People are leaving places like California and New York, for Texas and Florida respectively. In other words, people are leaving high tax states for low tax states.

If one were to check the incomes of those who leave, it is more than likely it’s the income producers that are leaving, with the low or no income people staying for the better government health care, welfare welfare checks, unemployment checks, and food subsides, in NY California. 

This leaves fewer high income earners behind to pay for the same number of people, more voters to vote themselves people who will take the high income producers, and worse budgets in the long term.

This gives municipal bond investors data to ponder.  California and New York are busy blowing another real estate bubble, which will temporarily paper over these structural problems, until the cycle inevitably ends, exposing these structural weaknesses.



Source: Pew Research Center

Deficits, Taxes, and Spending

37 year Study Shows Spending Cuts, Not Tax Increases, Best for Debt, Growth, Bond, Stock Markets

Bernanke Talked of Levying an Inflation Tax


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Bridgewater recently pondered a perfect storm in Europe, breaking down numbers, and listing five catalysts. Meanwhile, Felix Zulauf is also concerned. He noted that European bank writedowns are expected to be over one trillion Euros, while the EM has committed only sixty billion to bailouts.

The depositor haircuts in Cyprus showed investors and depositors who would likely be the targets the next time a crisis erupted.  Few of the structural issues have been dealt with, although a reduction in trade imbalances between Euro countries, and a positive fiscal balance in Greece, does show progress.

In 2012, I was quite pessimistic on the Euro staying together.  Some of this pessimism was due to history, some if it due to moral hazard.  However, the data point I mistakenly overlooked was in the polls.

This past spring the WSJ showed that even in Portugal, Italy, Ireland, Spain, and Greece, the public supported the European monetary union at a staggering rate of 60-70%. Evidently, the only politicians the people distrust more than Germans are the local politicians.

However, perhaps this merely needed more time to play out. The polls are still supportive of the EU, but they show a clear trend:


Support has fallen most notably in France (-7 to 62%) and Spain (-11 to 52%).



In a study of 245 unions covering 1948 to 1997, where 128 of the unions disolved, Niktsch (2004) showed:

“…departures from a currency union tend to occur when there is a large inflation differential between member countries, when the currency union involves a country which is relatively closed to international trade and trade flows fall, and when there is a change in political status of a member.

Germany’s inflation rate has diverged from the rest of Europe; in fact, they are working on a housing bubble of their very own.

Other risks include the sudden rise of a fringe party. Nazism came on abruptly in the 30s, and Niktsch confirmed political transitions as a threat to monetary unions.

As for stocks, European equities are quite inexpensive and have recently outperformed U.S. market. The time to buy is when everyone is negative and that’s certainly the case now.


Timing is everything though, better opportunities may be available on corrections.

Interestingly, in Sweden, where the public is most positive, they are busy blowing a housing bubble, and thus, at risk of a banking crisis.

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Weibo users and Chinese politicians are using a Tocquevillian pre-1789 French Revolution as a template for China. The Old Regime and the French Revolution hit the best seller list, and vice-premier Wang Qishan “recommended” it. ~ businessinsider

Historian Paul A. Rahe has long made the analogy, prompting a couple articles:

"Further news from the Front Suggesting that China Might Be in a Pre-Revolutionary Condition" and "What Occasions Revolutions"

For more than thirty years, at meetings of the Institute of Current Affairs,  I have been arguing that China would eventually come apart at the seams.

All that it would take, I argued, would be an economic downturn — and the place would blow up.

Speaking of which, Carmen Reinhart, in a 2009 PBS interview, raises the specter for an inflation and domestic debt crises in China, not just a banking crisis (a forecast made in this space long ago).

…many of the indicators in China have the markings of red lights of early warnings. It is also the case that these indicators may flash a warning for awhile before the crisis ultimately erupts;

…one of the contributions of our book is to document domestic debt crises (these often go together with banking crisis). While these often have limited international consequences, they are extremely damaging in terms of both output and inflation consequences. Complacency about China (and other emerging markets) at this juncture is not a great idea. ~ Carmen Reinhart

In "Waiting for a Crisis" Andy Xie, formerly of Morgan Stanley, had this to say recently:

"China’s credit-fueled investment model "is essentially a pyramid scheme," cautioning that "constraints have appeared."

I agree, export growth to developed markets is limited, wage costs are increasing, stimulus impacts food inflation (makes up 50% of household spending),  the environment, and people fed up with their land (read people are getting 2% of the value of land as compenstation.

Trust companies in China’s shadow banking system lent 5x more in first 11 months of 2012 vs 2011

The government has simply blown the credit and infrastructure bubble bigger -companies are fleecing foreign investors yet again raising money through junk bonds, like they did following 2008.

GMO’s James Montier says as much in "Feeding the Dragon: Why China’s Credit System Looks Vulnerable."  I’ve mentioned all of these things before, but it’s worth a refresh. The only thing relatively new is that the Credit growth is bigger, has moved to the shadow banking system, and capital flows out of the banking system have accelerated.

Beijing seems to be on the verge of losing control over the credit system. Savings are migrating from deposits in the state-owned banking system to higher-yielding nonbank credit instruments.

Furthermore, rich Chinese are increasingly willing to evade capital controls and take their money out of the country. As a result of these developments, deposits in the banking system are becoming less stable. “Red Capitalism,” namely the ability of the Chinese authorities to direct the country’s enormous savings for their own ends, faces an existential threat.

It brought to mind the still apt "Assume China Will Have a Financial Crises, What’s Next?" that I wrote in Sept 2011.

