First it was the government’s miraculous ability to deliver on-target GDP growth that got the permabulls bellowing again, then it was the striking (world-beating, one might even say), 12% currency-adjusted rally in its stock market that got them triumphantly pawing the ground. Nor did the drop in interest rates serve in any way to dampen the eternal hope that China was once again deferring meaningful structural reform in the face of a threat to near-term output.
Quite what was actually behind the equity rally is not easy to say. There were whispers that the Russians (who else?) were piling in, now that their assets were subject to arbitrary seizure as part of Nova Roma’s vilification of their leader and proxy war against their homeland. There was also talk that the imminent linkage of the Shanghai and HK bourses was driving an arbitrage between the unusually-discounted mainland A-shares and their offshore H-share equivalents. Finally, in a typically neat piece of circular reasoning, the imminent rebound in the economy which we have even seen some brave (or foolhardy, according to preference) souls project at a startling 8.5% (sic) early next year was held to be at work to push up what was an otherwise under-owned and thus optically ‘cheap’ emerging market.
On the face of it, news that, over the first seven months of the year, the increase in SOE earnings had accelerated from June’s 8.9% YOY to July’s 9.2% – well up on the first quarter’s paltry 3.3% pace – may have seemed to have offered some much-needed confirmation of this optimistic thesis. However, a closer glance at the figures would not have proven quite so reassuring, had anyone bothered to actually take one.
Over the past, supposedly brighter three months, revenues advanced a modest 6.2% compared to the like period in 2013, though with as-reported profits up an ostensibly more creditable 12.1%. There, all grounds for positive spin, alas, were exhausted. For one, operating profits were, in fact, only up 4.0% like-for-like (a wide discrepancy which can only excite suspicion as to the nature of the headline surplus) while financing costs vaulted a fifth higher.
Worse still, in eking out even this degree of improvement since May, liabilities have soared by an incredible CNY2.320 trillion (around $125 billion a month) – an increment fully half as big again as that registered twelve months ago and a sum which is actually greater than the entire reported sum of ‘total social finance’ over the trimester (that latter ‘only’ managed CNY 2.240 trillion after last month’s thoroughly unexpected swoon).
And what did our proud commanders of the economic heights achieve for shouldering such a hefty weight of obligations? An addition to revenues of CNY719 billion (extra debt to extra ‘sales’ therefore coming in at a ratio of 3.2:1); a pick-up in ‘profit’ of CNY76 billion (d[Debt]:d[Income] = 30:1); and a blip up in operating profit of just CNY16 billion (at a truly staggering ratio of 144 to 1).
Reversing these latter relationships, we can see that while swallowing up all of the nation’s available new credit since the spring, China’s SOEs added 31 fen per one renminbi in sales, 3.3 fen in reported profit, and a bare 0.7 fen in the operating version of income. Just the sort of performance on which to base expectations of a significant coming rise in growth and prosperity!
Armed with such an underwhelming use of resources – both physical and financial – it is perhaps no wonder that MIIT is again trying to shut down swathes of superfluous capacity, issuing what are effectively cease-and-desist orders against 132 firms in a whole range of heavy industries – iron, steel, coke, ferroalloy, calcium carbide, aluminium, copper and lead smelting, cement, flat glass, paper, leather, printing and dyeing, chemical fibres, and lead-acid batteries. Shipbuilding may not be far behind, either, given that it formed the main topic of discussion at a meeting of the National Committee of the CPPCC this week.
The language used was, in some cases, pretty uncompromising, too: “Total industrial capacity in cement and plate glass is still growing, but the industry-wide sales rate is in decline and accounts receivable are increasing… there are to be no new projects in the sector for any reason,” thundered the MIIT communique.
This time around, given Chairman Xi’s rigorous ‘anti-corruption’ campaign, there might well be a little less of the back-sliding and wilful defiance which has greeted such edicts in the past. The emperor is no longer quite so fare away, nor the mountain quite so high, if you are a recalcitrant local cadre these days!
Even before this, the signs were there for those with eyes to see. Despite the much-bruited pick-up in activity, Chinese power use, excluding the residential component, SLOWED to 4.5% YOY in the three months to July from 8.1% in the preceding three months. Nor did this come without a significant deceleration in so-called ‘tertiary’ industry sector (loosely, that encompassing services and light indstry) which is henceforth supposed to be the torchbearer for growth and employment. Here, consumption dropped from the spring’s 10%-plus rates to just 7.4% YOY last month. Added buring of lights and turning of lathes in the secondary industry category – essentially manufacturing – was a tardy 4.2% even though growth in industrial production, we were told, had averaged 9.0% in that same period.
Hmmmm. No wonder the PMI seems to be shedding some of its recent, rather inexplicable exuberance.
Round and round the circle of vicious consequences swirls. As Wang Xianzheng, President of the China Coal Industry Association, admitted: ‘Currently, more than 50 percent of enterprises are in payment arrears and have delayed paying wages.’ Of 26 large companies spread across nine provinces, he revealed that 20 are making losses, only 9 are still in the black, and the remainder are hovering uneasily between (commercial) life and death.
Other obvious signs of distress are to be had among the loan guarantee networks which had everywhere come into being with the then-laudable aim of persuading constitutionally reluctant banks to lend to customers other than SOEs when times were good. Now trapped in flagging businesses which are more correlated than perhaps the participants had realised – and often having succumbed to the diversion of funds to less commendable ends in the interim – they are all going sour together and the same interconnectedness which was once their mainstay is proving instead a sheet anchor with which to drag them all under.
As Zhou Dewen, president of Zhejiang Federation of Private Enterprise Investment, told the Global Times, the rash of bankruptcies in Zhejiang and Jiangsu provinces has disrupted production and led to lay-offs, with 80% of all sour loans in the area associated with such mutual guarantee schemes. So elevated is the level of distrust, as bad debts have risen at an annualized 30% pace this year, that banks are now trying to call loans in early and obtaining court orders to freeze the assets of those firms that are unable to comply with their demands.
The banks themselves are beginning to accelerate write-offs dramatically – even though the official NPL ratios still look woefully understated. They are also drawing heavily upon the markets in order to bolster their capital as a precaution. As the WSJ reported, the four largest state-owned lenders have started raising a planned $73 billion in debt and equity this year – a call which is expected to jump to more than $300bn in the next five years, according to the banking regulator.
In addition, five local governments in the south and east of the country are setting up so-called ‘asset-management companies’ – effectively state-sponsored ‘bad banks’ – in a mirror of the system used by Zhu Rongji in the 1990s to shuffle the more toxic stuff off its originators’ balance sheets and thus allow them to continue to lend while the bitter fruits of their previous mistakes were hidden away elsewhere.
Though this only disguises and does not in any way alleviate the economic waste spawned by the boom, it might at least allow banks to issue new equity-like capital – perhaps to the insurers who are themselves being heavily promoted by Beijing as the next battalion of systemic saviours – at above notional book value and hence to enable them to remain a viable source of new credit. Note that the last time this was done, the losses were essentially fiscalized: banks simply swapped the bad loans on their books for what have since proven to be irredeemable – but nonetheless fully par-valued – loans to the state entities which, in turn, financed the obliging AMCs. Balance sheets will not shrink, therefore, only become sanitised, by the operation of this mechanism.
Here, however, is where it all gets fraught once more, because the same local governments who are being marshalled to assume the banks’ bad debts (many of them ensuing from extending credit to LGFPs) are themselves becoming desperate for funds given that all too many of their own, sure-fire investment gambits are turning out to be the dampest of damp squibs.
As the Economic Information Daily reported, an audit of 448 eastern township platform companies found that two-fifths of them were curently loss making, while a further thirty percent barely broke even. With these bodies so heavily dependent on land sales to generate the revenues needed to cover their current outlays, much less their ambitious capital expansion plans and ongoing debt service costs – and with such ‘sales’ only being possible in large part if the authorities extend the credit to the purchasers in the first place – a decidedly negative feedback loop has begun to tighten around their necks as the property market itself enters a slump.
Indeed, according to research conducted by brokerage company Centaline Property Agency, twenty major developers have between them spent CNY182.5 billion yuan so far this year to purchase new sites – a drastic 38% down on the like period last year.
