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Venkata Subbu
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Investor and commentator
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  • How To Save The Euro - And Preserve Sovereignty - Part 3

    Yesterday (October 26th,2014), the ECB announced the results of its AQR, while the EBA released the results of its enhanced stress tests. It is good to see them working on enhancing their police power over banks, instead of resorting to the printing press.

    Meanwhile, Western governments are engaged in a process of destroying the basic trust that makes money money. If the usefulness of money earned can be revoked at will, simply because the payor does not like you or your behaviour, then its ability to serve as a store of value is seriously eroded. Participants in an economy where the value of its money is subject to revocation at will will resort to quickly converting their holdings into a form that they think more securely acts as a store of value - even if that means it is harder to transport and use in trade. Various commodities get hoarded and become difficult to acquire. If money becomes a tool for spying on your behaviour that removes incentive to hold money, and adds incentive to make secret one's commodity holdings - making it hard to even find them when you need them. The economy suffers - the volume of trade diminishes to that absolutely necessary for survival, goods and services become hard to find, and displays of wealth via conspicuous consumption are sharply curtailed.

    Right now Russia's Putin is demonstrating his disaffection for what the Western world is doing. It is hard not to be sympathetic about his threat to cut off gas supply to Ukraine - after all Ukraine is in default with repect to its payments, and worse, payment is in a form that is beginning to look less and less like money. Whether that payment is in euro or the US dollar does not make any difference - if Western governments apply sanctions, freezing financial assets and making it impossible to use earned money - then it really does not matter how much is paid. Sanctions are extremely destructive to the concept of money, because they directly attack the belief that the money will be usable when it is offered for something the holder desires. Unlike many others he is not just moaning about his disaffection, he is taking concrete action to address Western bad behaviour. The ultimate goal would be a worldwide commitment to forswear sanctions, to ban extraterritorial laws and taxation, and to preserve avenues to financial privacy.

    When faced with an opponent who is much more powerful, the only way to succeed and/or survive is trickery. In the US and UK we have the story of Brer Rabbit.

    "Dont throw me into the briar patch!"

    This is what I see as his game plan.

    First, the dollar (and euro) components of his foreign exchange reserves are likely to become unusable (and therefore valueless, even if they have nominal value in the Western world). So they need to be converted into a non-revocable store of value as efficiently as possible. Sources of goods and services outside the Western world need to be found and developed, as well as purchasers of Russian goods and services. Where Russian goods are essential to Western nations, trade in them needs to be converted to a payment form that is outside their control. The best deal would be for payment to be in rubles, and for rubles to be acceptable money everywhere. But that is very, very far from the case right now.

    Given the example of Iran, which tried circumventing sanctions using gold as substitute money, he knows that Western governments will react to "bad" behaviour by applying sanctions (he knows they dont have much stomach for more serious responses), and forcing down the price of commodities like gold as part of the process of making their sanctions effective. Since he does not really care about holding foreign reserves in the form of euros or dollars, this gives him an opportunity to exchange his euro/dollar reserves for gold as efficiently as possible, with western governments picking up the cost, and bankrupting themselves in terms of gold holdings. They will hold the door to this process open - because they believe they are enabling him to bankrupt Russia in euro/dollar terms. A low ruble also means he can mop up foreign holdings of rubles as efficiently as possible, making it eventually an extremely scarce commodity outside Russia.

    Meanwhile his country needs the goods and services that the west used to provide, and payment terms cannot be in euros or dollars. It should not be obvious that alternatives are available, otherwise the calculation in western governments would not result in commitment to sanctions and making them effective, but some other response. The western cost/benefit calculus in reaction is precisely why China cannot execute such strategy, even though it is better positioned for a head-on financial conflict. So, while those goods and services and the payment forms can be discussed and negotiated, the actual commitment to them can not occur until the West has committed itself to sanctions.

    In action, this explains what we see happening - Russia waltzes into Crimea (which overwhelmingly supports Russian annexation) with its little green men. The purpose is not to be able to deny Russian involvement, but to be seen trying to deny involvement, and to provoke sanctions; i.e. a direct challenge to US extra territorial Magnitsky type laws. A bloodless annexation helps with the illusion, removes the incentive for military action, and helps with popularity at home.

