This article was published at The Epoch Times.

For many traders, it was a shock to see the barrel of oil collapse to 12-month lows in June, despite an agreement from producers to cut supplies. However, not many people are talking about the falling prices in other commodities, as well as the positive impact of low oil prices on global growth.

So why is a barrel of West Texas Intermediate still trading for below $50? The problem is not just due to oversupply, but also to a slowdown in the growth of Asian demand. Chinese demand has supported prices for the past decade, as demand in developed markets has reduced thanks to increases in efficiency, substitution, and technology.

However, China’s stockpiles have risen to 511 million barrels in capacity, just below the 693 million barrels the United States held in March. Chinese industrial demand is also falling, due to rebalancing away from the industrial sector and toward services.

But oil prices, in this context, are just a symptom of a much more severe illness: the excess debt and overcapacity created in China to support an unsustainable growth model.

In the first five months of 2017, China has added more debt than the United States, United Kingdom, European Union, and Japan combined. While GDP growth looks healthy as is, it appears weak and potentially dangerous when compared to the increase in the money supply. As the old economy tapers off, fewer and fewer raw materials will be needed for production.

Dollar Flows

Low oil prices have knock-on effects on other emerging markets. Commodity producers like Mexico and Saudi Arabia are facing another “sudden stop”: the abrupt reduction in U.S. dollar inflows, as debt repayments in foreign currency escalate.

Most economic growth estimates for 2017 were made using much higher oil prices, and the market is likely to see downgrades in expectations of inflation and growth in the majority of the large emerging economies. We are already seeing significant downward revisions for Brazil, Argentina, Russia, and other economies.

According to ICBC Standard Bank, emerging market debt maturities through 2020 will exceed $1.4 trillion. At the same time, as rates rise in the United States, capital flows to emerging markets are much lower than those seen in the past decade. Low interest rates may mask these risks in the short term, as central banks are increasing the money supply by more than $200 billion per month, but they do not eliminate them.

Not Just Oil

There is another factor beyond oil prices worrying investors. Copper prices, a major indicator of global economic activity, continue to be weak due to oversupply and lower Chinese demand.

Market expectations for revamped growth and higher inflation in 2017 and 2018 stand at odds with the decline in major commodities like copper and oil. More importantly, the decline might be a warning sign of a much deeper problem. The more than $20 trillion in monetary stimuli globally has delivered disappointing growth, as well as contagion risk as financial imbalances across countries rose.

Low oil and commodity prices benefit the users of such commodities like the United States and Western Europe. However, given their negative impact on weaker emerging economies, their price decline may be the canary in the coal mine for the world economy.

Daniel Lacalle is a professor at IE Business School in Madrid, a fund manager at Adriza International Opportunities, and the author of “Escape from the Central Bank Trap.”

Article courtesy of The Epoch Times

Special contribution by Amit Tal (@amital13):

 

The relationship between the capital market line model, the amount of debt, inflation expectations, and the rise in the price of assets worldwide.

Introduction

One of the main problems in the world in recent times is high asset prices (stock indices, real estate prices, and food prices at an all-time high), a phenomenon that is widely shared by many markets around the world.

The process of rising property prices is a result of a complete lack of understanding of the implications of the Keynesian method, political events in the 1970s and the evolution of the Phillips Curve, which found a positive correlation between inflation and the labor market.

The purpose of the article is an attempt to explain the behavior of record-breaking stock indices, and its conclusion is that we are in a self-sustaining bubble that necessitates a continued rapid increase in assets. The alternative to this process is the total paralysis of the global economy and the creation of social chaos.

Historical background

The “Great Depression” of the 1930s left harsh feelings among economists in those years. This depression was the longest and most difficult in the history of the United States. The depression began in 1929, and lasted more than a decade, until the United States entered World War II. The Depression reached its peak in 1933 with a 60% fall in gross national product, a decline of about 80% in industrial output, unemployment of about 25%, and over 9,000 bankruptcies.