‘Worsening property sales have undercut the willingness of developers to buy land. Their focus now is on raising cash from the sales of what they’ve already built. Few are in the mood to buy more,’ said Zhang Dawei who headed up the company’s research team.
In July alone, aggregate land sales revenue for 300 Chinese cities was off by a half from the same month in 2013, as reported by the China Index Academy. Sales in the four largest cities of Beijing, Shanghai, Guangzhou, and Shenzhen – normally a slam-dunk – sank by a staggering 70%.
‘The downturn means that the scale of land sales for the remainder of this year could continue to contract. Developers have pushed the “conservative” button,’ said Zhang with commendable understatement.
And quite right, too, as anecdotal evidence grows that formerly avid house-buyers are beginning to adopt that age-old American practice of ‘jingle mail’ – that is, they are simply walking away from properties they either cannot afford or do not believe will again appreciate in price.
At one end of the scale, one Nanjing online estate agent recorded a growing back-log of such defalcations and referred to the ‘unspeakable pain’ in the local market – an agony apparently shared in at least six other of the districts neighbouring his.
Despite the widespread belief that Chinese buyers are sitting on a typical equity cushion of 30-40% of the property value – and hence, unlike their less well-endowed US, Irish, and Spanish cousins, are impervious to all bar the most extreme events in the market – the scary truth is that much of the real estate to which they do hold title has been, how shall we say, ‘rehypothecated’ – i.e., pledged as collateral for a range of business loans as well as for the more speculative use of funds.
‘In the past few years, many small business owners blindly invested in real estate, mining and other industries. These industries are now suffering from overcapacity and falling asset prices, so business owners are unable to pay their debts,’ said one general manager of a Wenzhou microfinance company.
‘Many [of these] use the house as collateral when business loans go wrong,‘ Ge Ningbo, a county bank manager, told a journalist.
To get a feel for the scale of the problem, consider press reports that in Wenzhou, 1,000 homes were abandoned as a result of the decline, homes with an ostensible market value of more than Y6.4 Billion – or roughly $1 million a pop! No scrabbling rural migrants, these, but possibly members of an increasingly scrutiny–shy party apparatus! Clearly, the banks will need to suck in even more money from their gullible preference shareholders if this phenomenon starts to spread and, in the meanwhile, it is hard to see how they will be empowered to make sufficient revenue-positive new loans to keep the whirligig in motion in such a climate of confusion and disabusal.
Sadly, we have not finished our tale of woe there because there are also stories circulating in the official media that those same local governments, who are in many ways the lynchpins of the whole merry-go-round, may be far deeper into the mire than has been recognised to date.
As the articles detail, a member of the relevant NPC standing committee confided to a press contact that when hidden liabilities are taken into account alongside those uncovered in a recent audit, the true total of LG debt almost doubles to a wince-inducing Y30 trillion. Just for sheer size – some 50% of national GDP – this would be a matter of concern, but it also should not be overlooked that far too much of that monstrous total is comprised of short-term obligations against which are held long-term, illiquid, and often economically redundant ‘assets’.
Given that the last NAO study showed that are some 3,700 governmental bodies across various categories which had debts in excess of 100% of their local GDP, something patently needs to be done if the mad Chinese juggler is to keep his profusion of balls bobbing in the air.
So, welcome to local scrip issues. Yes, it seems that ingenious local cadres have dusted off their depression-era news clippings and revisited the age of the mediaeval mint and simply started using their own IOUs as media of exchange wherever their writ may run.
Economic Information Daily reported that in Hubei, Hunan and Guangdong, among others, government IOUs have become a ‘discount currency.’ In fact, commentary on Caijing suggests that not only are even small, rural communities now doing likewise, but that some companies, too, are paying their workers in scrip – just as in the early days of the Western factory age when resort by employers to what was called the ‘truck’ or ‘Tommy’ system was widespread.
As the early 19th century English radical, William Cobbett noted, ‘… when this tommy system… makes its appearance where money has for ages been the medium of exchange, and of payments for labour; when this system makes its appearance in such a state of society, there is something wrong; things are out of joint; and it becomes us to inquire into the real cause of its being resorted to…’
His answer? The state of economic depression brought about by the costs imposed upon entrepreneurs by the dead-weight of government:-
‘It is not the fault of the masters, who can have no pleasure in making profit in this way: it is the fault of the taxes, which, by lowering the [net] price of their goods, have compelled them to resort to this means of diminishing their expenses, or to quit their business altogether, which a great part of them cannot do without being left without a penny… Everything was on the decline… I was assured that shop-keepers in general did not now sell half the quantity of goods in a month that they did in that space of time four or five years ago… need we then wonder that the iron in Staffordshire has fallen, within these five years, from thirteen pounds to five pounds a ton [metal-bashers were similarly bearing the brunt, it appears]… and need we wonder that the iron-masters, who have the same rent and taxes to pay that they had to pay before, have resorted to the tommy system, in order to assist in saving themselves from ruin!’
‘Here is the real cause of the tommy system; and if [we wish] to put an end to it… prevail upon the Parliament to take off taxes to the amount of forty millions a year.’
Caijing devoted quite some space to ‘netizen’ comments on this state of affairs, several of which reflected a considerable degree of awareness that this had come about because of the unbridled spending and lavish self-indulgence of the relevant officials, while some were also aware that such an emission of fiat money was a direct parallel of the official money-creation process and further that it could only persist for so long as some minimal degree of trust resided in the councils’ ability one day to redeem the claims. Moreover, it was noted that since people ultimately expect the discount between township paper and that issued by the PBOC to widen, they were using the former preferentially to buy and sell and clinging on to the latter – a classic, Gresham’s Law example of bad money driving out good.
If the localities are in such dire straits as these, then it is hard to resist the temptation to believe that we are approaching some sort of end-game. But what, we should ask ourselves, might be the trigger for its no-doubt jarring denouement?
Well, here we come full circle with the latest act of Xi Jinping’s grand ‘anti-corruption’ drive. For, as well as Our Glorious Leader’s insistence at last week’s Leading Group get-together that everyone must ‘truly push forward reform with real guns and knives’ (ulp!), news has come out that the National Audit Commission will next conduct a full, ‘rigorous’ check of all land sales and related transactions carried out between 2008-13 and that, moreover, the results will be to hand when the top men convene for their next Plenum this coming October.
One can only imagine the consternation in the ranks which this announcement has unleashed. After all, there is unlikely to be overmuch evidence that any of these deals were conducted transparently, competitively, honestly, and legally, in the absence of any and all inducements, kickbacks, or displays of favouritism, not only since such was the accepted practice during the reign of Wen and Hu – especially during the infamous, no questions asked, frenzy of post-Crash stimulus – but also because this is a sphere notoriously subject to peculation in what we fondly imagine to be our more enlightened polities, too.
We can therefore not only expect the bodycount to rise substantially as officials fearful of censure seek to avoid their imminent disgrace and subsequent punishment, but we should also be prepared for the possibility that when this most capacious of all cylindrical metallic containers of vermiform invertebrae is opened, it will be accompanied by a blast of sufficient megatonnage to bring the whole flawed edifice crashing to the ground.
Under such circumstances, we find it very hard to shake off the presentiment that, on the one side, some commentators’ touching faith in an incipient re-acceleration are horribly misplaced while, on the other, the tired old ‘Goldilocks’ scenario whereby all bad news is good because it presages the launch of another round of sustained, indiscriminate ‘stimulus’ seems equally out of key with what Xi tells us he is trying to achieve.
Having dealt at such length with China, let us try and dispose of the rest of the globe in as short a space as possible.
Japan: Abenomics is still a horrible failure as drooping machine orders, frozen store sales, and exports back at 4 ½ year (currency-adjusted), one-quarter-from-the-peak lows reveal. So, guess what? As the PM’s approval ratings slip, another ‘stimulus’ package is said to be in the offing (sigh!)
