There are strong indications that the remarkable run up of asset prices in the last few years is beginning to run out of steam and may be on the verge of collapse. We will leave aside the question of whether the asset inflation is symptomatic of a garden-variety inflationary boom or is a more virulent bubble phenomenon in which prices are rising today simply because buyers anticipate that they will rise tomorrow.
1. The dizzying climb of London real estate prices since the financial crisis, noted in a recent postby Dave Howden, may be fizzling out. Survey data from real-estate agents indicate London housing prices in September fell 0.1 percent from August, their first decline since November 2012. Meanwhile, an index of U.K. housing prices declined for the first time in 17 months. In explaining the “pronounced slowdown” in the London real estate market, the research director of Hometrack Ltd. commented, “Buyer uncertainty is growing in the face of a possible interest-rate rise, a general election on the horizon and recent warnings of a house-price bubble,” which is playing out “against a backdrop of tougher mortgage affordability checks and limits on high loan-to-income lending.”
2. Just released data from the Dow Jones S&P/Case Schiller Composite Home Price Indices through July 2014 shows a marked deceleration of U.S. housing prices. 17 of the 20 cities included in the 20-City Composite Index experienced lower price increases in July than in the previous month. Both the 10- and 20-City Index recorded a 6.7 percent year-over-year rate of increase, down sharply from the post-crisis peak of almost 14 percent less than a year ago.
3. More ominously, U.S. Total Household Net Worth (HNW), as recently reported by the Fed for the second quarter of 2014, reached a record high of $81.5 trillion, over $10 trillion higher than the level at the peak of the asset bubble in 2007. Furthermore, the 2014 figure was $20 trillion higher than the level of the post-crisis — and pre-QE — year of 2008, when asset prices and the real structure of production were just beginning to adjust to the massive capital consumption and malinvestment wreaked by the Great Asset Inflation of 1995-2005. The increase in household wealth has been driven mainly by the increase in prices of financial assets which was generated by the Fed’s zero interest rate policy and its force feeding of additional bank reserves into the financial system via its quantitative easing programs. (See chart below). These policies falsify profit and wealth calculations and give rise to unsustainable investments and overconsumption. Once interest rates begin to adjust to their natural levels, however, asset prices are revealed to be grossly inflated and collapse. The asset inflation may be reversed even without an increase of interest rates, if people lose confidence in the narratives fabricated and propagated by government policymakers, economists, and the financial commentators to promote the continuation of the inflation in asset markets. Furthermore it is risible to believe that real wealth in the US in terms of the factories and other capital goods to which financial assets are merely ownership claims, has increased by over one-third since 2008, especially in light of the additional malinvestment and overconsumption caused by monetary and fiscal policy “stimulus” since then.
4. If we look at HNW in historical perspective, we note that, in the chart below, the HNW/GDP (or wealth to income) ratio is now at an all-time high. From 1952 to the mid-1990s this ratio averaged a little more than 350 percent and never went above 400 percent until 1998 as the dot-com bubble was blowing up. It peaked at nearly 450 percent before the bubble collapsed causing the ratio to plummet to slightly below 400 percent, indicating the beginning of the purging of the illusory capital gains created during the asset inflation.
But just as the adjustment was beginning to take hold in 2002, the Greenspan Fed played the deflationphobia card, driving interest rates to postwar lows and pumping up the money supply (MZM) by $2 trillion from beginning of 2001 to the end of2005. During this second phase of the Great Asset Inflation, the HNW/GDP ratio again reached a new high before plunging below 400 percent during the financial crisis. And, tragically, the nascent readjustment of financial markets to the underlying reality of the economy’s shattered and shrunken production structure was yet again aborted by government intervention in the form of the heterodox monetary policies of Bernankeism combined with the outsized deficits of the Obama administration. These policies succeeded in driving the HNW/GDP ratio to yet another new high, but without having the expected stimulatory effect on consumption and investment spending.
In sum, I do not expect that the ratio will rise much above 500 percent — Americans have just not saved enough since 1995 to have increased their real wealth from 3.5 times to 5 times their annual income. Nor is there much reason to expect a plateau anywhere near the current level. Once interest rates begin to rise — and rise they must, whether as a result of Fed policy or not — the end of the asset price inflation will be at hand. The result will be another financial crisis and accompanying recession. The Fed and the Administration will no doubt attempt to bail and stimulate their way out but given the still dangerously enervated state of the financial system and the real economy, it will be like dosing a horse that has already been overdosed to death. Thus my forecast for the U.S. economy one year to two years out echoes that of Clubber Lang, the villain in the movie Rocky III. When questioned about his forecast for the forthcoming fight against Rocky, Lang replied, “Pain.”
In its latest edition, in a piece entitled ‘Monetary policy: Tight, loose, irrelevant’, the ineffably dire Ekonomista considers the work of three members of the Sloan School of Management who conducted a study of the factors which – according to their rendering of the testimony of the 60-odd years of data which they analysed in their paper, “The behaviour of aggregate corporate investment” – have historically exerted the most influence on the propensity for American businesses to ‘invest’.
The article itself starts by deploying that unfailingly patronising, ‘it’s economics 101′ cliché by which we should really have long ago learned to expect some weary truism will soon be rehashed as fresh journalistic wisdom.
It may be only partly an exaggeration to say that the weekly then adopts a breathless, teen-hysterical approach to a set of results which, with all due respect to the worthies who compiled them, should have been instantly apparent to anyone devoting a moment’s thought to the issue (and if that’s too big a task for the average Ekonomista writer, perhaps they could pause to ask one of those grubby-sleeved artisans who actually RUNS a business what it is exactly that they get up to, down there at the coalface of international capitalism). Far from being a Statement of the Bleedin’ Obvious, our fearless expositors of the Fourth Estate instead seem to regard what appears to be a tediously positivist exercise in data mining as some combination of the elucidation of the nature of the genetic code and the first exposition of the uncertainty principle. This in itself is a telling indictment of the mindset at work.
For can you even imagine what it was that our trio of geniuses ‘discovered’? Only that firms tend to invest more eagerly if they are profitable and if those profits (or their prospect) are being suitably rewarded with a rising share price – i.e. if their actions are contributing to capital formation, realised or expected, and hence to the credible promise of a maintained, increased, lengthened or accelerated schedule of income flows – that latter condition being one which also means the firms concerned can issue equity on advantageous terms, where necessary, in the furtherance of their aims.
[As an aside, do you remember when we used to ISSUE equity for purposes other than as a panic measure to keep the business afloat after some megalomaniac CEO disaster of over-leverage or as part of a soak-the-patsies cash-out for the latest batch of serial shell-gamers and their start-up sponsors?]
Shock, horror! Our pioneering profs then go on to share the revelation that firms have even been known to invest WHEN INTEREST RATES ARE RISING; i.e., when the specific real rate facing each firm (rather than the fairly meaningless, economy-wide aggregate rate observable in the capital market with which it is here being conflated) is therefore NOT estimated to constitute any impediment to the future attainment (or preservation) of profit. Whatever happened to the central bank mantra of the ‘wealth effect’ and its dogma about ‘channels’ of monetary transmission? How could those boorish mechanicals in industry not know they are only to invest when their pecuniary paramounts signal they should, by lowering official interest rates or hoovering up oodles of government securities?