    The moment military action has been ruled out and the commitment to using sanctions has been made, the pretense of non-involvement is given up. But apparent care not to seriously offend keeps open the door to dollar sales and ruble "defense" by the Russian central bank. Replacement of euro denominated farm products by peso and ruble denominated ones is presented as a tit-for-tat response to European sanctions rather than a market changing central command decision. A ten year old discussion of gas sales to China is finally resolved, with Rosneft still apparently trying to tie gas prices to dollar denominated oil prices - but we dont know if that is actually the case since that part of the deal is secret.

    Russia's gold stockpile is duly devalued by Western action in spite of the crisis, but instead of seeing sales by Russia we see purchases, plus we see a lackadaisical defense of the ruble. China also goes on a commodity purchasing spree and opens a gold trade settlement facility in Shanghai.

    Meanwhile the conversation over Ukraine changes. Rather than talking about Ukraine being run by fascists, now the party line is that Ukraine has "not been paying its bill", and therefore must pay in advance. Cutting off supplies becomes an extension of standard business practice for handling deadbeats. Europeans who help Ukraine by offering some of their own supply are smacked with a reduction of their own supply. When close to agreement, there is a demand that Europe guarantee payment.

    If Europe agrees to this demand, it in effect agrees to give up on the revocability of euro deposits and so sanctions. Putin may accept that as good enough for his purposes.

    But I am not sure that is sufficient for the world. I believe the following is necessary for the liberty of people of the world:-

    A UN treaty that says:

    1) No country may unilaterally determine the legality of any activity outside its territory, tax any activity outside its territory, or demand information be obtained from entities outside its territory.
    2) No country may interfere with the trade of any other country or unilaterally apply sanctions. Any such action is tantamount to war. After all sanctions are the modern equivalent of a seige.
    3) No country may make cash transactions a crime, set up a legal environment that penalizes cash transactions or makes them difficult, seize cash or accounts without a public court order, or demand reporting of information about financial transactions without a public warrant for a specific individual.
    4) Any individual may report or publish details of any transaction that he or she believes is part of a crime that has been committed or about to be committed.

    If Europe does not agree to the above demand, I expect a waiting period followed by a further escalation. Supplies are cut off or curtailed, and the demand naturally escalates into a demand for payment in a more reliable currency, such as the ruble, the yuan, or gold. At this point the Western world, especially the US, will not have these in sufficient quantities, sanctions will have made Western demand relatively irrelevant, prices would have been determined at low ruble valuations, and valuation ratios will suddenly flip. The Western world will then enter a major stagflationary or hyperinflationary period.

    I do not think Putin wants that either. Much as I hate to say it, he sounds like more of a classical free trade advocate than the US does right now. A general reduction in trade is bad enough. Worse, a sudden loss of privilege often results in a resort to violence, and the US has sufficient military power that she can be a serious problem. Maybe we are there already, as it seems extra-judicial assassination with serious collateral damage is now considered acceptable US government conduct. Maybe we are at the stage where Putin, not the President of the United States, is the leader of the free world.

    The ECB can help dodge that scenario. A great thing about physical money is its anonymity, but the greatest thing about paper money (or any money in the form of physical tokens like coins or bills) is its non-revocable value (other than inflation) and especially the non-targetability of its owners. Whenever a bank fails, which hopefully is more often given the ECB's enhanced powers, the ECB should stop runs and losses of "small" depositors by issuing them physical currency notes in the largest possible denomination, instead of transferring their accounts to a surviving bank, and cause the failing bank officials to experience a hard, public, highly embarrassing, and career ending failure. "Small" depositors dont lose their money, but are put through a minor inconvenience, enough to make them pay continuing attention to the quality of their bank. "larger" depositors will find the physical format a major inconvenience, and promptly redeposit it in another bank. The fractional reserve system will then promptly enhance the money supply at the new (hopefully better) bank. The economy receives a cash infusion precisely when and where it needs it - when bank quality is low and failures are high. Maybe the ECB could even achieve its goal of a trillion euro injection by enhancing the bank failure rate. The much wider availability (and use) of cash will mean that governments that overtax will wind up being simply ignored by their citizens and fall, while the economy carries on. Harmful policies like sanctions will be much harder to implement. Excess cash under mattresses will need to be constantly attracted back into the banking system with generally higher interest rates, giving the ECB more room to maneuver.

    Tags: economy
    Oct 29 5:25 PM | Link | Comment!
  • Is Mr. Bernanke Helping Or Hurting?

    The market works because of the signal carried in prices.