Europe: Even one of Hollande’s own ministers confided to the press a couple of weeks back, ‘the truth is, he thinks we don’t have a chance’ – who are we to disagree? Meanwhile, the chap at the head of the other Sick Man, Matteo Renzi, has undergone a moment of almost Caligulan delusion, assuring supporters that the hour had come for Italy ‘to tow Europe out of the crisis’ and ‘to assume… the leadership’ of the Continent.
And what of his first steps to make good on such a vaunting claim? Why, in an Onion-like act of farce, to insist that ISTAT no longer releases the GDP numbers a week ahead of its peers and thereby afford underemployed analysts and commentators more opportunity to be critical of the country’s performance! And then there’s the Neocon-inspired catastrophe unfolding on the bloc’s eastern fringe from which the emergence of a bout of renewed economic difficulty is the very least of our worries.
USA: Chairperson Yellen is currently holding court at Jackson Hole as the US numbers continue their rebound from the winter’s retardation. What a moment for her to take the stage. Non-financials (large cap-led) are at new records, Tech at new, post-Bubble highs; junk spreads have narrowed sharply; vol has again crashed, correlations fallen, and put-call ratios evaporated. With the Bund-UST spread at a 15-year high and equities outperforming, the USD stands on the verge of a break out and up from what is already its best level in a year. The cycle is still running in favour of the States on a comparison basis, no matter how ninety-Nth percentile many of its valuations are when considered in isolation.
With money supply still swelling rapidly – and amid hints that it is being more actively utilised than of late—it is hard to see quite what will bring that run to an end in the near term. Were we to really be critical, one of the few clouds ‘no bigger than a man’s hand’ is that the growth of both inventories and payroll expenses are outstripping sales in the durable goods sector. Thus, while US assets are hardly ‘investible’ in the Benjamin Graham sense, they are also a tough short in the Sell’em Ben Smith one.
Britain: While MPC member David Miles saw fit to describe the EU as ‘dead in the water’ as a trade partner, closer to home some of the gloss is finally coming off the reputation of one of the country’s most expensive recent imports, its egregious Bank governor.
No doubt, dear reader, you too were shocked – shocked! – to hear local Tory Mark Field, the Honourable Member for the Cities of London and Westminster, opine to his mates in Grub Street that “…from the moment Mark Carney became governor in July 2013, it was pretty clear forward guidance was an indication rates would not rise this side of the election – for all the talk of Bank of England independence, there was a clear bargain between him and George Osborne.” Be that as it may, it is surely not too cynical to note that Fred Carney’s Army will not want to contibute to a possible defeat by Alex the Bruce’s forces in the coming Scottish independence vote.
You can just hear it now, that ringing oration:-
‘Aye, vote ‘Yes’ and interest rates may rise. Vote ‘No’ and they’ll stay as is … at least a while. And dying in your beds, many years from now, would you be willin’ to trade ALL the days, from this day to that, for one chance, just one chance, to come back here and tell our neighbours that they may take our pound and their nuclear subs, but they’ll never take… OUR FREEDOM!
Truth be told, it has not been the kindest of summers for commodities. Since reaching their late June peak, returns have suffered a 7.5% slump to touch six month lows even as US equities have added 2%. For the record, in that crumbling eight week stretch EM stocks put on 4.7%, US bonds were up 1% and junk was flat.
Within commodities themselves, what some commentators have been calling a ‘Garden of Eden’ summer in the US grain belt has ensured that the corn is as high as an elephant’s eye almost everywhere you look, while oilseeds and wheat have been similarly profuse. A loss of 11.3% and, in fact, the casting into jeopardy of the entire cyclical bull market in prices has been the result.
Energy, too, has suffered, as the record longs in oil finally began to liquidate, triggering the biggest 6-week sell-off of positions in WTI on record. IN notional value terms, net spec longs in Brent and WTI combined crashed from close to $97 billion worth of contracts to $59 billion. It is possible to read the charts to declare that this swoon has violated the uptrend in place for the last five years, as well as breaking all major MAs. Against that, we are arguably a touch oversold and the last four years’ sideways stationary, Arab Spring range remains intact. Tacticians, Faites vos jeux!
Dollar strength, the subsidence of financial market anxieties alluded to above, and the cessation of labour unrest in SA have hardly been conducive to higher PM prices (palladium — and Russia—excepted). Gold has also broken 200, 100, 50-day MAs and is threatening the uptrend drawn from the June 30-Dec 31 $1180 double bottom and June 3rd’s $1240 probe. Lease rates remain positive and net specs—at 43% of total O/I – as long as they have been on average throughout the last 12 years’ bull market.
Only Base metals seem to offer any hope (they rallied 4.2% while everything else was collapsing). Strength has partly been predicated upon what we think are decidedly ephemeral signs of a Chinese renaissance, but also on evidence of dwindling stockpiles and the litany of capex cuts and asset disposals emanating from the mining industry. They appear, therefore, to offer the least dirty shirt in the laundry basket.
Despite all the massive monetary pumping over the past six years and the lowering of interest rates to almost zero most commentators have expressed disappointment with the pace of economic growth. For instance, the yearly rate of growth of the EMU real GDP fell to 0.7% in Q2 from 0.9% in the previous quarter. In Q1 2007 the yearly rate of growth stood at 3.7%. In Japan the yearly rate of growth of real GDP fell to 0% in Q2 from 2.7% in Q1 and 5.8% in Q3 2010.
In the US the yearly rate of growth of real GDP stood at 2.4% in Q2 against 1.9% in the prior quarter. Note that since Q1 2010 the rate of growth followed a sideways path of around 2.2%. The exception is the UK where the growth momentum of GDP shows strengthening with the yearly rate of growth closing at 3.1% in Q2 from 3% in Q1. Observe however, that the yearly rate of growth in Q3 2007 stood at 4.3%.
In addition to still subdued economic activity most central bankers are concerned with the weakness of workers earnings.
Some of them are puzzled that despite injecting trillions of dollars into the financial system so little of it is showing up in workers earnings?
After all, it is held, the higher earnings are the more consumers can spend and consequently, the stronger the economic growth is going to be, so it is held.
The yearly rate of growth of US average hourly earnings stood at 2% in July against 3.9% in June 2007.
In the EMU the yearly rate of growth of weekly earnings plunged to 1.3% in Q1 from 5.4% in Q2 2009.
In the UK the yearly rate of growth of average weekly earnings fell to 0.7% in June this year from 5% in August 2007.
According to the Vice Chairman of the US Federal Reserve Stanley Fischer the US and global recoveries have been “disappointing” so far and may point to a permanent downshift in economic potential. Fisher has suggested that a slowing productivity could be an important factor behind all this.
That a fall in the productivity of workers could be an important factor is a good beginning in trying to establish what is really happening. It is however, just the identification of a symptom – it is not the cause of the problem.
Now, higher wages are possible if workers’ contribution to the generation of real wealth is expanding. The more a particular worker generates as far as real wealth is concerned the more he/she can demand in terms of wages.
An important factor that permits a worker to lift productivity is the magnitude and the quality of the infrastructure that is available to him. With better tools and machinery more output per hour can be generated and hence higher wages can be paid.
It is by allocating a larger slice out of a given pool of real wealth towards the buildup and the enhancement of the infrastructure that more capital goods per worker emerges (more tools and machinery per worker) and this sets the platform for higher worker productivity and hence to an expansion in real wealth and thus lifts prospects for higher wages. (With better infrastructure workers can now produce more goods and services).
The key factors that undermine the expansion in the capital goods per worker are an ever expanding government and loose monetary policies of the central bank. According to the popular view, what drives the economy is the demand for goods and services.
If, for whatever reasons, insufficient demand emerges it is the role of the government and the central bank to strengthen the demand to keep the economy going, so it is held. There is, however, no independent category such as demand that drives an economy. Every demand must be funded by a previous production of wealth. By producing something useful to other individuals an individual can exercise a demand for other useful goods.
Any policy, which artificially boosts demand, leads to consumption that is not backed up by a previous production of wealth. For instance, monetary pumping that is supposedly aimed at lifting the economy in fact generates activities that cannot support themselves. This means that their existence is only possible by diverting real wealth from wealth generators.