At this point we might stop to insist that the supercilious, wielders of the ‘Eco 101’ trope at the Ekonomista note that these firms’ own heightened appetite for a presumably finite pool of loanable funds should firmly be expected to nudge interest rates higher precisely in order to bring forth the necessary extra supply thereof, just as a similar shift in demand would do in any other well-functioning market (DOH!), so please could they take the time in future to ponder the workings of cause and effect before they dare to condescend to us.
They might also reflect upon the fact that when the banking system functions to supplement such hard-won funds with its own, purely ethereal emissions of unsaved credit – thereby keeping them too cheap for too long and so removing the intrinsically self-regulating and helpfully selective effect which their increasing scarcity would otherwise have had on proposedschemes of investment – they pervert, if not utterly vitiate, a most fundamental market process. Having a pronounced tendency to bring about a profound disco-ordination in the system to the point of precluding a holistic ordering of ends and means as well as of disrupting the timetable on which the one may be transformed into the other, we Austrians recognize this as theprimary cause of that needless and wasteful phenomenon which is the business cycle. It is therefore decidedly not a cause for perplexity that investment, quote: ‘…expands and contracts far more dramatically than the economy as a whole’ as the Ekonomista wonderingly remarks
Nigh on unbelievable as it may appear to the policy-obsessed, mainstream journos who reviewed the academics’ work, all of this further implies that the past two centuries-odd of absolutely unprecedented and near-universal material progress did NOT take place simply because the central banks and their precursors courageously and unswervingly spent the whole interval doing ‘whatever it took’ to progressively lower interest rates to (and in some cases, through) zero! Somewhere along the line, one supposes that the marvels of entrepreneurship must have intruded, as well as what Deidre McCloskey famously refers to as an upsurge in ‘bourgeois dignity’ – i.e., the ever greater social estimation which came to be accorded to such agents of wholesale advance. This truly must shake the pillars of the temple of the cult of top-down, macro-economic command of which the Ekonomista is the house journal.
Remarkably, the Ekonomista’s piece is also daringly heterodox in inferring that, given this highly singular insensitivity to market interest rates, we might therefore return more assuredly to the long-forsaken path of growth if Mario Draghi and his ilk were to treat themselves to a long, contemplative sojourn, taking the waters at one of Europe’s idyllic (German) spa townsinstead of constantly hogging the limelight by dreaming up (and occasionally implementing) ever more involved, Cunning Plans directed towards driving people to act in ways in which they would otherwise not choose to do, but in which Mario and Co. conceitedly deem that they should.
Rather, the hacks have the temerity to assert – and here, Keynes be spared! – it might do much more for the investment climate if the Big Government to which they so routinely and so obsequiously defer were to pause awhile in its unrelenting programme to destroy all private capital, to suppress all economic initiative, and to restrict the disposition of income to thecentralized mandates of its minions and not to trust them to the delocalized vagaries of the market – all crimes which it more readily may perpetrate under the camouflage provided by the central banks’ mindless and increasingly counter-productive, asset-bubble inflationism.
Having reached this pass, might we dare to push the deduction one step closer to its logical conclusion and suggest that the only reason we continue today to suffer a malaise which the self-exculpatory elite (of whom none is more representative than the staff of the Ekonomista itself) loves to refer to as ‘secular stagnation’ is because its own toxic brew of patent nostrums is making the unfortunate patient upon whom it inflicts them even more sick? That, pace Obama the Great, The One True Indispensable Chief of the NWO, the three principal threats we currently face are not Ebola, but QE-bola – a largely ineradicable pandemic of destruction far more virulent than even that dreadful fever; not the locally disruptive Islamic State but the globally detrimental Interventionist State – the perpetrator of a similarly backward and repressive ideology which the IMF imamate seeks to impose on us all; and definitely not the Kremlin’s alleged (though highly disputable) revanchism being played out on Europe’s ‘fringe’ but the Kafkaesque reality of stifling and undeniable regulationism at work throughout its length and breadth?
We might end by reminding the would-be wearer of the One Ring, as He lurks warily, watching the opinion polls from His lair in the White House, that in being so active in propagating each one of these genuinely existential threats to our common well-being, He (capitalization ironically intended) will not so much ‘help light the world’ – as He nauseatingly claimed in His purple-drenched, sophomore’s set-piece at the UN recently – as help extinguish what little light there still remains to us poor, downtrodden masses.
The offending article:
Tight, loose, irrelevant
Interest rates do not seem to affect investment as economists assume
IT IS Economics 101. If central bankers want to spur economic activity, they cut interest rates. If they want to dampen it, they raise them. The assumption is that, as it becomes cheaper or more expensive for businesses and households to borrow, they will adjust their spending accordingly. But for businesses in America, at least, a new study* suggests that the accepted wisdom on monetary policy is broadly (but not entirely) wrong.
Using data stretching back to 1952, the paper concludes that market interest rates, which central banks aim to influence when they set their policy rates, play some role in how much firms invest, but not much. Other factors—most notably how profitable a firm is and how well its shares do—are far more important (see chart). A government that wants to pep up the economy, says S.P. Kothari of the Sloan School of Management, one of the authors, would have more luck with other measures, such as lower taxes or less onerous regulation.
Establishing what drives business investment is difficult, not. These shifts were particularly manic in the late 1950s (both up and down), mid-1960s (up), and 2000s (down, up, then down again). Overall, investment has been in slight decline since the early 1980s.
Having sifted through decades of data, however, the authors conclude that neither volatility in the financial markets nor credit-default swaps, a measure of corporate credit risk that tends to influence the rates firms pay, has much impact. In fact, investment often rises when interest rates go up and volatility increases.
Investment grows most quickly, though, in response to a surge in profits and drops with bad news. These ups and downs suggest shifts in investment go too far and are often ill-timed. At any rate, they do little good: big cuts can substantially boost profits, but only briefly; big increases in investment slightly decrease profits.
Companies, Mr Kothari says, tend to dwell too much on recent experience when deciding how much to invest and too little on how changing circumstances may affect future returns. This is particularly true in difficult times. Appealing opportunities may exist, and they may be all the more attractive because of low interest rates. That should matter—but the data suggest it does not.
* “The behaviour of aggregate corporate investment”, S.P. Kothari, Jonathan Lewellen, Jerold Warner
Economists at the Federal Reserve have devised a new indicator, which they hold will enable US central bank policy makers to get better information regarding the state of the labour market. The metric is labelled as the Labour Market Conditions Index (LMCI).
Note that one of the key data Fed policy makers are paying attention to is the labour market. The state of this market dictates the type of monetary policy that is going to be implemented.
Fed policy makers are of the view that it is the task of the central bank to navigate the economy toward a path of stable self-sustaining economic growth.
One of the indicators that is believed could inform policy makers about how far the economy is from this path is the state of the labour market.
A strengthening of the labour market is seen as indicative that the economy may not be far from the desired growth path.
A weakening in the labour market is interpreted as indicating that the distance is widening and the economy’s ability to stand on its own feet is diminishing.
Once the labour market shows strengthening this also raises the likelihood that the Fed will reduce its support to the economy. After all, to provide support whilst the economy is on a path of stable self-sustained growth could push the economy away from this path towards a path of accelerating price inflation, so it is held.
Conversely, a weakening labour market conditions raises the likelihood that the Fed will either maintain or strengthen its loose monetary stance. Failing to do so, it is held, could push the economy onto a path of price deflation and economic crisis.
The uniqueness of the LMCI, it is held, is that it covers a broader range of labour market pieces of information thereby raising the likelihood of depicting a more correct state of labour market conditions than an individual piece of information could provide.
