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“I wish you to live in the interesting times”, goes the old Chinese course. In times when there are fundamental realignments of interpersonal, economic, social and international relations. From psychological point of view, those realignments are very important, as the tendency of man is not to change something if it works. The only time that something needs changing, improving or fixing is when it is broken.

Crises enable us to reflect, to identify the elements that caused it, and work towards eliminating or modifying those same elements.

If there are too many of such elements, or they are such that they would fundamentally change the product or activity, sometimes this activity has to be discontinued, or rebuilt again on stronger foundations and by keeping the new facts in mind.

If the crisis is strong enough, we quickly start examining the strength of foundations themselves. Then, we examine if the axioms and assumptions on which we have built the foundations still hold true, and whether they should be adjusted accordingly. Every now and again it happens that the foundations lay on so far outdated foundations that in order to move forward, those foundations need to be demolished and rebuilt from scratch on new assumptions. Such examples were the French and October revolutions.

The fact is that today we are at one such breaking point. We realise that some things are fundamentally wrong. We can only hope that the things can be adjusted without demolishing the foundations, as when the old foundations crumbled, and the new ones have arisen to prominence yet, there is Chaos. Chaos is necessary for the Catharsis of mankind, but can be very painful from the point of view of individual person, as people lose the anchor on which their whole life was based.

Chaos happens also when the foundations for decision making are destroyed. One of such events happened when, under enormous political pressure, American agency for accounting standards, agreed that the banks can keep their losses off their profit and loss statements if they claim that they do not intent to sell underlying assets at current valuations. Even more, they are allowed to include those assets in their capital at full value. This can quickly bring the crisis of trust, as capital is sort of warranty that enables bank to cover certain degree of losses. If market value of this capital is considerably lower than the book value, then in case of liquidation, all indicators are wrong as they do not account for the case of liquidation.

After adjusting to new accounting rule, most of the big banks have published profits amounting to a few billion USD each. At the same time, US Treasury is stalling with the publication of the results of the stress test. If there would be even a glimmer of hope that the banking sector is solvent, the treasury would rush to publish the results and calm the markets. Since there is no such hope, we can see slow, drop by drop release of methodology and incomplete disclosure of data, which will happen in may, at least a month after the conclusion of the tests.

It is quite possible indeed that we will also witness an explanation, which will inform us that we had understood one of the rules too strict and that this criteria meant something completely else. After such a “massage” of criteria, we will see that apart from small exceptions (which will remain undisclosed), most of the banking sector has successfully passed the stress test.

Frederick Cannon, an analyst of KBW, claims, based on simulated in-house stress test by KBW, that the US banking system needs at least $1 Trillion ($ 1 000 000 000 000) of additional capital. Many analysts are convinced that if we use strict interpretation of criteria, 16 out of 19 banks would fail.

In an independent world, monitored by an independent regulator, publication of enormous profit, followed by capital raising exercise to cover the losses would immediately send the alarm bells ringing. Even if we leave the moral questions aside, logic claims that those two data are either un-comparable (due to methodology) or that one is an outright lie.

Such “data massage” should cause extreme concern with the majority of investors and cause that they, as rational beings, withdraw from the market due to lack of trust in the data provided.

This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading Slovenian Investment Magazine KAPITAL, on 27.04.2009. Original article is available at the following URL:http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6695

Politicians are, in a hurry to decrease swelling budget deficits, seeking new and new taxes and clamping down on tax heavens. The issue of taxation went that far that every citizen of Slovenia is taxed at least twice on the same money. First, at the source when he earns money and pays income tax, and then, at the point of consumption, when he pays VAT on whatever he spent (and the money he spent had already been taxed via income taxes). But, since during the credit crunch, budget shortfall keeps increasing dramatically, we can see new taxes, excise duties, environmental compensations and “voluntary contributions” whose sole intent is to close or at least decrease the yawning budget gap.

But still, compared to the UK, we have been quite lucky. On top of all the other taxes, they have the Council Tax, a tax for the right to live in a property, which costs between 1000 and 2000 Euros each year, depending on the property value, and goes straight to the council budget.

While, on the other hand, most of the politicians keep on forgetting that budget deficit can be decreased not only with increased taxes, but also with decreased public expenditure. There is a way to decrease the expenditure, while at the same time increasing the amount of money available for given service.