Printing presses set in motion an exchange of nothing for something. Note that a monetary pumping sets a platform for various non-productive or bubble activities – instead of wealth being used to fund the expansion of a wealth generating infrastructure, the monetary pumping channels wealth towards wealth squandering activities.
This means that monetary pumping leads to the squandering of real wealth. Similarly a policy of artificially lowering interest rates in order to boost demand in fact provides support for various non-productive activities that in a free market environment would never emerge.
We suggest that the longer central banks world wide persist with their loose monetary policies the greater the risk of severely damaging the wealth generating process is. This in turn raises the likelihood of a prolonged stagnation.
All this however, can be reversed by shrinking the size of the government and by the closure of all the loopholes of the monetary expansion. Obviously a tighter fiscal and monetary stance is going to hurt various non-productive activities.
The data was not really surprising and neither was the response from the commentariat. After a run of weak reports from Germany over recent months, last week’s release of GDP data for the eurozone confirmed that the economy had been flatlining in the second quarter. Predictably, this led to new calls for ECB action. “Europe now needs full-blown QE” diagnosed the leader writer of the Financial Times, and in its main report on page one the paper quoted Richard Barwell, European economist at Royal Bank of Scotland with “It’s time the ECB took control and we got the real deal, instead of the weaker measure unveiled in June.”
I wonder if calls for more ‘stimulus’ are now simply knee-jerk reactions, mere Pavlovian reflexes imbued by five years of near relentless policy easing. Do these economists and leader writers still really think about their suggestions? If so, what do they think Europe’s ills are that easy money and cheap credit are going to cure them? Is pumping ever more freshly printed money into the banking system really the answer to every economic problem? And has QE been a success where it has been pursued?
The fact is that money has hardly been tight in years – at least not at the central bank level, at the core of the system. Granted, banks have not been falling over one another to extend new loans but that is surely not surprising given that they still lick their wounds from 2008. The ongoing “asset quality review” and tighter regulation are doing their bit, too, and if these are needed to make finance safer, as their proponents claim, then abandoning them for the sake of a quick – and ultimately short-lived – GDP rebound doesn’t seem advisable. The simple fact is that lenders are reluctant to lend and borrowers reluctant to borrow, and both may have good reasons for their reluctance.
Do we really think that Italian, French, and German companies have drawers full of exciting investment projects that would instantly be put to work if only rates were lower? I think it is a fairly safe bet that whatever investment project Siemens, BMW, Total and Fiat can be cajoled into via the lure of easy money will by now have been realized. The easy-money drug has a rapidly diminishing marginal return.
In most major economies, rates have been close to zero for more than five years and various additional stimulus measures have been taken, including some by the ECB, even if they fell short of outright QE. Yet, the global economy is hardly buzzing. The advocates of central bank activism will point to the US and the UK. Growth there has recently been stronger and many expect a rise in interest rates in the not too distant future. Yet, even if we take the US’ latest quarterly GDP data of an annualized 4 percent at face value (it was a powerful snap-back from a contraction in Q1), the present recovery, having started in 2009, still is the slowest in the post-World-War-II period, and by some margin. The Fed is not done with its bond-buying program yet, fading it out ever so slowly and carefully, fearful that the economy, or at any rate overstretched financial markets, could buckle under a more ‘normal’ policy environment, if anybody still knows what that may look like. We will see how much spring is left in the economy’s step once stimulus has been removed fully and interest rates begin to rise — if that will ever happen.
Then there is Japan, under Abe and Kuroda firmly committed to QE-square and thus the new poster-boy of the growth-through-money-printing movement. Here the economy contracted in Q2 by a staggering 6.8% annualized, mimicking its performance from when it was hit by a tsunami in 2011. This time economic contraction appears to have been mainly driven by an increase in the country’s sale tax (I guess the government has to rein in its deficit at some stage, even in Japan), which had initially caused a strong Q1, as consumers front-loaded purchases in anticipation of the tax hike. Now it was pay-back time. Still, looking through the two quarters, the Wall Street Journal speaks of “Japan’s slow recovery despite heavy stimulus”.
Elsewhere the debate has moved on
In the Anglo-Saxon countries the debate about the negative side-effects of ultra-easy money seems to be intensifying. Last week Martin Feldstein and Robert Rubin, in an editorial for the Wall Street Journal, warned of risks to financial stability from the Fed’s long-standing policy stimulus, pointing towards high asset values and tight risk premiums, stressing that monetary policy was asked to do too much. Paul Singer, founder of the Elliott Management hedge fund and the nemesis of Argentina’s Cristina Fernandez de Kirchner, was reported as saying that ultra-easy monetary policy had failed and that structural reforms and a more business-friendly regulatory environment were needed instead. All of this even before you consider my case (the Austrian School case) that every form of monetary stimulus is ultimately disruptive because it can at best buy some growth near term at the price of distorting capital markets and sowing the seeds of a correction in the future. No monetary stimulus can ever lead to lasting growth.
None of this seems to faze the enthusiasts for more monetary intervention in Europe. When data is soft, the inevitable response is to ask the ECB to print more money.
The ECB’s critics are correct when they claim that the ECB has recently been less accommodative than some of its cousins, namely the Fed and the Bank of Japan. So the eurozone economy stands in front of us naked and without much monetary make-up. If we do not like what we see then the blame should go to Europe’s ineffectual political elite, to France’s socialist president Hollande, whose eat-the-rich tax policies and out-of-control state bureaucracy cripple the country; to Ms Merkel, who not only has failed to enact a single pro-growth reform program since becoming Germany’s chancellor (how long can the country rest on the Schroeder reforms of 2002?) but now embraces a national minimum wage and a lower retirement age of 63, positions she previously objected to; to Italy’s sunny-boy Renzi who talks the talk but has so far failed to walk the walk. But then it has been argued that under democracy the people get the rulers they deserve. Europe’s structural impediments to growth often appear to enjoy great public support.
Calls for yet easier monetary conditions and more cheap credit are a sign of intellectual bankruptcy and political incompetence. They will probably be heeded.
[Editor's note: this article, by Mateusz Machaj, first appeared at mises.org]
One often wonders whether differences in economic schools of thought are big enough to justify strict theoretical segregations. One such case is “marginal economics.” Most textbooks point to the triumvirate of Walras, Jevons, and Menger, who independently discovered the notion of marginal utility and its relevance to the pricing process. Quite often these brilliant thinkers are homogenized as more or less indistinguishable figures who paved the way for modern microeconomic theory.
The usual simplification of the history of economic thought will tell us that the big three introduced concepts of marginalism and marginal utility into economic science (the exact name “marginal utility” came from Friedrich von Wieser). In general, marginalism was introduced to combat the belief of classical economists that prices have not much to do with individual utility and consumer satisfaction (since many useful things have low prices, as the so-called paradox of value demonstrated). The biggest contribution of the marginal revolutionaries was to invite the concept of utility back into newly-rebuilt consumer theory. Consequently, economics became a much more universal science than it had been.
It cannot be denied that Walras, Jevons, and Menger all played major roles in the advancement of modern consumer theory. Marginal units and marginal utility well-explained how prices are shaped in accordance with subjective preferences and consumer choice. Yet it would be a mistake to say there were no major differences between them. Well-established economist William Jaffé published a famous article about “dehomogenization” of those thinkers. His main point was that Menger differed significantly from Walras and Jevons in presenting marginal theory with Menger’s usage of a non-mathematical apparatus. Various other authors describing the development of marginal theory also referred to this difference. Unfortunately, many of them focused on this aspect as if it somehow illustrated a deficiency of Menger’s thought in that he did not mathematized his theory. Famous Chicago economist George Stigler criticized Menger and argued that it was his main “weakness,” because he could not arrive at the concept of “maximizing want satisfaction.” In other words, Stigler claims Menger’s theory is inferior because he did not write equations and present his conclusions in the form of a mathematical apparatus.
Mathematical marginalism can indeed appear to be more rigorous. But just because it looks more complicated does not mean it is a better description of the valuation process. Menger’s so-called weakness is actually his strength, because it adds a more fruitful dimension to marginal theory, which was completely absent in the mathematical approaches of Jevons and Walras. Even though all three economists are seen as referring to “marginal units,” in Menger, this concept means something other than what it does in Jevons and Walras. In the case of Jevons and Walras, marginal units are infinitely small, continuous, and in consequence almost irrelevant. It becomes a part of a broader utility function which can be “maximized” as Stigler wishes with the use of various derivatives.