The LMCI is derived from 19 indicators such as the number of people employed full time and part time, the labour participation rate, the hiring rate, hiring plans etc.
When the index is rising above the zero line it is interpreted that labour market conditions are strengthening. A fall in the index below the zero line is taken as a deterioration in the labour market.
In September the index rose by 2.5 points after gaining 2 points in August. Note however that in April this year the index increased by 7.1 points. Following the logic of Fed policy makers and assuming that they will pay some attention to the LMCI, if the index were to continue strengthening then the Fed may start considering tightening its monetary stance.
We suggest that the Fed’s responses to the LMCI are not going to bring the economy onto a path of stability and self-sustaining economic growth, but on the contrary will lead to more instability and economic impoverishment.
The state of a particular indicator such as the LMCI cannot tell us the state of the pool of real wealth i.e. whether it is expanding or shrinking.
It is not important to have people employed as such but to have them employed in wealth generating activities. Employment such as digging ditches and building non-wealth generating projects are only depriving wealth generators from the expansion of the pool of real wealth. This undermines the ability to grow the economy and leads to economic misery.
The belief that the Fed can navigate and grow the economy is wishful thinking. All that Fed officials can do is to pump money and tamper with the interest rate structure. None of this however can lead to economic growth.
The key to economic growth is the expansion in capital goods per individual. This expansion however must be done in accordance with the dictates of the free market and not on account of an artificial lowering of interest rates and monetary pumping.
Loose monetary policy will only result in the expansion of capital goods for non-wealth generating projects i.e. capital consumption.
Only by means of the allocation of resources in accordance with the dictates of the market can a wealth generating infrastructure be established. Such infrastructure is going to lead to economic prosperity.
To conclude then, the Fed’s new indicator adds more means for US central bank officials to tamper with the economy, which will lead to greater economic instability and economic impoverishment.
Summary and conclusions
The Fed has introduced a new economic indicator labelled the Labour Market Conditions Index (LMCI). The LMCI is derived from 19 labour market related indicators; hence it is held it is likely to provide a more realistic state of the labour market.
This in turn will enable Fed policy makers to navigate more accurately the economy toward a path of stable non-inflationary economic growth.
We suggest that what is required is not information about the strength of the labour market as such but information on how changes in labour market conditions are related to the wealth generation process.
This however, the LMCI doesn’t provide. Since Fed officials are likely to react to movements in the LMCI we hold this will only lead to a deepening in the misallocation of resources and to a further weakening of the wealth generation process.
[Editor's note: this article, by Carmen Elena Dorobat, first appeared at Mises.org]
Amidst news of the prolonged worldwide recession, new air strikes, secession attempts, and climate change, international trade — which in 2008 went through its largest crisis in history — has been mostly out of the public eye. Yet we’ve been told not to fear: the World Trade Organization, the foremost global body for promoting multilateral trade, remains watchful, and is optimistic that efforts for liberalization will bear fruit in the near future.
Sadly, the WTO’s hopes aren’t justified: the Doha Round of trade negotiations began in 2001, and even after thirteen years, success is nowhere in sight.
Seeking to address the liberalization concerns of WTO’s less-developed members, the Doha Development Round was supposed to culminate in 2005 with a new trade agreement. The envisioned deal concerned the reduction of trade barriers in commodities and services, as well as a new international framework for intellectual property rights. But soon after negotiations began, governments from developing countries — India, Brazil, China, and South Africa — and NGOs (non-governmental organization) began to worry that international negotiations were an obstacle to the governmental protection of developing sectors and regulation of financial services. After the failure of the Cancún proceedings in 2004, trade scholars worried that Doha might not be completed by its original deadline, but kept the hope that negotiations would continue. However, trade talks came to a deadlock in 2006, 2009, and 2011, mainly due to differences in agricultural policies. The US and the EU even backed out of previous agreements to reduce export support and agricultural subsidies, arguing that they did not want to weaken their bargaining positions too early in the Round.
Attempts to reconcile disagreements among countries since then have been largely in vain. But in December 2013, new tailwinds seemed to push the Doha Round to more favorable shores. The Bali Ministerial Conference, which concluded with the signing of a package deal on trade customs collection and a post-Bali development agenda, was touted to have “achieved what many believed was impossible”: bringing together the 160 WTO members for the first time in twelve years. But even though the Bali package does not have much to do with free trade — it facilitates the collection, but not the reduction, of custom duties — the agreement still wasn’t signed by all members in July 2014. This time, India vetoed the ratification to gain more bargaining power for Prime Minister Modi’s program of domestic food subsidies. Reuters reported that “trade diplomats in Geneva have said they are ‘flabbergasted,’ ‘astonished,’ and ‘dismayed,’ and described India’s position as ‘hostage-taking’ and ‘suicidal’.”
Perhaps commentators would have been less surprised if they had identified the negotiation deadlock as only the symptom of a more pervasive underlying cause: the national — read: political — interest of all countries at the negotiations table. The bread and butter of WTO member states is the extent to which they can encroach upon private enterprise, and control both product and financial markets. Under these circumstances, committing to open one’s borders to international trade is simply idle talk. Free exchange and competition would undermine the leverage of domestic interest groups, and cut through the structure of government intervention.
As Ludwig von Mises wrote to Friedrich Hoenig, one of his correspondents, in 1951:
U.S. representatives occasionally indulge in talk of free trade. This is pure illusion. American agricultural policies — parity prices, subsidies, limitation of crop surfaces … would collapse overnight if foreign imports were freely allowed into the country. Can you imagine a present-day England or present-day France with a regime of free trade? The more a country proceeds toward comprehensive control of all business activities, the more it must close itself to foreign countries.
Anyone reading modern day trade agreements would not be surprised to discover that they focus less and less on reducing import duties, and more on developing national industries, promoting exports, and ensuring domestic policy space. Their true purpose, a position of middle-of-the-road protectionism, is concealed under vague terms such as ‘freer, fair trade’, ‘gradual liberalization,’ ‘reciprocal concessions,’ or ‘development packages.’ However, the benefits of international trade do not lie in moderation and degree of reciprocity. True free trade is a policy of no trade barriers, to be pursued unilaterally by each and every country. If markets were released from the heavy hand of governments, international free trade would follow at one stroke.
The inherent incompatibility between free trade and increasing domestic government control will thus continue to hinder the dreams of WTO supporters, and the more distant ideal of free trade. Sadly, the golden days of Richard Cobden — who together with Michel Chevalier managed to sway the British Parliament and the French Emperor away from spending money on armaments and toward a free trade agreement — are long lost. All that is needed for flourishing international trade is a sound monetary system and the freedom of private enterprise. However, in a world where states have open-ended budgets for military campaigns and total control over the money supply, the bureaucratic structure in Geneva will only serve political interests.
“Sir, The next financial apocalypse is imminent. I know this to be true because the House & Home section in FT Weekend is now assuming the epic proportions last seen before the great crash. Twenty-four pages chock full of adverts for mansions and wicker tea-trays for $1,000. You’re all mad.
Sell everything and run for your lives.”
- Letter to the FT from Matt Long, Seilh, France, 3rd October 2014.
