were little bigger than the governments. The whole debt has been shifted from private corporations to the government. When the government has the debt its considered sovereign debt. The situation in 2008 and now in 2011 are the same. Both are debt crisis. This time the volume is lot larger. And there are not many way outs... The world economy is basically in uncharted territory.

When the bail outs of these multi billion institutions were done in 2008, it was famously called "too big to fail" companies. What it meant was - if these institutions incur huge loses or go bankrupt it will affect the overall economy and will have ripple effect in the country as a whole, causing a scenario where there is no growth for many years. That was the rhetoric then. Now it turns out these institutions are "too big to be bailed out too". Now that the corporations have been shored up., the governments had gone into deep debt. The Euro zone and US are going through the exact same problem. Euro has immediate problems and US has significant long term issues. The group of Euro countries standing behind the Euro are being challenged. The effect of having same monetary policy and different fiscal policy has become the focal point. very famously when the Euro came into existence, Milton Friedman, the noted free-market economist had predicted, it is not possible to have a economic union where there is a common monetary policy and not fiscal policy. This nightmare has come true for the Euro zone. Germany and France have come up with an idea to see Euro bonds instead of individual nation bonds. This is easily said than done. There are only two options - Euro gets more integrated and work based on common financial policy or they break up. The break-up could mean the weaker nations like Greece walk out of the Euro first. This may cause incentive for others to walk out "after they have debt problems". Both the Euro and US have stepped in to create new money and pump it in to the economy to solve previous debt and attempt to avoid going into recession again in what is famously referred as "stimulus". The recent downgrade of US sovereign debt from AAA rating to AA+ by S&P, is historic. Many years from now, we will turn back to see this moment and realize the country that prints the world's reserve money is not a credit worthy borrower. It is not going to have immediate effects and the ratings are sentimental. But these are definitely symptoms of a much larger problem as we head into the future.

Main stream media portrays there was a recession in 2008 in the US and there there was a recovery and now there is a possibility of another recession . Eminent economist who predicted the current crisis Peter Schiff says, there is no double dip, and the recession that started in 2008 is still intact.. and what has happened is the government really put a pause to recession by pumping in new money. Once the stimulus ended the recession is back. He refuses to acknowledge its a double dip but just a one long recession that started in 2008. You think about it., it sounds very true.

The global recovery and positive growth is what is going to get back the world economy on its foot. unfortunately there are no signs of it so far. All we see are new problems. Some of them long pending due even before the 2008 crisis. They have just come to the fore.Every country in the world has borrowed more than it can make. As a result everybody owes a lot of money to lot of people and no one wants to pay back now. It is particularly true in developed countries.

Usually when the expenditure of a government is more than its income the government makes effort to increase income by additional taxation. Did you ever realize why the government never runs out of money ? is that not impossible ? You cannot increase spending without increasing revenue. Since growth has stalled in most developed economies the incoming money as taxes have come down significantly. It is ironic, at the same time governments around the world particularly the Western nations have managed to increase spending many folds. You go and ask an ordinary citizen, his taxes have not gone up. So what it means is the government has conveniently chose the option of printing more "currency bills" instead of real productive income. This is more electoral friendly and post pones the initial pain for its citizen. Unfortunately the value of currency falls making everyone poorer in the long run. We cannot get out of the problem by printing more money. It just gives a temporary illusion of richness and will fade with more misery.

The whole concept of solving real economic issues by controlling the money supply was advocated by a noted economist Keynes. According to his theory, the government should primarily control "demand and supply" in the society. This is far away from Austrian economics which says limited government and sound monetary policy backed by commodities such as Gold. Unfortunately Keynes economic model is what is taught as economics around the world with emphasis that government will solve all of people's problem. When paper money loses value, people would realize the harmful effects of this ill culture perpetuated by the governments. If we go by history, the currency crisis in the world is long due and we may be on the brink of it.

The value of precious metals such as Gold, Silver are signalling the lack of confidence in paper money. Gold for example has went up from $250/ounce to $1900/ounce in the last ten years simply beating any other investments in those time period. Commodities such as food, oil are going up for the exact same reasons. Not because food production is going down, but there is too much paper money in the world that is going behind produced food products.

Recent astronomical rise in inflation in India are also the effects of the same problem. If the world prints lot of money the Indian Rupees has to appreciate against those currencies. But unfortunately the India government prints more money to maintain the weakness of the Rupee. This they say, will help exports and make Indian-made products competitive. It will not. Might help in short term but not long term. One day the developing countries like ours will come to senses on this and allow their own currency to appreciate. Remember, real economic growth comes from - production and savings. Not by printing more money or by exporting to nations that give a currency of more value and that currency just came out of their printing press.

One thing readers must know is the common definition of inflation given in media is rising prices. It is not. That is what the government wants you to believe. Inflation is "expanding monetary base" and price rise is a "consequence" of that action.

One of the analogy given by Peter Schiff goes like this, Just imagine an auction where everyone has Rs. 100/- only in their pockets. Whatever the product that may be auctioned -> they will not be worth more than Rs 100 whatsoever. Will they be?