In the case of Menger, “marginal” units are something else. They are finite and discrete, not continuous, and therefore it is not part of some broader already-existing utility function which can be maximized with the use of derivatives (since only continuous functions can have derivatives).
It may all sound as a minor technical detail; nevertheless, the next steps in the reasoning process are significant and lead us to the vital role of social institutions for economizing scarce resources. If a marginal unit is irrelevant and seen as a part of an already-existing utility function, one can solve on paper the utility equations and offer an optimal solution for allocations. If, on the other hand, a marginal unit is something discrete, not subjected to an already-existing function, the “optimal” resolution cannot be derived a priori on paper. The concrete and discrete unit is possessed by someone and that someone has to make a choice to allocate it. Hence the main difference between marginal units in Menger and marginal units in Walras is Walras’s theory leads to an economics of assumed functions, whereas Menger’s theory leads to an economics of real choices. The term “marginal unit” in the Austrian and neoclassical theory may be the same. The content is radically different.
Through finite marginal units, Menger firmly opens the door for the explanation of how various units of goods are being monetarily appraised by acting individuals. If marginal units are scatters of Walrasian equations they do not have to be appraised by entrepreneurs — the mathematical function is in a way doing it for them. It is no surprise that Menger’s heir, Mises, was the one to build a theory of entrepreneurship and demonstrate entrepreneurial roles in solving problems of proper allocations for consumer satisfaction. It also comes as no surprise that Walras’s successors did not see the strength of Mises’s theory of entrepreneurship, because for them the process of optimal allocation can be simply solved by maximization of functions. Mengerian marginal units need to be acted upon and selectively valued. The driving force for their valuation is human choice. Their value is not pre-determined. Walrasian marginal units, on the contrary, are part of valuation equations, therefore they are already appraised once we mathematically describe their economic place. There is no room left for choice. Why bother then with examining the personal valuations of entrepreneurs if marginal units have already assigned roles?
Here in fact lies the main difference between the Austrian microeconomic theory and the neoclassical economic theory. Surely it cannot be denied there are similarities, but differences are not only of a pedagogical nature. Discrete marginalism, despite being non-mathematical, is superior to neoclassical marginalism. Usage of derivatives is not a sign of a more scientific method.
“Anything can happen in stock markets and you ought to conduct your affairs so that if the most extraordinary events happen, you’re still around to play the next day.”
Vice Admiral James Stockdale has a good claim to have been one of the most extraordinary Americans ever to have lived. On September 9th, 1965 he was shot down over North Vietnam and seized by a mob. Having broken a bone in his back ejecting from his plane he had his leg broken and his arm badly injured. He would spend the next seven years in Hoa Lo Prison, the infamous “Hanoi Hilton”. The physical brutality was unspeakable, and the mental torture never stopped. He would be kept in solitary confinement, in total darkness, for four years. He would be kept in heavy leg-irons for two years, on a starvation diet, deprived even of letters from home. Throughout it all, Stockdale was stoic. When told he would be paraded in front of foreign journalists, he slashed his own scalp with a razor and beat himself in the face with a wooden stool so that he would be unrecognisable and useless to the enemy’s press. When he discovered that his fellow prisoners were being tortured to death, he slashed his wrists to show his torturers that he would not submit to them. When his guards finally realised that he would die before cooperating, they relented. The torture of American prisoners ended, and the treatment of all American prisoners of war improved. After being released in 1973, Stockdale was awarded the Medal of Honour. He was one of the most decorated officers in US naval history, with 26 personal combat decorations, including four Silver Stars. Jim Collins, author of the influential study of US businesses, ‘Good to Great’, interviewed Stockdale during his research for the book. How had he found the courage to survive those long, dark years ?
“I never lost faith in the end of the story,” replied Stockdale.
“I never doubted not only that I would get out, but also that I would prevail in the end and turn the experience into the defining moment of my life, which in retrospect, I would not trade.”
Collins was silent for a few minutes. The two men walked along, Stockdale with a heavy limp, swinging a stiff leg that had never properly recovered from repeated torture. Finally, Collins went on to ask another question. Who didn’t make it out ?
“Oh, that’s easy,” replied Stockdale. “The optimists.”
Collins was confused.
“The optimists. Oh, they were the ones who said, ‘We’re going to be out by Christmas.’ And Christmas would come, and Christmas would go. Then they’d say, ‘We’re going to be out by Easter.’ And Easter would come, and Easter would go. And then Thanksgiving. And then it would be Christmas again. And they died of a broken heart.”
As the two men walked slowly onward, Stockdale turned to Collins.
“This is a very important lesson. You must never confuse faith that you will prevail in the end – which you can never afford to lose – with the discipline to confront the most brutal facts of your current reality, whatever they might be.”
As Collins’ book came to be published, this observation came to be known as the Stockdale Paradox. For Collins, it was exactly the same sort of behaviour displayed by those company founders who had led their businesses through thick and thin. The alternative was the average managers at also-ran companies that enjoyed average returns at best, or that failed completely.
At the risk of stating the blindingly obvious, this is hardly a ‘good news’ market. Ebola. Ukraine. Iraq. Gaza. In a more narrowly financial sphere, the euro zone economy looks to be slowing, with Italy flirting with a triple dip recession, Portugal suffering a renewed banking crisis, and the ECB on the brink of rolling out QE. If government bond yields are a reflection of investor confidence, the fact that two-year German rates have gone below zero is hardly inspiring.
And we have had interest rates held at emergency levels for five years now – gently igniting who knows what form of as yet unseen problems to come. In Europe interest rates seem set to stay low or go even lower. But in the UK and the US, the markets nervously await the first rate hike of a new cycle while central bankers bluster and dither.
What are the implications for global asset allocation and stock selection ?
Both in absolute terms and relative to equities, most bond markets (notably the Anglo-Saxon) are ridiculously overvalued. Since the risk-free rate has now become the return-free risk, cash now looks like the superior asset class diversifier.
As regards stock markets, price is what you pay, and value (or lack thereof) is what you get. On any fair analysis, the US market in particular is a fly in search of a windscreen. Using Professor Robert Shiller’s cyclically adjusted price / earnings ratio for the broad US stock market, shown below, US stocks have only been more expensive than they are today on two occasions in the past 130 years: in 1929, and in 2000. The peak-to-trough fall for the Dow Jones Industrial Average from 1929 equated to 89%. The peak-to-trough fall for the Dow from 2000 equated to “just” 38%. Time will tell just how disappointing (both by scale and by duration) the coming years will be for US equity market bulls.
But we’re not interested in markets per se – we’re interested in value opportunities incorporating a margin of safety. If the geographic allocations within Greg Fisher’s Asian Prosperity Fund are any guide, those value opportunities are currently most numerous in Japan and Vietnam. In the fund’s latest report he writes:
“Interestingly, and despite China’s continued underperformance, the Asian markets in aggregate have done better at this stage in 2014 than last year, while other global markets have fared less well. In our view the reason is simple – a combination of more attractive valuations than western markets, especially the US, but also, compared with 12-18 months ago, recognisably poor investor sentiment and consequently under-positioning in Asia, leading to the chance of positive surprises.”
Cylically adjusted price / earnings ratio for the S&P 500 Index
The Asian Prosperity Fund is practically a poster child for the opportunity inherent in global, unconstrained, Ben Graham-style value investing. Its average price / earnings ratio stands at 9x (versus 18x for the FTSE 100 and 17x for the S&P 500); its price / book ratio stands at just one; historic return on equity is an attractive 15%; average dividend yield stands at 4.2%. And this from a region where long-term economic growth seems entirely plausible rather than a delusional fantasy.