“Investors unfortunately face enormous pressure—both real pressure from their anxious clients and their consultants and imagined pressure emanating from their own adrenaline, ego and fear—to deliver strong near-term results. Even though this pressure greatly distracts investors from a long-term orientation and may, in fact, be anathema to good long-term performance, there is no easy way to reduce it. Human nature involves the extremes of investor emotion—both greed and fear—in the moment; it is hard for most people to overcome and act in opposition to their emotions. Also, most investors tend to project near-term trends—both favourable and adverse—indefinitely into the future. Ironically, it is this very short-term pressure to produce—this gun to the head of everyone—that encourages excessive risk taking which manifests itself in several ways: a fully invested posture at all times; for many, the use of significant and even extreme leverage; and a market-centric orientation that makes it difficult to stand apart from the crowd and take a long-term perspective.”
- Seth Klarman, Presentation to MIT, October 2007.
“At first, the pendulum was swinging towards infinite interest, threatening the dollar with hyperinflation. Right now the pendulum is swinging to the other extreme, to zero interest, spelling hyper-deflation. This is just as damaging to producers as the swing towards infinite interest was in the early 1980’s. It is impossible to predict whether one or the other extreme in the swinging of the wrecking ball will bring about the world economy’s collapse. Hyperinflation and hyper-deflation are just two different forms of the same phenomenon: credit collapse. Arguing which of the two forms will dominate is futile: it blurs the focus of inquiry and frustrates efforts to avoid disaster.”
- Professor Antal Fekete, ‘Monetary Economics 101: The real bills doctrine of Adam Smith. Lecture 10: The Revolt of Quality’.
“Low interest rate policy has the following grave consequences:
- Normally conservative investors are increasingly under duress and due to the outlook for interest rates remaining low for a long time, are taking on excessive risk. This leads to capital misallocation and the formation of bubbles.
- The sweet poison of low interest rates and easy money therefore leads to massive asset price inflation (stocks, art, real estate).
- Through carry trades, interest rates that are structurally too low in the industrialized nations lead to asset bubbles and contagion effects in emerging markets.
- A structural weakening of financial markets, as reckless behaviour of market participants is fostered (moral hazard).
- A change in human behaviour patterns, due to continually declining purchasing power. While thrift is slowly but surely transmogrified into a relic of the past, taking on debt becomes rational.
- The acquisition of personal wealth becomes gradually more difficult.
- The importance of money as a medium of exchange and a unit of account increases in importance relative to its role as a store of value.
- Incentives for fiscal probity decline. Central banks have bought time for governments. Large deficits appear less problematic, there is no incentive to implement reform, resp. consolidate public finances in a sustainable manner.
- The emergence of zombie-banks and zombie-companies. Very low interest rates prevent the healthy process of creative destruction. Zero interest rate policy makes it possible for companies with low profitability to survive, similar to Japan in the 1990s. Banks are enabled to nigh endlessly roll over potentially delinquent loans and consequently lower their write-offs.
- Unjust redistribution (Cantillon effect): the effect describes the fact that newly created money is neither uniformly nor simultaneously distributed in the population. Monetary expansion is therefore never neutral. There is a permanent transfer of wealth from later to earlier receivers of new money.”
- Ronald-Peter Stöferle, from ‘In Gold We Trust 2014 – Extended Version’, Incrementum AG.
The commentary will have its next outing on Monday 27th October.
“When sorrows come,” wrote Shakespeare, “they come not single spies, but in battalions.” Jeremy Warner for the Daily Telegraph identifies ten of them. His ‘ten biggest threats to the global economy’ comprise:
- Geopolitical risk;
- The threat of oil and gas price spikes;
- A hard landing in China;
- Normalisation of monetary policy in the Anglo-Saxon economies;
- Euro zone deflation;
- ‘Secular stagnation’;
- The size of the debt overhang;
- Complacent markets;
- House price bubbles;
- Ageing populations.
Other than making the fair observation that stock markets (for example) are not entirely correlated to economic performance – an observation for which euro zone equity investors must surely be hugely grateful – we offer the following response.
- Geopolitical risk, like the poor, will always be with us.
- Yes, the prices for oil and natural gas could spike, but as things stand WTI crude futures have fallen by over 15% from their June highs, in spite of the clear geopolitical problems. And the US fracking revolution, in combination with fast-improving fundamentals for solar power, may turn out to be a secular (and disinflationary) game-changer for energy prices.
- China, however, is tougher to dismiss. If we had any meaningful exposure to Chinese equity or debt we would be more concerned. But we don’t, so we aren’t.
- Five of Jeremy Warner’s ‘threats’ are inextricably linked. The pending normalisation of monetary policy in the UK and US clearly threatens the integrity of the credit markets. It’s worth asking whether either central bank could possibly afford to let interest rates rise. This begets a follow-on question: could the markets afford to let the central banks off the hook ? Could we, in other words, finally see the return of the long absent and much desired bond market vigilantes ? That monetary policy rates are so low is a function of the growing prospect of euro zone deflation (less of a threat to solvent consumers, but deadly for heavily indebted governments). Absent a capitulation by the Bundesbank to Draghi’s hopes or intentions for full-blown QE, it’s difficult to see how the policy log-jam gets resolved. But since all German government paper out to three years now offers a negative yield, it’s difficult to see why any euro zone debt is worth buying today for risk-conscious investors. Cash is probably preferable and gives optionality into the bargain. ‘Secular stagnation’ is now a fair definition of the euro zone’s economic prospects. But all things lead back to Warner’s point 7: the size of the debt overhang. Since this was never addressed in the immediate aftermath of the Global Financial Crisis, it’s hardly a surprise to see its poison continue to drip onto all things financial. And since the policy response has been to slash rates and keep them at multi-century lows, it’s hardly a surprise to see property prices in the ascendant.
- Complacent markets ? Check. But stocks have lost a lot of their nerve over the last week. Not before time.
- Ageing populations ? Yes, but this problem has been widely discussed in the investment community over the past two decades – it simply isn’t new news.
We saw one particularly eye-catching chart last week, via Grant Williams, comparing the leverage ratios of major US financial institutions over recent years (shown below).
Source: Grant Williams, ‘Things that make you go Hmmm…’
The Fed’s leverage ratio (total assets to capital) now stands at just under 80x. That compares with Lehman Brothers’ leverage ratio, just before it went bankrupt, of just under 30x. Sometimes a picture really does paint a thousand words. And this, again, brings us back to the defining problem of our time, as we see it: too much debt in the system, and simply not enough ideas about how to bring it down – other than through inflationism, and even that doesn’t seem to be working quite yet.
In a recent interview with Jim Grant, Sprott Global questioned the famed interest rate observer about the likely outlook for bonds:
“What would a bear market in bonds look like? Would it be accompanied by a bear market in the stocks?
“Well, we have a pretty good historical record of what a bear market in bonds would look like. We had one in modern history, from 1946 to 1981. We had 25 years’ worth of persistently – if not steadily – rising interest rates, and falling bond prices. It began with only around a quarter of a percent on long-dates US Treasuries, and ended with about 15% on long-dated US Treasuries. That’s one historical beacon. I think that the difference today might be that the movement up in yield, and down in price, might be more violent than it was during the first ten years of the bear market beginning in about 1946. Then, it took about ten years for yields to advance even 100 basis points, if I remember correctly. One difference today is the nature of the bond market. It is increasingly illiquid and it is a market in which investors – many investors – have the right to enter a sales ticket, and to expect their money within a day. So I’m not sure what a bear market would look like, but I think that it would be characterized at first by a lot of people rushing through a very narrow gate. I think problems with illiquidity would surface in the corporate debt markets. One of the unintended consequences of the financial reforms that followed the sorrows of 2007 to 2009 is that dealers who used to hold a lot of corporate debt in inventories no longer do so. If interest rates began to rise and people wanted out, I think that the corporate debt market would encounter a lot of ‘air pockets’ and a lot of very discontinuous action to the downside.”