    When Mr. Bernanke pours money into securities attempting to raise their prices, the market naturally reacts by going for the items where money is most easily made, and ignoring other parts of the economy. As margin balances show, the market is even willing to take out money from other parts of the economy to "invest" in what seems to be the most productive investment. Mr. Bernanke is causing the slowdown in the economy and delaying its recovery, rather than boosting it! His actions show that he is acting on his conclusions regarding the 1930s rather than on what he (should?) knows about markets. I think history will eventually compare our times to the 1920s rather than the 1930s.

    The best way to boost the real economy would be to make financial (rent-seeking) investment UN-attractive. Then money would go into other parts of the economy. It is especially necessary to make people wait for the results of investments before paying off on investments. And that is the role of government, to penalize the quick buck, and to ensure that real returns ensue from an investment before an investment pays off. Securitization and insurance from that point of view is a negative thing - regulation is needed to make sure that it is grounded in reality. For example - we need to enforce the rule of NO naked shorts - in all assets, including gold, silver, derivatives etc.

    It is pointless to forbid something that is going to be done anyway. So, rather than making things illegal, a better way is to impose a cost, such as a tax, on returns on an investment that exceed the return on the underlying real economic activity.

    A financial transaction tax effective on investments of less than a year is one way. Similarly, a financial transaction tax should be imposed on any futures or derivative transactions not settled in kind. Shorts and options not covered by delivery of physical shares would be subjected to the tax. Capital gain on shares would be subject to the tax if the percentage gain exceeded the prorated annual revenue increase of the underlying entity.

    Or we can go back to making naked shorts (including via derivatives) truly illegal with real criminal penalties, and abolishing the Fed - making Congress again responsible and taking the political heat for increasing the money supply. Corporations that violate the naked shorting laws should be given "jail" sentences - i.e. they cannot transact any business for the same period of time that a person violating the law would be sentenced to.

    Disclosure: I am long SLV, FCX, SH, ORCL, RAX, YHOO.

    May 03 8:37 PM | Link | Comment!
  • The Future For Google

    One always has to marvel about human nature - and here specifically the instinctive defensive crouch an aging person or organization adopts to protect against competition. Unable to take on a fight directly and win, such a person or organization will attempt to use their experience and political clout to organize the world in such a manner as to disable competition before the fight even begins. This results in a poorer world for everybody, and preventing this behaviour (e.g. see here) is often even beneficial to one who would indulge in it.

    Currently we have Google (NASDAQ:GOOG) planning to adopt a shareholder scheme whereby a majority of shareholders will be disenfranchised, in order to preserve the control of its founders Sergei Brin and Larry Page over the organization. This is being justified by an appeal to the long term interests of its shareholders, saying in effect that the founders can address them better if they were not distracted by the short term interests of Wall Street. A Forbes article addresses this in detail, so I will not talk about it further.

    There is another defensive stance being adopted that could be much more detrimental to Google. We are already seeing the effects and they are due to get much worse. Unless this is part of a plan to diversify Google's business, this could get ugly in a hurry.

    As everybody knows, the primary business of Google is pay-per-click advertising. Search is what brings eyes to the advertising, but is not Google's primary business. It does provide part of the sell - advertisers only pay for "interested" viewers - not for all viewers - many of whom have ad blindness and don't even see ads that are on the page they are viewing. Unlike Yahoo or AOL that actually provide content or use email to attract viewers, Google relies on "publishers" to provide content - offering them an easy way to be found and monetize the content they are publishing by sharing the pay-per-click revenues.

    The pay-per-click sell has its downside. Advertisers complain about publishers who click on ads alongside their own content, and Google is forced to install mechanisms to detect "click-fraud" and punish publishers who do it. Publishers who put up content often see a lot of activity on their site, but very few clicks. Large publishers who can generate their own advertising can maximize their revenues by eliminating pay-per-click and/or bypassing Google as the middleman. This leaves the middle and lower tier publisher as Google's main content provider.

    Punishment of an errant publisher is draconian - a complete cut-off of Google advertising to that account. After the fall-off in advertising earlier this year, Google instituted across the board information sharing about accounts; after the spring results it used that to cut off even more accounts - under the belief that this would bring back the advertisers. But what it is really doing is eliminating and/or annoying it's eligible content base. Already one can see a major reduction in the number of sites carrying Google ads.

    What is worse, under the current policies it is now even possible for a random website to cut off the advertising flow to a perfectly well behaved and respectable website, allowing Google's competitors, annoyed publishers, or competing publishers to mount a denial of service attack. I believe this is already happening, and Google's next few rounds of results are liable to bring a nightmare to Google investors.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Tags: GOOG, short-ideas
    Jun 06 10:59 AM | Link | Comment!
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