Following that traumatic crisis, John Maynard Keynes, a British economist, wrote his economic theory in the book Economic Theory of Employment, Interest and Money. This book caused a great deal of change among economists, who saw this theory as a revolution. Keynes argued that the relative rate of savings in the economy increases with the rise in the level of income, while the increase in investments reduces the increase in savings. The funds used as savings reduce the general purchasing power of the economy, and therefore there is a relative lag in the demand for goods and services, although in absolute numbers this demand is rising. Surplus supply creates a state of imbalance, and with it, unemployment increases.

According to Keynes, the only way out of a crisis situations, in which the supply-to-demand balance is not in full employment, is government intervention. Keynes argued that the government should create a deficit and invest money in infrastructure. That same government investment will trigger a re-start of the economy.

The adoption of Keynes’ approach led to a significant increase in the level of US debt relative to previous years. The assumptions of the Keynesian model were used in later periods for the development of the Phillips Curve, which states that the inverse relationship between the unemployment rate and inflation rate caused economists to defend inflation.

Cancelling the gold standard

In 1971, the gold standard was cancelled as a basis for the dollar by US President Nixon. The background to the decision was an increase in the trade deficit and an increase in the budget deficit following the Vietnam War. The decision made it possible for the governments of the USA to increase state debt considerably.

 

Figure 1 – Federal government debt in the United States

 

 

 

Figure 2- Federal government debt.

 

Capm model (Capital Market Line)

The model is based on two central equations. One of them is the market line equation(CML). This equation shows the relationship between the expected excess yields on an investment portfolio, which results from the distribution of investments between a risk-free asset and the portfolio’s risk, which is expressed in its standard deviation.

A risk-free asset according to the model is government bonds.

 

Debt bubbles

In the 50 years since the US decided to cancel the gold standard, and following the easing of credit in the 1980s, the amount of global debt began to grow considerably.

I want to illustrate how the mechanism of credit bubbles works, in my opinion. I will do it with parallels between all economic agents and markets (government, companies, households) and the average citizen. For example, let’s say that a person is interested in taking a loan and when the time comes and he or she has to pay the bank, the person doesn’t have the financial possibility at the moment. The person faces two options: bankruptcy or a bigger loan on more favorable term (lower interest rate). In the past 45 years, all markets have preferred the second option.

This line of reasoning explains the behavior of interest rates in recent decades. In addition, whenever the interest rate rises, a crisis arises.

Figure 3- the yield of USA government bonds.

 

Is there a chance that central banks know this and try to do everything in their hands to prevent this explosion? A look at the bond market proves so.

Figure 4- Fed behavior in recent year.

A combination of the market line equation and the debt bubble

Let’s look at the equation that composes the market line

Risk-free interest is decreasing, as we understood from the debt bubble process. In order to maintain the same expectation of the portfolio investor must increase the risk in the portfolio (standard deviation of the normal).

Increasing the risk involves at some stage the taking of loans that are invested in the market. This increases the debt bubble and requires further lowering interest rates.

And so we are in an endless loop of risk-taking, price increases of self-sustaining assets.

This line of thought explains this graph

 

Figure 5- market vs debt

Is there an alternative?

In my opinion, the alternative is much worse and would be the explosion of this credit bubble, which could lead to total chaos in the market. This behavior of markets must continue. The problem will arise when the middle class collapses.

 

This is a contribution by Amit Tal @amital13

 

My response:

I explain alternative solutions in my book Escape from the Central Bank Trap.

It is undoubtable that the perennial increase in debt that governments have implemented requires what Keynesians call “moderate inflation”. The fact that the modern capitalist economy post-Bretton Woods has become a credit economy where all economic agents add more debt expecting asset prices to rise is also a fact.

However, as we have exceeded the point of debt saturation, we go from productive debt to unproductive and dangerous debt, creating weak growth and declining productivity. This makes monetary policy create abnormal price inflation and, at the same time, a disproportionate amount of debt exposed to financial assets (margin debt).