We like that phrase “a lot of very discontinuous action to the downside”. Grant was also asked if it was possible for the Fed to lose control of the bond market:
“Absolutely, it could. The Fed does not control events for the most part. Events certainly will end up controlling the Fed. To answer your question – yeah. I think the Fed can and will lose control of the bond market.”
As we have written on innumerable prior occasions, we wholeheartedly agree. Geopolitics, energy prices, demographics – all interesting ‘what if’ parlour games. But what will drive pretty much all asset markets over the near, medium and longer term is almost entirely down to how credit markets behave. The fundamentals, clearly, are utterly shocking. The implications for investors are, in our view, clear. And as a wise investor once observed, if you’re going to panic, panic early.
Recent evidence points increasingly towards global economic contraction.
Parts of the Eurozone are in great difficulty, and only last weekend S&P the rating agency warned that Greece will default on its debts “at some point in the next fifteen months”. Japan is collapsing under the wealth-destruction of Abenomics. China is juggling with a debt bubble that threatens to implode. The US tells us through government statistics that their outlook is promising, but the reality is very different with one-third of employable adults not working; furthermore the GDP deflator is significantly greater than officially admitted. And the UK is financially over-geared and over-dependent on a failing Eurozone.
This is hardly surprising, because the monetary inflation of recent years has transferred wealth from the majority of the saving and working population to a financial minority. A stealth tax through monetary inflation has been imposed on the majority of people trying to earn an honest living on a fixed salary. It has been under-recorded in consumer price statistics but has occurred nonetheless. Six years of this wealth transfer may have enriched Wall Street, but it has also impoverished Main Street.
The developed world is now in deep financial trouble. This is a situation which may be coming to a debt-laden conclusion. Those in charge of our money know that monetary expansion has failed to stimulate recovery. They also know that their management of financial markets, always with the objective of fostering confidence, has left them with market distortions that now threaten to derail bonds, equities and derivatives.
Today, central banking’s greatest worry is falling prices. The early signs are now upon us, reflected in dollar strength, as well as falling commodity and energy prices. In an economic contraction exposure to foreign currencies is the primary risk faced by international businesses and investors. The world’s financial system is based on the dollar as reserve currency for all the others: it is the back-to-base option for international exposure. The trouble is that leverage between foreign currencies and the US dollar has grown to highly dangerous levels, as shown below.
Plainly, there is great potential for currency instability, compounded by over-priced bond markets. Greece, facing another default, borrows ten-year money in euros at about 6.5%, while Spain and Italy at 2.1% and 2.3% respectively. Investors accepting these low returns should be asking themselves what will be the marginal cost of financing a large increase in government deficits brought on by an economic slump.
A slump will obviously escalate risk for owners of government bonds. The principal holders are banks whose asset-to-equity ratios can be as much as 40-50 times excluding goodwill, particularly when derivative exposure is taken into account. The stark reality is that banks risk failure not because of Irving Fisher’s debt-deflation theory, but because they are exposed to a government debt bubble that will inevitably burst: only a two per cent rise in Eurozone bond yields may be sufficient to trigger a global banking crisis. Fisher’s nightmare of bad debts from failing businesses and falling loan collateral values will merely be an additional burden.
Macro-economists refer to a slump as deflation, but we face something far more complex worth taking the trouble to understand.
The weakness of modern macro-economics is it is not based on a credible theory of prices. Instead of a mechanical relationship between changes in the quantity of money and prices, the purchasing power of a fiat currency is mainly dependent on the confidence its users have in it. This is expressed in preferences for money compared with goods, and these preferences can change for any number of reasons.
When an indebted individual is unable to access further credit, he may be forced to raise cash by selling marketable assets and by reducing consumption. In a normal economy, there are always some people doing this, but when they are outnumbered by others in a happier position, overall the economy progresses. A slump occurs when those that need or want to reduce their financial commitments outnumber those that don’t. There arises an overall shift in preferences in favour of cash, so all other things being equal prices fall.
Shifts in these preferences are almost always the result of past and anticipated state intervention, which replaces the randomness of a free market with a behavioural bias. But this is just one factor that sets price relationships: confidence in the purchasing power of government-issued currency must also be considered and will be uppermost in the minds of those not facing financial difficulties. This is reflected by markets reacting, among other things, to the changing outlook for the issuing government’s finances. If it appears to enough people that the issuing government’s finances are likely to deteriorate significantly, there will be a run against the currency, usually in favour of the dollar upon which all currencies are based. And those holding dollars and aware of the increasing risk to the dollar’s own future purchasing power can only turn to gold and subsequently those goods that represent the necessities of life. And when that happens we have a crack-up boom and the final destruction of the dollar as money.
So the idea that the outlook is for either deflation or inflation is incorrect, and betrays a superficial analysis founded on the misconceptions of macro-economics. Nor does one lead to the other: what really happens is the overall preference between money and goods shifts, influenced not only by current events but by anticipated ones as well.
Recently a rising dollar has led to a falling gold price. This raises the question as to whether further dollar strength against other currencies will continue to undermine the gold price.
Let us assume that the central banks will at some time in the future try to prevent a financial crisis triggered by an economic slump. Their natural response is to expand money and credit. However, this policy-route will be closed off for non-dollar currencies already weakened by a flight into the dollar, leaving us with the bulk of the world’s monetary reflation the responsibility of the Fed.
With this background to the gold price, Asians in their domestic markets are likely to continue to accumulate physical gold, perhaps accelerating their purchases to reflect a renewed bout of scepticism over the local currency. Wealthy investors in Europe will also buy gold, partly through bullion banks, but on the margin demand for delivered physical seems likely to increase. Investment managers and hedge funds in North America will likely close their paper-gold shorts and go long when their computers (which do most of the trading) detect a change in trend.
It seems likely that a change in trend for the gold price in western capital markets will be a component part of a wider reset for all financial markets, because it will signal a change in perceptions of risk for bonds and currencies. With a growing realisation that the great welfare economies are all sliding into a slump, the moment for this reset has moved an important step closer.
“There are two ways of learning how to ride a fractious horse; one is to get on him and learn by actual practice how each motion and trick may be best met; the other is to sit on a fence and watch the beast a while, and then retire to the house and at leisure figure out the best way of overcoming his jumps and kicks. The latter system is the safest; but the former, on the whole, turns out the larger proportion of good riders. It is very much the same in learning to ride a flying machine; if you are looking for perfect safety, you will do well to sit on a fence and watch the birds, but if you really wish to learn, you must mount a machine and become acquainted with its tricks by actual trial.”
“So, too, for the stock market. It is easy to study stock tables in solitude from the comfort of your office and declare the market efficient. Or you can be a full-time investor for a number of years and, if your eyes are open, learn that it is not. As with the Wrights, the burden of proof is somehow made to fall on the practitioner to demonstrate that he or she has accomplished something the so-called experts said could not be done (and even he may find himself explained away as aberrational). Almost none of the burden seems to fall on the armchair academics, who cling to their theories even in the face of strong evidence that they are wrong.”