With the tax relief on voluntary donations to particular non-profit NGO’s the state can efficiently and on the basis of market mechanism transfer most of social and health services to such non-profit NGO’s, while at the same time decreasing its own expenditure on the services and increasing the total pool of money available for those same services. It only takes a few short steps. First, the state needs to prepare a public tender for the provision of service, limited to non-profit NGO’s. The state then transfers to them their obligation to fulfil government goals and guarantees them the minimal resources to fulfil them (those minimal resources shall be no bigger than the current expenditure). At the same time, the state shall publish the tax relief for voluntary contributions to organisations that won the tender (has to be more than 1 to ensure competition). This would encourage citizens to donate money to such organisations. Since the income from the donations is higher that the lost income from lower taxes (since we luckily do not have 100% taxation yet), the state saves money, as it does not have to pay for the services if NGO’s raise more than minimum in donations, while there is more money to improve the quantity and quality of the service. If we enable more non-profit NGO’s to compete in the same field, this introduces the efficiency of market mechanism into the equation, by automatically channelling donations towards the highest quality provider. We can add that later on the state recoups most of the money that it lost as a consequence of tax relief, in the form of VAT receipts on the total amount of donations, higher wage taxes and higher taxes on profits from suppliers of those NGO’s.  This mechanism thus enables the state to lower expenditure, increase the quality of services and increase tax collection. We can quickly see that this is a WIN-WIN situation.

This does not mean that taxes should be eliminated altogether, as we need the state to ensure law and order, enforcement of legislation, protection of competition and protection of external borders. On top of it, we need different government department that are responsible for setting the strategy in education, health and social policy, while the tactical implementation is better of being done in private sector, supported by donations.

This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading Slovenian Investment Magazine KAPITAL, on 27.04.2009. Original article is available at the following URL:http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6696

In the last month, we have heard a lot about quantitative easing, a method that is currently being used by central banks of Japan, England and USA to combat the credit crunch. Japan first tested the method during their lost decade. Lately, European Central Bank has come under a lot of pressure from analysts who claim that it is falling behind the curve and failing to rescue European economy by quantitative easing. Main goal of the method is to increase the amount of money in circulation and thus start inflation, which will then send the information to producers that certain goods are in short supply, thus needing increase production, so they will employ more people and increase economic growth. Latest increase in the SDR, agreed during G-20 has similar goal. SDR is a virtual basket of large world currencies.

What is Inflation and why do we want it so much?

If we increase the amount of water in the lake, without widening the lake, the level of water is going to increase. Money works the same way. If we increase the amount of money, without increasing the amount of goods, level of prices will increase. Money starts losing value, prices of goods are increasing. The biggest losers of unexpected inflation are the savers, while the biggest gainers are the spenders, as the goods cost more and more. This adjustment is short term, but in high inflation can be very sharp. Then, people adjust and start expecting inflation.

When inflation is expected, people adjust and include inflation in their plans. Business people see that their product is not competitive, but they calculate that at current inflation, it will be in three years, so they invest today to lock in today’s prices. If they save, it will cost them much more in three years time. Consumers do not want to stay behind and watch the inflation eat their earnings, so they rush to the shops and spend it all, as tomorrow they can buy less with that money. In the short term, this increases the economic growth, as people spend the majority of their income. Long term effects of inflationary growth can be observed in the case of former Yugoslavia, where everybody lived happily in the short term, buying property on loan that was quickly worthless, and enjoying inflationary growth.

What about deflation?

Deflation is just the opposite. If the amount of money decreases or the quantity of goods increases, the level of prices decreases as well. The main gainers during unexpected deflation are the savers, as their savings are worth less, while the main losers are spenders. Deflation thus increases savings which in the short term depresses economic activity. This means that in the short term, there are more unemployed and less tax receivables for the state, which causes problems to the state budget.

Is there a middle way?

The answer is yes and no. There is no method that would keep all the prices at the same level all the time. And it is neither desirable. There is a way to keep the real value of the money that would send entrepreneurs reliable signals regarding the relative rarity of goods. Currency whose amount is fixed and unchangeable is the solution that sends such signals. If we are producing too much of goods A, their price will fall and people will start removing the capacity to produce those goods. Analogously, is we are producing too little of goods B, their price will increase, thus encouraging the people to invest more in producing the goods B.

The way to keep the quantity of money constant and thus keeping the value of money is the same as with the publicly traded companies. If the quantity of shares outstanding is constant, shareholders keep all of the excess value that the company creates, so they are worth more. If this company issues new shares, it has partly diluted old shareholders, especially if the old shareholders have purchased shares at a higher value that the new ones, so there is less of excess value created by the company left for the shareholders. Nobody is encouraging publicly traded companies to keep on issuing new shares year after year. On the contrary, shareholders are avoiding them. Yet the countries are doing exactly that with their currencies.

Throughout history we can see that only real excess value (savings) can be the basis for sustainable economic growth and economic development. Any other growth, such as inflationary or credit based growth, has quickly been proven to be unsustainable, as people have been spending the excess value on unnecessary goods and thus have been destroying the foundations for the economic growth. If the quantity of money is stable and unchangeable, there is no danger that the country or the central bank will, by increasing amount of money in circulation, inflationary dilute our savings. This security increases saving and, in the long run, sustainably increases economic growth.

This is an English translation of an article by Mitja Sadar that was published, in Slovenian, in the leading Slovenian Investment Magazine KAPITAL, on 14.04.2009. Original article is available at the following URL:http://www.revijakapital.com/kapital/poslovnefinance.php?idclanka=6654