So the objective of central banks and monetary policy must be to prevent bubbles bursting into a massive financial crisis, given that the possibility of returning to full sound money policy is virtually impossible. Therefore, we can introduce limits to monetary policy in order to avoid the constant boom and bust cycles. There are numerous articles in this website about this subject if you want to expand.

I hope you enjoy Escape from the Central Bank Trap, the details are all there.

Daniel Lacalle is Chief Economist at Tressis SV, has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

Images courtesy Google Images, zero hedge, and Amit Tal.

 

It is sad to see that, facing the evidence of the failure of demand-side policies and money printing, many commentators propose some of the most outdated and failed policies in modern economic history. In the UK, Mr. Jeremy Corbyn, the new leader of the Labour Party, believes that the government spends too little. With a current 44.4% of GDP public spending, saying the government spends “too little” is an insult to taxpayers and efficient public bodies alike.

But Mr. Corbyn wants to penalize the private sector creating the largest transfer of wealth from savers and taxpayers to government ever designed. The People´s QE (quantitative easing).

In Europe, we are already used to the follies of magic solutions from populist parties. Syriza, Podemos, and others always come up with “magic” and allegedly “simple” ideas to solve large and complex economic issues, and always fail when reality kicks in, but there are few that match the monumental nonsense of the wrongly-called “People´s QE”. It is the “Government´s QE”, rather.

Why is this People’s QE a bad idea?

The analysis starts from the right premise. Quantitative Easing, as we know it, does not work, and creates massive imbalances. So what do they propose? Sound money? Erasing perverse incentives of printing money and unjustifiably low rates? No. Doing exactly the same, but passing the massive perverse incentive of currency debasement to politicians who, as we all know, have no perverse incentive whatsoever to overspend (note the irony).

The UK policy of increasing money supply in the past has always been based on two premises to avoid hyperinflation and currency destruction: the independence of the central bank as a central pillar of monetary policy, and the constant sterilization of asset purchases (ie, what it buys is also sold to monitor market real demand). The balance sheet of the Bank of England has remained stable since 2012, coinciding with the highest economic growth period, and is below 25% of GDP.

Corbyn´s People´s QE means that the central bank will lose its independence altogether and become a government agency that prints currency whenever the government wants, but the increase of money supply does not become part of the transmission mechanism that reaches job creators and citizens in the real economy. All the new money is for the government, with the Bank of England forced to buy all the debt issued by a “Public Investment Bank”.

The first problem is evident. The Bank of England would create money to be used indiscriminately for white elephants, a disastrous policy as seen in many EU countries, that only leaves overcapacity and a massive debt hole. By providing the public investment bank with unlimited funding, the risk of irresponsible spending is guaranteed. In a country where citizens are aware of wasteful public infrastructure, this is not a small risk. However, the monetary imbalances created by this policy would generate a massive “crowding-out” effect and incentivise cronyism, as the private sector would suffer the consequences of inflationary and tax pressures as well as unfair competition from government and its crony sectors.

The second problem is that rising public debt, even if “monetised” (hidden in the balance sheet of the investment bank), would still cripple the economy even with perennial QE. Printing money does not reduce the risk of rising imbalances as we are seeing all over the world. And the new bank´s potential losses would be covered with more taxes.

The idea of building lots of bridges and airports all over the place to “create” jobs would be mildly amusing if it hadn’t failed time and time again and forgets the cost of running those infrastructure projects once built, apart from the debt incurred. All paid by the taxpayer, who guarantees the capital of the Public Investment Bank.

The third problem is that inflation created by these projects is paid by the usual suspects, the private sector, and citizens, who do not benefit from this spending as the laws of diminishing returns and debt saturation show.

The Socialist idea that governments artificially creating money will not cause inflation, because the supply of money will rise in tandem with supply and demand of goods and services, is simply science fiction. The government does not have a better or more accurate understanding of the needs and demand for goods and services or the productive capacity of the economy. In fact it has all the incentives to overspend and transfer its inefficiencies to everyone else. As such, like any perverse incentive under the so-called “stimulate internal demand” fallacy, the government simply creates larger monetary imbalances to disguise the fiscal deficit created by spending and lending without real economic return: Creating massive inflation, economic stagnation as productivity collapses and impoverishing everyone… except itself.