Days of miracle and wonder in the bond markets.. but not necessarily in any good way. Last week we highlighted the seeming anomaly that even as there has never been so much debt in the history of the world, it has also never been so expensive. Between 2000 and 2013, the value of outstanding tradeable debt rose from $33 trillion to $100 trillion, according to research from Incrementum AG. (Over the same period, total equity market capitalisation rose “merely” from $49 trillion to $66 trillion.) Although we would suggest there is now no semblance of traditional value in conventional government debt whatsoever, it could yet get more expensive still.
Albert Edwards of SocGen deserves some credit for maintaining his ‘Ice Age’ thesis over a sustained period of widespread scepticism from other market participants. He summarises it as follows:
“First, that the West would drift ever closer to outright deflation, following Japan’s template a decade earlier. And second, financial markets would adjust in the same way as in Japan. Government bonds would re-rate in absolute and relative terms compared to equities, which would also de-rate in absolute terms..
“Another associated element of the Ice Age we also saw in Japan is that with each cyclical upturn, equity investors have assumed with child-like innocence that central banks have somehow ‘fixed’ the problem and we were back in a self-sustaining recovery. These hopes would only be crushed as the next cyclical downturn took inflation, bond yields and equity valuations to new destructive lows. In the Ice Age, hope is the biggest enemy..
“Investors are beginning to see how impotent the Fed and ECB’s efforts are to prevent deflation. And as the scales lift from their eyes, equity, credit and other risk assets trading at extraordinarily high valuations will take their next Ice Age stride towards the final denouement.”
It is certainly staggering that even after expanding its balance sheet by $3.5 trillion, the Fed has been unable to trigger visible price inflation in anything other than financial assets. One dreads to contemplate the scale of the altogether less visible private sector deleveraging that has cancelled it out. One notes that while bonds are behaving precisely in line with the Ice Age thesis, stock markets – by and large – are not quite following the plot. But there were signs last week that they may finally have got a copy of the script.
The tragedy of our times, unfolding slowly but surely via ever-lower bond yields, is that there is a vacuum at the heart of the political process where bold action – not least to grasp the debt nettle – should reside. Since nature abhors the vacuum, central bankers have filled it. They say that to a man with a hammer, everything looks like a nail. To a central banker facing the prospect of outright deflation, the answer to everything is the printing of ex nihilo money and the manipulation of financial asset prices. The by-product of these malign trends is that it makes rational investment and asset allocation, indeed more narrowly the pursuit of real capital preservation, impossible.
Since the integrity of the debt (and currency) markets is clearly at risk, we have long sought alternatives that offer much diminished credit and counterparty risk. The time-honoured alternative has been gold. As the chart below (via Nick Laird) shows, between 2000 and 2011, gold
tracked the expansion in US debt pretty handily. In 2008 and then in 2011/2012 gold became overextended relative to US debt. Beginning in 2013 gold then decoupled in the opposite direction. As things stand today, if one expects that relationship to resume – and we do – then gold looks anomalously cheap relative to the gross level of US debt, which clearly is not going to contract any time soon.
A second rationale for holding gold takes into account the balance sheet expansion of the broader universe of central banks:
If one accepts that gold is not merely an industrial commodity but an alternative form of money (and central banks clearly do, or they would not be holding it in the form of reserves), than it clearly makes sense to favour a money whose supply is growing at 1.5% per annum over monies whose supply is growing at between 8% and 20% per annum. It then merely comes down to biding one’s time and waiting for Albert Edwards’ “final denouement” (or simply the next phase of the global financial crisis that never really went away).
Two recent tweets from George Cooper on the topic of bond investing are also worthy of republication here:
“The combination of indexing / rating agencies and syndication means that collectively the investment industry does not provide effective discipline to borrowers.”
This is a clear example of market failure brought about by institutional fund managers and the consultants that “guide” their institutional investor clients. There is simply no punishment for ill-disciplined government borrowers (i.e., all of them). To put it another way, where have the bond vigilantes gone ? And,
“The best thing the ECB could do here is state clearly that it has reached the limit of monetary policy and the rest is up to politicians.”
It is not as if politicians asleep at the wheel have gone entirely unnoticed. Two high-profile reports have been published this year drawing attention to the debt problems gnawing away at the economic vitality of the West. Perhaps the most damning response to date has come from the euro zone’s pre-eminent political cynic, Jean-Claude Juncker:
“We all know what to do, we just don’t know how to get re-elected after we’ve done it.”
No discussion of the bond market could possibly be complete without a brief mention of the defenestration of the so-called ‘Bond King’, Bill Gross, from Pimco. For the benefit of anyone living under a rock these past weeks, the manager of the world’s largest bond fund jumped ship before he could be shoved overboard. Pimco’s owners, Allianz, must surely regret having allowed so much power to be centralised in the form of one single ‘star’ manager. In a messy transfer that nobody came out of well, Janus Capital announced that Bill Gross would be joining to run a start-up bond fund, before he had even announced his resignation from Pimco (but then Janus was a two-faced god). This was deliriously tacky behaviour from within a normally staid backwater of the financial markets. Some financial media reported this as a ‘David vs Goliath’ story; in reality it is anything but. The story can be more accurately summarised as ‘Bond fund manager leaves gigantic asset gatherer for other gigantic asset gatherer’ (Janus Capital’s $178 billion in client capital being hardly small potatoes). This is barely about asset management in the truest, aspirational sense of the phrase. This writer recalls the giddy marketing of a particularly new economy-oriented growth vehicle called the ‘Janus Twenty’ fund in the UK back in 2000. Between March 2000 and September 2001, that particular growth vehicle lost 63% of its value. Faddish opportunism is clearly still alive and well. This gross behaviour may mark a market top for bonds, but probably not. But it’s difficult to shake off the suspicion that navigating the bond markets profitably over the coming months will require almost supernatural powers in second-guessing both central banks and one’s peers – especially if doing so on an indexed basis. For what it’s worth this is a game we won’t even bother playing. Our pursuit of the rational alternative – compelling deep value in equity markets – continues.
Orders for US non-military capital goods excluding aircraft rose by 0.6% in August after a 0.2% decline in July to stand at $73.2 billion. Observe that after closing at $48 billion in May 2009 capital goods orders have been trending up.
Most commentators regard this strengthening as evidence that companies are investing both in the replacement of existing capital goods and in new capital goods in order to expand their growth.
There is no doubt that an increase in the quality and the quantity of tools and machinery i.e. capital goods, is the key for the expansion of goods and services. But is it always good for economic growth? Is it always good for the wealth generation process?
Consider the case when the central bank is engaging in loose monetary policy i.e. monetary pumping and an artificial lowering of the interest rate structure. Such type of policy sets the platform for various non-productive or bubble activities.
In order to survive these activities require real funding, which is diverted to them by means of loose monetary policy. (Once loose monetary policy is set in motion this allows the emergence of various bubble activities).
Note various individuals that are employed in these activities are the early recipients of money; they can now divert to themselves various goods and services from the pool of real wealth.
These individuals are now engaging in the exchange of nothing for something. (Individuals that are engage in bubble activities don’t produce any meaningful real wealth they however by means of the pumped money take a slice from the pool of real wealth. Again note that these individuals are contributing nothing to this pool).
Now bubble activities like any non-bubble activity also require tools and machinery i.e. capital goods. So various capital goods generated for these activities is in fact a waste of real wealth. Since the tools and machinery that are generated here are going to be employed in the production of goods and services that without the monetary pumping of the central bank would never emerge. (Wrong infrastructure has emerged).