Vice Admiral Stockdale was unequivocal: while we need to confront the “brutal facts” of the marketplace, we also need to keep faith that we will prevail. To us, that boils down to avoiding conspicuous overvaluation (in most bond markets, for example, and a significant portion of the developed equity markets) and embracing equally conspicuous value – where poor sentiment is likely to intensify subsequent returns. In this uniquely oppressive financial environment, with the skies darkening with the prospect of a turn in the interest rate cycle, we think optimism could be fatal. Or as Warren Buffett once observed,
“You pay a very high price in the stock market for a cheery consensus.”
When it comes to the world of international finance, Jim Rickards has quite nearly seen it all. As a young man, he worked for Citibank in Pakistan, of all places. In the 1990s, he served as General Counsel for Long-Term Capital Management, Jim Merriwether’s large, notorious hedge fund that collapsed spectacularly in 1998. In recent years, he has been a regular participant in Pentagon ‘wargames’, in particular those incorporating financial or currency warfare in some way, and he has served as an advisor to the US intelligence community.
Yet while his experiences are vast in breadth, they have all occurred within the historically narrow confines of a peculiar international monetary regime, one lacking a gold- or silver-backed international reserve currency. Yes, reserve currencies have come and gone through history, but it is the US dollar, and only the US dollar, that has ever served as an unbacked global monetary reserve.
Nevertheless, in CURRENCY WARS and THE DEATH OF MONEY, Jim does an excellent job of exploring pertinent historical parallels to the situation as it exists today, in which the international monetary regime has been critically undermined by a series of crises and flawed policy responses thereto. He also applies not only economic but also complexity theory to provide a framework and deepen understanding.
As for what happens next, he does have a few compelling ideas, as we explore in the following pages. To begin, however, we explore what it was that got him interested in international monetary relations in the first place.
BACK TO THE 1970S: THE DECADE OF DISCO AND DOLLAR CRISES
JB: Jim, you might recall the rolling crises of the 1970s, beginning with the ‘Nixon Shock’ in 1971, when the US ‘closed the gold window’, to the related oil shocks and then the de facto global ‘run on the dollar’ at the end of the decade. At the time, as a student, did you have a sense as to what was happening, or any inclination to see this as the dollar’s first real test as an unbacked global monetary reserve? Did these events have any influence on your decision to study international economics and to work in finance?
JR: I was a graduate student in international economics in 1972-74, and a law student from 1974-77, so my student years coincided exactly with the most tumultous years of the combined oil, inflation and dollar crises of the 1970s. Most observers know that Nixon closed the gold window in 1971, but that was not considered the end of the gold standard at the time. Nixon said he was ‘temporarily’ suspending convertibility, but the dollar was still officially valued at 1/35th of an ounce of gold. It was not until 1975 that the IMF officially demonitised gold although, at French insistence, gold could still be counted as part of a country’s reserve position. I was in the last class of students who were actually taught about gold as a monetary asset. Since 1975, any student who learns anything about gold as money is self-taught because it is no longer part of any economics curriculum. During the dark days of the dollar crisis in 1977, I spoke to one of my international law professors about whether the Deutschemark would replace the dollar as the global reserve currency. He smiled and said, “No, there aren’t enough of them.” That was an important lesson in the built-in resilience of the dollar and the fact that no currency could replace the dollar unless it had a sufficiently large, liquid bond market – something the euro does not yet have to this day. From law school I joined Citibank as their international tax counsel. There is no question that my academic experiences in a period of borderline hyperinflation and currency turmoil played a powerful role in my decision to pursue a career in international finance.
JB: As you argued in CURRENCY WARS and now again in THE DEATH OF MONEY, the US debt situation, public and private, is now critical. It would be exceedingly difficult for another Paul Volcker to arrive at the Federal Reserve and shore up confidence in the system with high real interest rates. But why has it come to this? Why is it that the ‘power of the printing press’ has been so abused, so corrupted? Is this due to poor federal governance, as David Stockman argues in THE GREAT DEFORMATION? Is it due to the incompetence or ignorance of the series of Federal Reserve officials who failed to appreciate the threat of global economic imbalances? Or is it due perhaps to a fundamental flaw in the US economic and monetary policy regime itself?
JR: It is still possible to strengthen the dollar and cement its position as the keystone of the international financial system, but not without costs. Reducing money printing and raising interest rates would strengthen the dollar, but they would pop the asset bubbles in stocks and housing that have been re-created since 2009. This would also put the policy problem in the laps of Congress and the White House where it belongs. The problems in the economy today are structural, not liquidity-related. The Fed is trying to solve structural problems with liquidity solutions. That will never work, but it might destroy confidence in the dollar in the process. Federal Reserve officials have misperceived the problem and misapprehend the statistical properties of risk. They are using equilbirium models in a complex system. (Ed note: Complexity Theory explores the fundamental properties of dynamic rather than equilibrium systems and how they react and adapt to exogenous or endogenous stimuli.) That is also bound to fail. Fiat money can work but only if money issuance is rule-based and designed to maintain confidence. Today’s Fed has no rule and is destroying confidence. Based on present policy, a complete loss of confidence in the dollar and a global currency crisis is just a matter of time.
JB: Thinking more internationally, the dollar is in quite good company. ‘Abenomics’ in Japan appears to have failed to confer any meaningful, lasting benefits and has further undermined what little confidence was left in the yen; China’s bursting credit and investment bubble threatens the yuan; the other BRICS have similar if less dramatic credit excess to work off; and while the European Central Bank and most EU fiscal authorities have been highly restrained for domestic political reasons in the past few years, there are signs that this may be about to change. Clearly this is not a situation in which countries can easily trust one another in monetary matters. But as monetary trust supports trust in trade and commerce generally, isn’t it just a matter of time before the currency wars of today morph into the trade wars of tomorrow? And wouldn’t a modern-day Smoot-Hawley be an unparalleled disaster for today’s globalised, highly-integrated economy?
JR: Currency wars can turn into trade wars as happened in the 1920s and 1930s. Such an outcome is certainly possible today. The root cause is lack of growth on a global basis. When growth is robust, large countries don’t care if smaller trading partners grab some temporary advantage by devaluing their currencies. But when global growth in anemic, as it is now, a positive sum game becomes a zero-sum game and trading partners fight for every scrap of growth. Cheapening your currency, which simultaneously promotes exports and imports inflation via the cross rate mechanism, is a tempting strategy when there’s not enough growth to go around. We are already seeing a twenty-first century version of Smoot-Hawley in the form of economic sanctions imposed on major countries like Iran and Russia by the United States. This has more to do with geopolitics than economics, but the result is the same – reduced global growth that makes the existing depression even worse.
JB: You may recall that, in my book, THE GOLDEN REVOLUTION, I borrow your scenario of how Russia could, conceivably, undermine the remaining international trust in the dollar with a pre-emptive ‘monetary strike’ by backing the rouble with gold. Do you regard the escalating situation in Ukraine, as well as US policies in much of the Black Sea/Caucasus/Caspian region generally, as a potential trigger for such a move?
JR: There is almost no possibility that either the Russian rouble or the Chinese yuan can be a global reserve currency in the next ten years. This is because both Russia and China lack a good rule or law and a well-developed liquid bond market. Both things are required for reserve curreny status. The reason Russia and China are acquiring gold and will continue to do so is not to launch a new gold-backed currency, but rather to hedge their dollar positions and reduce their dependence on dollar reserves. If there is a replacement for the dollar as the leading reserve currency, it will either be the euro, the special drawing right (SDRs), or perhaps a new currency devised by the BRICS.
JB: Leaving geo-politics aside for the moment, you mention right at the start of THE DEATH OF MONEY, citing the classic financial thriller ROLLOVER, that even non-state actors could, perhaps for a variety of reasons, spontaneously begin to act in ways that, given the fragility of the current global monetary order, cascade into a run on the dollar and rush to accumulate gold. If you were to do a remake of ROLLOVER today, how would you structure the plot? Who could be the first to begin selling dollars and accumulating gold? Who might join them? What would be the trigger that turned a trickle of dollar selling into a flood? How might the US government respond?