Additionally, trade deficits would widen to unsustainable levels as imports outweigh exports.

Tax increases, higher cost of living and, above all, destroying a large part of the British private sector as the government monopolizes the major sectors of the economy and increases taxes for the rest.

These dangerous magic solution policies have already been implemented in the past. It is the Argentine model of Kirchner and Kiciloff disguised in Anglo-Saxon terms, a model that has only created stagflation. It is also the Venezuela model (Mr. Corbyn was a defender of Chavez and his economic policies). To think that the government can decide how much money is created and spend it on whatever it wants without thinking of the consequences for the economy.

The myth is that they say printing money will not cause inflation because it will increase productivity and the increase in money supply will come in tandem with more goods and services.

“Inflation occurs when you have more money chasing the same or less amount of goods and services. If you have money creation that increases productivity, yes you have more money but you also have more goods and services…the supply of both increases in tandem, so you don’t necessarily have to have inflation.”

The problem? It is simply a myth debunked by history. Every single attempt at this socialist myth of productivity, supply and demand moving in tandem because the government says so, fails. It never happens. The government does not have better or more detailed information than the private sector of what goods and services the economy needs, and even less knowledge of how to boost productivity because it does not have the incentive of profitability and efficiency, just of maximising budget spending.

Productivity collapses as government overspends on white elephants and politically motivated investments with no real economic return. The supply of goods and services does not increase in tandem with money supply in an open economy dependent on imports like the UK’s. Basically, the theory sounds nice, it simply never happens.

At least, when private banks “create money”, they have an incentive to lend with a real economic return and to try to recover the principal, with an interest. They might fail, and therefore my defense of a minimum cash coefficient and sound money. However, the government has no such incentive, rather the opposite. To create money to spend on politically motivated items, and pass the imbalance through inflation and currency debasement to the productive sectors.

The lesson from Japan was clear: “Individual consumption only went up by around 0.1-0.2% of GDP and failed to increase long-run consumption. Overall, the program did not ignite inflation or help Japan out of its economic rut”. And the lessons from Chile with Allende, Argentina with Kiciloff are scary.

Corbyn forgets that the public sector cannot exist without private sector revenues. Printing money does not create prosperity, it dilutes it. Be it through current or other QEs.

The aristocrats of public spending always think that intervening on money creation and the economy is going to solve everything.

Do they know this will not work either? Yes, but the final objective is different. To make government control all aspects of the economy, whether it is in recession or in depression. For Corbyn, the government is infallible and any mistake it makes has to be blamed on an external enemy.

If Corbyn implements this “People’s QE”, it will be “Venezuela with tea and cakes”.

The People’s QE is the same as any other quantitative easing, a massive monetary imbalance today under the promise of solving it in the future. The current QEs will likely end with a financial crisis. The People’s QE would do the same.  Except that the “alleged” beneficiaries, the “people”, will likely be drowned in inflation as the mirage of money supply and goods and services growing in tandem is proven as fake as it is in today’s QE programs. But without sterilization and transmission mechanisms, the inflation that is created today in financial assets would make prices soar due to devaluation.

Monetary imbalances always create inflation. Whether it is asset price inflation or goods, it is the symptom of aa larger problem. Because all monetary imbalances end with either a financial crisis, massive inflation or massive unemployment once the small and temporary effect of the monetary placebo ends.

The artificial creation of money without any support is always behind every crisis. The People’s QE has failed every time it has been implemented. This would not be different.

Daniel Lacalle is Chief Economist at Tressis SV, has a PhD in Economics and is author of “Escape from the Central Bank Trap”, “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

Images courtesy Google Images

Further Read: The Upside Down World of MMT

Money, Fiscal Policy and Interest Rates. A Critique of MMT