These activities do not add to the pool of real wealth, they are in fact draining it. (This amounts to economic impoverishment). The more aggressive the central bank’s loose monetary stance is the more drainage of real wealth takes place and the less real wealth left at the disposal of true wealth generators. If such policy persists for too long this could slow or even shrink the pool of real wealth and set in motion a severe economic crisis.
We suggest that the strong bounce in capital goods orders since May 2009 is on account of extremely loose monetary stance of the Fed. Note that the wild fluctuations in our monetary measure AMS after a time lag followed by sharp swings in capital goods orders.
An increase in the growth momentum of money followed by the increase in capital goods orders to support the increase in various bubble activities. Conversely, a decline in the growth momentum of money supply followed by a decline in capital goods orders.
We suggest that a down-trend in the growth momentum of money supply since October 2011 is currently on the verge of asserting its dominance. This means that various bubble activities are likely to come under pressure. Slower monetary growth is going to slow down the diversion of real wealth to them from wealth generating activities.
Consequently capital goods orders are going to come under pressure in the months ahead. (The build-up of a wrong infrastructure is going to slow down – a fewer pyramids will be built).
As stated in the preceding column, here, eminent labor economist Jared Bernstein recently called, in the New York Times, for the dethroning of “King Dollar,” claiming that the reserve currency status of the dollar has cost the United States as many as “six million jobs in 2008, and these would tend to be the sort of high-wage manufacturing jobs.”
Six million is about as many jobs as presidents Bush and Obama together, over 13+ years, created. So this is a big claim. Whether or not one accepts the magnitude of the jobs deficit proclaimed by Dr. Bernstein, reserve currency status comes with heavy costs.
As former president of the Federal Reserve Bank of Dallas Bob McTeer wrote in a Forbes.com column entitled Reserve Currency Status — A Mixed Blessing:
The advantages of reserve currency status for the dollar are well known. The world’s willingness to accumulate dollar reserves in the post World War II period first removed and later reduced the requirement of maintaining balance of payments equilibrium, or, more specifically, current account balance. By removing or weakening this restraint, U.S. policymakers had more freedom than policymakers in other countries to pursue strictly domestic objectives. We ran current account deficits year after year, balanced, or paid for, by capital inflows from our trading partners. The good side of that was that we could import real goods and services for domestic consumption or absorption and pay for them with paper, or the electronic equivalent. In other words, our contemporary standard of living was enhanced by others’ willingness to hold our currency without “cashing it in” for goods and services, or, before 1971, gold.
The bad side of our reserve currency status, although seldom recognized, was that the very leeway that enhanced our current standard of living built up debt (and/or reduced foreign assets) to dangerous levels. I remember well when, in 1985, the United States ceased being a net creditor nation to the rest of the world and, instead, became a net debtor nation. Our net indebtedness has only grown over the years, and hangs over us like the legendary sword of Damocles.
Sword of Damocles? Lehrman, in his Money, Gold, and History states:
[W]hen one country’s currency — the dollar reserve currency of today — is used to settle international payments, the international settlement and adjustment mechanism is jammed — for that country — and for the world. This is no abstract notion. …
The reality behind the “twin deficits” is simply this: the greater and more permanent the Federal Reserve and foreign reserve facilities for financing the U.S. budget and trade deficits, the greater will be the twin deficits and the growth of the Federal government. All congressional, administrative and statutory attempts to end the U.S. deficit have proved futile, and will prove futile, until the crucial underlying flaw — namely the absence of an efficient international settlements and adjustment mechanism — is remedied by international monetary reform inaugurating a new international gold standard and the prohibition of official reserve currencies.
By pinning down the future price level by gold convertibility, the immediate effect of international monetary reform will be to end currency speculation in floating currencies, and terminate the immense costs of inflation hedging. Gold convertibility eliminates the very costly exchange of currencies at the profit-seeking banks. Thus, new savings will be channeled out of financial arbitrage and speculation, into long-term financial markets.
Increased long-term investment and improvements in world productivity will surely follow, as investment capital moves out of unproductive hedges and speculation — made necessary by floating exchange rates — seeking new and productive investments, leading to more quality jobs.
The sobering views expressed by McTeer and by Lehrman more than neutralize Heritage Foundation’s Bryan Riley and William Wilson’s valiant championship of the dollar’s reserve currency status, in opposition to Bernstein. Heritage’s championship is gallant but … unpersuasive.
John Mueller, who served as gold standard advocate Jack Kemp’s chief economist and now as the Ethics and Public Policy Center’s Lehrman Institute Fellow in Economics and Director, Economics and Ethics Program, crisply observes in an interview for this column:
As Kenneth Austin lucidly reminded us, it is a necessity of double-entry bookkeeping that any increase in foreign official dollar reserves equals the increase in combined US current and private capital account deficits. Denying the connection requires magical thinking. The entire decline in the international investment position since 1976 is due to Congress’s borrowing from foreign central banks–that is, the dollar’s official reserve currency role–while the books of private US residents with the rest of the world have remained close to balance.
There are differing schools of thought among the gold standard’s most prominent adherents as to the significance of merchandise deficit account. Their theoretical differences about current accounts are likely to prove, operationally, immaterial.
Both the Forbes and Lehrman schools share mortal opposition to mercantilism. Both passionately oppose the cheapening of the dollar. Both see the gold standard as a critical mechanism to restoring the brisk growth of, as Lehrman termed it, “quality jobs” … and the restoration of median family income growth that began, profoundly, to stagnate with Nixon’s destruction of Bretton Woods.
In this columnist’s own earnest, if much less erudite, view the most significant element of the reserve currency curse derives from how it subtracts capital from the real, e.g. goods and services, economy. Corporate earnings are taken, in return for local currency, into the coffers of the relevant international central bank. That central bank then promptly loans the proceeds directly to the federal government of the United States by purchase of treasury instruments.
The way the world of central banking works thus subverts a process extolled by Adam Smith (in the context of his analysis of the benefits of fractional reserve money) in Wealth of Nations. Smith:
When, therefore, by the substitution of paper, the gold and silver necessary for circulation is reduced to, perhaps, a fifth part of the former quantity, if the value of only the greater part of the other four-fifths be added to the funds which are destined for the maintenance of industry, it must make a very considerable addition to the quantity of that industry, and, consequently, to the value of the annual produce of land and labour.
The mechanics of the reserve currency system preempt these funds’ ready availability for “the maintenance of industry.” The mechanics of the dollar as a reserve asset, therefore, finance bigger government while insidiously preempting productivity, jobs, and equitable prosperity.
This columnist agrees wholeheartedly with Bernstein on what seem his three most important points. The reserve currency status of the dollar causes American workers, and the world, big problems. The exorbitant privilege deserves and demands far more attention than it receives. Moving the dollar away from being the world’s reserve currency would be a great deal easier than many now assume.
Bernstein, in his blog, identifies four mechanisms as “out there” (without explicitly endorsing, or critiquing, them): by legislation (which this columnist views as playing with tariff fire); taxation (thereby “raising the price of currency management,” which this columnist finds hardly an obvious source of job creation); reciprocity (demanding the right to buy foreign treasuries); and an international reserve currency.
Mueller says of Bernstein’s legislative and tax proposals, “you simply can’t solve a monetary problem with a fiscal solution.”