JR: If Rollover were re-made today, it would not be a simple Arab v. US monetary plot. The action would be multilateral including Russia, China, Iran, the Arabs and others. Massive dumping of dollars might be the consequence but it would not be the cause of the panic. A more likely scenario is something entirely unexpected such as a failure to deliver physical gold by a major gold exchange or dealer. That would start panic buying of gold and dumping of dollars. Another scenario might begin with a real estate collapse and credit crash in China. That could cause a demand shock for gold among ordinary Chinese investors, which would cause a hyperbolic price spike in gold. A rising gold price is just the flip side of a collapsing dollar.
JB: This entire discussion all follows from the fragility of the current international monetary system. Were the system more robust, we could leave the dollar crisis topic to Hollywood for entertainment rather than to treat it with utmost concern for personal, national or even international security. But what is it that makes systems fragile? Authors ranging from George Gilder (KNOWLEDGE AND POWER), to Joseph Tainter (THE COLLAPSE OF COMPLEX SOCIETIES) and even Edward Gibbon (THE RISE AND FALL OF THE ROMAN EMPIRE) have applied such thinking to ancient and modern economies and societies. They all conclude that, beyond a certain point, centralisation of power is destabilising. Does this mean that a robust monetary system would ‘de-centralise’ monetary power? Isn’t this incompatible with any attempt by the G20 and IMF to transform the Special Drawing Right (SDR) from a unit of account into a centrally-managed, global reserve currency?
JR: Yes. Complex systems collapse because increases in complexity require exponential increases in energy to maintain the system. Energy can take many forms including money, which can be thought of as a form of stored energy. We are already past the point where there is enough real money to support the complexity of the financial system. Elites are now resorting to psuedo-money such as deriviatives and other forms of leverage to keep the system going but even that will collapse in time. The proper solution is to reduce the complexity of the system and restore the energy/money inputs to a sustainable level. This means reducing leverage, banning most derivatives and breaking up big banks. None of this is very likely because it cuts against the financial interests of the power elites who run the system. Therefore a continued path toward near-term collapse is the most likely outcome.
JB: In CURRENCY WARS you make plain that, although you are highly critical of the current economic policy mainstream for a variety of reasons, you are an agnostic when it comes to economic theory. Yet clearly you draw heavily on economists of the Austrian School (eg Hayek) and in THE DEATH OF MONEY you even mention the pre-classicist and proto-Austrian Richard Cantillon. While I doubt you are a closet convert to the Austrian School, could you perhaps describe what it is about it that you do find compelling, vis-à-vis the increasingly obvious flaws of current, mainstream economic thinking?
JR: There is much to admire in Austrian economics. Austrians are correct that central planning is bound to fail and free markets produce optimal solutions to the problem of scarce resources. Complexity Theory as applied to capital markets is just an extension of that thinking with a more rigorous scientific foundation. Computers have allowed complexity theorists to conduct experiments that were beyond the capabilities of early Austrians. The results verify the intuition of the Austrians, but frame the issue in formal mathematical models that are useful in risk management and portfolio allocation. If Ludwig von Mises were alive today he would be a complexity theorist.
JB: You may have heard the old Irish adage of the young man, lost in the countryside, who happens across an older man and asks him for directions to Dublin, to which the old man replies, unhelpfully, “Well I wouldn’t start from here.” If you were tasked with trying, as best you could, to restore monetary stability to the United States and by extension the global economy, how would you go about it? You have suggested devaluing the dollar (or other currencies) versus gold to a point that would make the existing debt burdens, public and private, credibly serviceable. But does this solve the fundamental systemic problem? What is to stop the US and global economy from printing excessive money and leveraging up all over again, and in a decade or two facing the same issues, only on a grander scale? Is there a better system? Could a proper remonetisation of gold a la the classical gold standard do the trick? Might there be a role for new monetary technology such as cryptocurrency?
JR: The classic definition of money involves three functions: store of value, medium of exchange and unit of account. Of these, store of value is the most important. If users have confidence in value then they will accept the money as a medium of exchange. The unit of account function is trivial. The store of value is maintained by trust and confidence. Gold is an excellent store of value because it is scarce and no trust in third parties is required since gold is an asset that is not simultaneously the liability of another party. Fiat money can also be a store of value if confidence is maintained in the party issuing the money. The best way to do that is to use a monetary rule. Such rules can take many forms including gold backing or a mathematical formula linked to inflation. The problem today is that there is no monetary rule of any kind. Also, trust is being abused in the effort to create inflation, which is form of theft. As knowledge of this abuse of trust becomes more widespread, confidence will be lost and the currency will collapse. Cryptocurrencies offer some technological advantages but they also rely on confidence to mainatin value and, in that sense, they are not an improvement on traditional fiat currencies. Confidence in cryptocurrencies is also fragile and can easily be lost. It is true that stable systems have failed repeatedly and may do so again. The solution for individual investors is to go on a personal gold standard by acquiring physical gold. That way, they will preserve wealth regardless of the monetary rule or lack thereof pursued by monetary authorities.
JB: Thanks Jim for your time. I’m sure it is greatly appreciated by all readers of the Amphora Report many of whom have probably already acquired a copy of THE DEATH OF MONEY.
In a world of rapidly escalating crises in several regions, all of which have a clear economic or financial dimension, Jim’s answers to the various questions above are immensely helpful. The world is changing rapidly, arguably more rapidly that at any time since the implosion of the Soviet Union in the early 1990s. Yet back then, the changes had the near-term effect of strengthening rather than weakening the dominant US position in global geopolitical, economic and monetary affairs. Today, the trend is clearly the opposite.
Jim’s use of Complexity Theory specifically is particularly helpful, as the balance of power now shifts away from the US, destabilising the entire system. Were the US economy more robust and resilient, perhaps a general global rebalancing could be a gradual and entirely peaceful affair. But with the single most powerful actor weakening not only in relative but arguably in absolute terms, for structural reasons Jim explains above, the risks of a disorderly rebalancing are commensurately greater.
The more disorderly the transition, however, the less trust will exist between countries, at least for a time, and as Jim points out it is just not realistic for either the Russian rouble or Chinese yuan to replace the dollar any time soon. As I argue in THE GOLDEN REVOLUTION, this makes it highly likely that as the dollar’s share of global trade declines, not only will other currencies be competing with the dollar; all currencies, including the dollar, will increasingly be competing with gold. There is simply nothing to prevent one or more countries lacking trust in the system to demand gold or gold-backed securities of some kind in exchange for exports, such as oil, gas or other vital commodities.
Jim puts the IMF’s SDR forward as a possible alternative, but here, too, he is sceptical there is sufficient global cooperation at present to turn the SDR into a functioning global reserve currency. The world may indeed be on the path to monetary collapse, as Jim fears, but history demonstrates that collapse leads to reset and renewal, and in this case it seems more likely that not that gold will provide part of the necessary global monetary foundation, at least during the collapse, reset and renewal period. Once trust in the new system is sufficient, perhaps the world will once again drift away from gold, and perhaps toward unbacked cryptocurrencies such as bitcoin, but it seems unlikely that a great leap forward into the monetary unknown would occur prior to a falling-back onto what is known to have provided for the relative monetary and economic stability that prevailed prior to the catastrophic First World War, which as readers may note began 100 years ago this month.
The Federal Reserve increasingly is attracting scrutiny across the board. Now add to that a roller coaster of a thriller, using a miracle of a rare device, shining a light into the operations of the Fed — that contemporary riddle wrapped in a mystery inside an enigma: Matthew Quirk’s latest novel, The Directive.
“If I’ve made myself too clear, you must have misunderstood me,” Fed Chairman Alan Greenspan once famously said. The era of a mystagogue Fed may be ending. Recently, the House Government Oversight Committee passed, and referred to the full House, theFederal Reserve Transparency Act of 2014. This legislation is part of the legacy of the great former Representative Ron Paul. It popularly is known as “Audit the Fed.” How ironic that a mystery novel proves a device to dispel some of the Fed’s obscurantist mystery.
Novelist/reporter Matthew Quirk’s The Directive does for he Fed what Alan Drury did for Senate intrigue with his Pulitzer Prize winning Advise and Consent, what Aaron Sorkin did for the White House in The West Wing and, now, what Beau Willimon, is doing for the Congress with House of Cards. Quirk takes the genre of political thriller into virgin territory: the Fed. Make to mistake. Engaging the popular imagination has political potency. As Victor Hugo, nicely paraphrased, observed: Nothing is as powerful as an idea whose time has come.