Lessons from The 1997-1998 Asian Financial Crises suggest the next stage of the crises will be missed debt payments by a major Chinese firm. This will trigger a crises of confidence about other firms. The debt and corruption is systemic, so it could be a property developer, SOE, financial institution, or industrial company.

What happens then? The central government is displeased at the corruption and abuse at the local level. They could let them fail. We can assume bailouts of SOE, Banks, and corporations, putting their sovereign rating at risk. It’ll be interesting to see if these banks are able to fleece foreign investors one more time and raise capital. Or rather, at what price they will be able to do so.

The answer is yes; Chinese banks successfully raised capital from the Middle East and U.S. Banks following the 2008 crisis. However, Goldman Sachs recently sold their stake in ICBC, yet yield starved foreign investors have come back for more, purchasing bonds of accounting challenged Chinese corporations.


Bubbles can grow bigger, but this quote is apt, which applies equally to the west:

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved. ~ Ludwig Von Mises

The U.S. Energy Information Administration is out with their latest estimates of oil in the South Sea.

Middlebury College put together a great map showing the myriad of overlapping claims, as well as the location of oil fields in the South Sea:


Businessinsider points out that these “9 Wars That Were Really About Commodities” not ideology.

Speaking of the South Sea, in a Washington Post interview, Japan’s Prime Minister Shinzo Abe says:

China has a “deeply ingrained” need to spar with Japan and other Asian neighbors over territory, because the ruling Communist Party uses the disputes to maintain strong domestic support, Japanese Prime Minister Shinzo Abe said in an interview.

Clashes with neighbors, notably Japan, play to popular opinion, Abe said, given a Chinese education system that emphasizes patriotism and “anti-Japanese sentiment.”

Like the West, Abe is fond of printing money. This brings to mind a quote:

Endless money forms the sinews of war. ~ Cicero

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In a panel discussion from Davos, Ray Dalio said 2013 will be a transition year, when cash moves into “everything.” It’s quite incredible really; the markets are up triple digits, gas is at record levels, investors have been pouring money into junk…bonds, stock and bond markets in countries with questionable accounting standards have surged, and many real estate markets are rising at a twenty percent clip.

Yet, this massive pile of cash – an “asset” class that is losing value by the day – stands on the sidelines ready to be deployed. 


Who knows how high prices could go once people begin trading in their cash for “stuff” in earnest?

Europe and China may provide temporary dips amid the meltup; still, the S&P experienced corrections of only about ten to twenty percent amid the Asian Flu in 1997 and when Russia defaulted in 1998. 

Whenever I want to understand a cause and effect principle,  I look at extreme scenarios, such as this chart of inflation and nominal stock prices. All of this liquidity will eventually find a home in “stuff.”


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Japanese equities remain depressed and inexpensive, having recently traded for 0.7 of book value and below long term averages. image

Inflation is great for equities, in nominal terms. A copious amount of domestic public debt, and the ability to print, are among the best leading indicators of high or hyperinflations “The way rich countries default is through inflation,” points out Ken Rogoff (2009).

“Speculators, wealthy industrialists who can borrow cheap, debtors like the government, farmers, and those with mortgages have benefitted the most from hyperinflations.” ~ Adam Ferguson, author of When Money Dies.”

An undervalued real estate market and inflation risk provide attractive opportunities to capitalize on this potential inflationary tail event in Japan.


However, one needs to hedge the currency debasement and sovereign debt risk. For example, recently Japanese equities were up 21% in local currency terms over the past 12 months, but since the ¥/$ fell 14%, real gains were only 7% in U.S. Dollar terms.

The yen has fallen recently, but over the long term, the Yen remains overvalued. Real exchange rate overvaluation is useful for predicting currency market crashes (Frankel and Saravelos, 2011).


The weaker yen need not lead to a JGB crash right away. For example, a central bank could pledge to buy all securities in excess of some interest rate. In fact, people floated this idea in the U.S. and may do so again if central banks become concerned inflation will drive interest rates up, and governments into a debt crisis.

Surely, central banksters would prefer inflation risk over sovereign debt risk. Regardless, Studies exploring the consequences of currency crashes in industrial economies have shown that currency crashes have generally not led to an increase in bond yields (Gagnon 2009a).

Efforts to create inflation will likely work all too well. Inflation is expected to rise by 40bps for every 10% decrease in the value of the currency, according to Credit Suisse, adding to pressure on JGBs. ~ FT


Japanese equities are not without their risks; notably, an expected China hard landing, reduced competitiveness, and escalating political tension with China could create several negative shocks along the way.

Since 2002, Japanese export volumes to China are up +76% while they are down -30% in the EU and -27% in the US, highlighting the importance of the Sino-Japanese relationship.


Weakening exports on anti-Japanese backlash has hurt the current account. Current-account reversals are usually accompanied by sudden stops in capital flows and large exchange rate depreciations, which in turn trigger banking crises ~ De Mello, Pier Padoan, Rousová (2011).



Financial Times

When the time comes for a crisis in JGBs, Japanese banks will suffer like the European banks did when sovereign yields came under pressure.

Japanese Banks hold JGBs worth 900% of their Tier 1 capital, according to the UK’s Telegraph. Their portfolios would be decimated if long rates punched above 2%.


One can look at this level as a “tipping point.” Waiting for a trigger to hedge or speculate on a crisis in Japanese Bonds will be too late.


  • “The Course Towards JPY Weakness” ~ Morgan Stanley (pdf)
  • Gold Lures Japan’s Pension Funds as Abe Targets Inflation ~ bloomberg
  • Japan’s Property Prices May Have Fallen Too Much, Nishimura Says ~ bloomberg
  • Japan Defense ministry is to request extra $100 billion budget Increase ~ fx live

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