As for reciprocity, the United States Treasury, even under a Joe Biden or even a Bernie Sanders presidency, is never going to turn away ready lenders. This homely truth seems about as self-evident as it gets. Beyond that, even if China were to undertake market-oriented reforms — and, according to the Wall Street Journal, the political winds seem to be blowing the other way just now — the RMB accounts for only 1.64% of global payments. It is not even close to being a power player. Beyond the beyond … it is well beyond dubious to expect international central banks enthusiastically to bulk up on the debt instruments of the People’s Republic of China for the indefinite future.
An “international reserve currency,” however, is a sound proposition if well designed. Proposing SDRs for that role does not hold up. As then-Treasury Secretary Tim Geithner, during a hearing of the House Appropriations Subcommittee on Foreign Operations on March 9, 2011, stated, “There is no risk of the SDR playing that [a reserve currency] role. The SDR is not a currency. It’s a unit of account. And it can’t provide the role that many people aspire to it. There is no risk of that happening.” Mueller, elucidating why this is so, states:
It’s not possible to solve the problems caused by tying other nations’ domestic currencies to one nation’s inconvertible domestic currency (the dollar), by tying them all to a basket of inconvertible domestic fiat currencies–that is, to a subset of themselves. The result has no anchor. And the world economy always gravitates to a single “final asset,” because using several multiplies transactions costs.
There appear to be but two technically plausible ways of getting there. One is Nobel economics laureate Robert Mundell’s proposal of a world currency. The other, of course, represents a sort of “reversion to the mean.” Restore a 21st century international gold standard.
While the gold standard is very unfashionable it by no means is absurd. Then-World Bank Group president Robert Zoellick, in 2010, was dead on when he observed in an FT column that “Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.” About a year later, the Bank of England issued a startling but meticulous white paper demonstrating that the “Federal Reserve Note standard” materially has underperformed, in every area considered, both the Bretton Woods gold-exchange standard and the classical gold standard itself.
As previously referenced in this column Bundesbank president Jens Weidmann, in a 2012 speech, forthrightly stated:
Concrete objects have served as money for most of human history; we may therefore speak of commodity money. A great deal of trust was placed in particular in precious and rare metals – gold first and foremost – due to their assumed intrinsic value. In its function as a medium of exchange, medium of payment and store of value, gold is thus, in a sense, a timeless classic.
The gold standard, notwithstanding Churchill’s not-to-be-repeated 1925 blunder, is in no way a prescription for austerity. The classical gold standard, properly constructed, is a recipe for workers, and median income families, to flourish economically.
We have not flourished, consistently, since its last remnants were destroyed by President Nixon on August 15, 1971. So… what to do?
The first thing to do is to address the important issue, squarely. By shrewdly posing the right question Jared Bernstein has raised the odds, perhaps significantly, that we finally will find our way to the right answer. Getting out of the woods may be no more complicated than following JFK/LBJ economic advisor Walter Heller’s most famous dictum: “Put aside principle and do what’s right.”
Adroitly resolving the reserve currency issue as part of implementing an international reserve currency is far more likely to be fruitful in generating quality jobs, by the millions, than are earnest jeremiads, such as that by Dr. Bernstein himself, that “American political elites have completely failed to understand what the Fed should be doing right now.” Relying on central bankers consistently to get discretionary management right represents a triumph of hope over experience. Or as novelist Rita Mae Brown memorably observed, “insanity is doing the same thing over and over again but expecting different results.”
Let us take Keynes, in The Economic Consequences of the Peace, chapter VI, to heart:
Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. … Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.
As Steve Forbes pithily puts it, “You’ve got to get the money right.” Time to lift the reserve currency curse. Time to fix the dollar.
Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/09/30/the-rise-and-fall-and-rise-and-fall-of-king-dollar-part-2/
Dr David Andolfatto, who is Vice President of the St. Louis Fed, has been one of the most forward-looking people at central banks around the world when it comes to crypto-currencies. Here he speaks with Max Rangeley, Editor at The Cobden Centre, and gives his views on what Bitcoin means for commerce, finance, and the dollar itself.
Max: How have you found the reactions to Bitcoin within the Fed?
David: Bitcoin is barely on the radar screen for most Fed researchers and policymakers. This is to be expected, given the large size of the Fed’s balance sheet and the debate over how to conduct monetary policy with the existence of large excess reserves. But I am aware of a small group of researchers scattered throughout the Fed system that seem interested in the Bitcoin phenomenon. Some, like Francois Velde of the Chicago Fed, have written nice primers on the phenomenon. I am also aware of a cryptocurrency workshop that meets monthly at the New York Fed. The reaction of most people (who study it) might be described as “academic agnosticism” in the sense that people are curious, but not enthusiastically in favor or against the idea.
Max: How do you see Bitcoin being used in the future? Do you foresee private currencies being commonly used on the high street alongside state-backed currencies, or remaining largely online phenomena?
David: Who can say how the future will evolve, especially in this space? My best guess is that Bitcoin will find a niche market. It’s cool to use bitcoin to pay for your Starbucks latte on university campuses (this is what my university is doing). It may very well find a place on the high street, at least among some shops catering to the “cool” crowd. But for advanced economies, at least, it is hard to see how consumers will benefit directly by using bitcoins instead of dollars or pounds. As Satoshi Nakamoto wrote in his seminal 2008 paper introducing Bitcoin, “…the [current] system works well enough for most transactions…”
Max: If the use of private currencies became more widespread, do you think that central banks would ever track monetary aggregates in circulation, even if just approximately, much as M2, M3 etc are tracked now?
David: Anything is possible, but I doubt it. One issue is that there many of these “wildcat” currencies, with more appearing every day (every online game has its own currency for example, as do most social media sites). In a sense, these currencies are “local” monies (much like the local currencies that have always existed, like the Ithaca hour, for example). I’m not sure how a statistical agency could keep track of all these little local currencies, or whether it would even be worthwhile to do so. But who knows?
Max: If private currencies were to become widely used around the world, do you think that this could have an effect on the business cycle, since central banks would not have as much control over monetary factors?
David: I do not think it would have much of an effect on the business cycle, which I think is rooted more in “real” and “financial” factors, rather than “monetary” factors, per se.
Max: You mentioned in your presentation on Bitcoin that although supply is fixed, demand can fluctuate significantly, which causes volatility, would you say this is a weakness inherent in private currencies, or is there the possibility that algorithms could evolve to incorporate a degree of elasticity?
David: Remember that Bitcoin is *more* than a private currency: it is a payment system and monetary policy with *no trusted intermediary* involved. Most private currencies entail the use of trusted third parties. EVE online, for example, an online game founded in 2003 has evidently managed its money supply in a manner that keeps its value relatively stable. It may be possible to code an “elastic money supply” rule in the Bitcoin protocol, but it is not immediately clear to me how this might work. Injecting new money into the system would be easy. The tricky part would be in how to destroy money (having the algorithm debit Bitcoin wallets that are secured by private keys).
Max: You mentioned that you welcome the competition for central banks; if private currencies became widely used, could it chip away at American supremacy, a degree of which is based on the dollar, the so-called “exorbitant privilege”?
David: In my view, America supremacy is not based on the dollar. The status of the dollar simply reflects American supremacy, which is based fundamentally on the structure of that economy (something “real” not “monetary”). The America dollar already faces stiff competition from a variety of alternative candidates, including the Yen, the Euro, and gold. If gold cannot displace the USD, why would we expect Bitcoin to?