Quirk, according to his website,“studied history and literature at Harvard College. After graduation, he spent five years at The Atlantic reporting on crimes, private military contractors, the opium trade, terrorism prosecutions, and international gangs.” His background shows. Quirk’s writings drips with the kind of eye for the telling detail that only a canny reporter, detective, or spy possesses. (Readers will learn, just in passing, the plausible identity of the mysterious “secure undisclosed location” where the vice president was secreted following 9/11.)
If you like Ludlum you are certain to like Quirk. And who isn’t intrigued by such a mysteriously powerful entity as the Fed? Booklist calls The Directive a “nonstop heart-pounding ride in which moral blacks and whites turn gray in the ‘efficient alignment of power and interests’ that is big time politics.” Amen.
The Directive describes an effort to rob the biggest bank in the world. The object of the heist is not the tons of gold secured in the basement of 33 Liberty Street. (As Ian Fleming pointed out, in Goldfinger it logistically is impossible to move the mass of so much gold quickly enough to effect a robbery.) Rather, Quirk uses as his literary device, with a touch of dramatic license, the interception of the Federal Open Market Committee’s directive to the trading desk of the Federal Reserve Bank of New York to raise (or lower) interest rates in order to use that insider information to make a fast killing.
Lest anyone doubt the power of such insider information consider William Safire’s report, from his White House classic memoir Before the Fall, of the weekend at Camp David before Nixon “closed the gold window.”
After the Quadriad meeting, the President remained alone while the rest of the group dined at the Laurel Cabin. The no-phone-calls edict was still in force, raising some eyebrows of men who had shown themselves to be trustworthy repositories of events. but the 6’8″, dour Treasury Under Secretary Volcker explained a different dimension to the need for no leaks: “Fortunes could be made with this information.” Haldeman, mock-serious, leaned forward and whispered loudly, “Exactly how?” The tension broken, Volcker asked Schulz, “How much is your budget deficit?” George estimated, “Oh, twenty three billion or so — why?” Volcker looked dreamily at the ceiling. “Give me a billion dollars and a free hand on Monday, and I could make up that deficit in the money markets.”
Safire provides context making Volcker’s integrity indisputable lest anyone be tempted to misinterpret this as a trial balloon.
This columnist has been inside the headquarters of the Fed, including, many years ago, the boardroom. Quirk:
Every eight weeks or so, a committee gathers near the National Mall in a marble citadel known as the Board of Governors of the Federal Reserve. Twenty-five men and women sit at a long wooden table with an inset of black stone shined to a high gloss. By noon they decide the fate of the American economy.
This columnist never has stepped foot inside the Federal Reserve Bank of New York, much less its trading floor(s). Few have entered that sanctum sanctorum. By taking his readers inside Quirk provides his readers a narrative grasp to how the Fed does what it does.
[T]he Fed is by design very friendly to large New York banks. When the committee in DC decides what interest rates should be, they can’t simply dictate them to the banks. They decide on a target interest, and then send the directive to the trading desk at the New York Fed to instruct them about how to achieve it. The traders upstairs go into the markets and wheel and deal with the big banks, buying and selling Treasury bills and other government debts, essentially IOUs from Uncle Sam. When the Fed buys up a lot of those IOUs, they flood the economy with money; when they sell them, they take money out of circulation.
They are effectively creating and destroying cash. By shrinking or expanding the supply of money in the global economy, making it more or less scarce, they also make it more or less expensive to borrow; the interest rate. In this way, trading back and forth with the largest banks in the world, they can drive interest rates toward their target.
The amount of actual physical currency in circulation is only a quarter of the total monetary supply. The rest is just numbers on a computer somewhere. When people say the government can print as much money as it wants, they’re really talking about the desk doing its daily work of resizing the monetary supply—tacking zeros onto a bunch of electronic accounts—that big banks are allowed to lend out to you and me.
Every morning, on the ninth floor of the New York Fed, the desk gets ready to go out and manipulate the markets according to the instructions laid out in the directive. Its traders are linked by computer with twenty-one of the largest banks in the world. When they’re ready to buy and sell, in what are called open market operation, one trader presses a button on his terminal and three chimes — the notes F-E-D — sound on the terminals of his counterparties. Then they’re off to the races.
There are usually eight to ten people on that desk, mostly guys in their late twenties and early thirties, and they manage a portfolio of government securities worth nearly $4 trillion that backs our currency. Without it, the bills in your wallet would be as worthless as Monopoly cash. The traders on that floor carry out nearly $5.5 billion in trades per day, set the value of every penny you earn or spend, and steer the global economy.
As Quirk recently told Matthew Yglesias, at Vox.com:
I was casting about for the biggest hoards of money in the world, and you get to the Federal Reserve Bank in New York fairly quickly. But that’s been done. Then I learned more and more about the trading desk, and my mind was blown.
You get to have this great line where you say, “There’s $300 billion worth of gold in the basement, but the real money is on the ninth floor.” …
I was a reporter in Washington for a while, and I thought, “Oh, the Fed sets interest rates,” because that’s always what people say. But as you dig into it, you realize that the Fed just has to induce interest rates to where they want to be. They have to trade back and forth with these 19 or 20 banks, and they have 8‑10 guys at this trading desk, trading about $5.5 billion a day. That’s actually how the government prints money and expands and contracts the monetary supply.
It’s this high wire act. You explain it to people and they say, “Oh, it’s a conspiracy thriller.” You say, “No, no. That’s the real part. I haven’t gotten to the conspiracy yet.” But it’s a miracle that it works.
Quirk’s own dual mandate? Combine fast-paced drama with a peek behind the scenes of the world’s biggest bank, providing vivid entertainment while teaching more about the way that one of the most powerful and mysterious institutions in the world works. In The Directive Matthew Quirk shakes, rather than stirs, his readers brilliantly.
Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/08/04/signs-of-the-feds-era-of-secrecy-coming-to-an-end/
At the end of July global equity bull markets had a moment of doubt, falling three or four per cent. In the seven trading days up to 1st August the S&P500 fell 3.8%, and we are not out of the woods yet. At the same time the Russell 2000, an index of small-cap US companies fell an exceptional 9%, and more worryingly it looks like it has lost bullish momentum as shown in the chart below. This indicates a possible double-top formation in the making.
Meanwhile yield-spreads on junk bonds widened significantly, sending a signal that markets were reconsidering appropriate yields on risky bonds.
This is conventional analysis and the common backbone of most brokers’ reports. Put simply, investment is now all about the trend and little else. You never have to value anything properly any more: just measure confidence. This approach to investing resonates with post-Keynesian economics and government planning. The expectations of the crowd, or its animal spirits, are now there to be managed. No longer is there the seemingly irrational behaviour of unfettered markets dominated by independent thinkers. Forward guidance is just the latest manifestation of this policy. It represents the triumph of economic management over the markets.
Central banks have for a long time subscribed to management of expectations. Initially it was setting interest rates to accelerate the growth of money and credit. Investors and market traders soon learned that interest rate policy is the most important factor in pricing everything. Out of credit cycles technical analysis evolved, which sought to identify trends and turning points for investment purposes.
Today this control goes much further because of two precedents: in 2001-02 the Fed under Alan Greenspan’s chairmanship cut interest rates specifically to rescue the stock market out of its slump, and secondly the Fed’s rescue of the banking system in the wake of the Lehman crisis extended direct intervention into all financial markets.
Both of these actions succeeded in their objectives. Ubiquitous intervention continues to this day, and is copied elsewhere. It is no accident that Spanish bond yields for example are priced as if Spain’s sovereign debt is amongst the safest on the planet; and as if France’s bond yields reflect a credible plan to repay its debt.
We have known for years that through intervention central banks have managed to control the prices of currencies, precious metals and government bonds; but there is increasing evidence of direct buying of other financial assets, including equities. The means for continual price management are there: there are central banks, exchange stabilisation funds, sovereign wealth funds and government-controlled pension funds, which between them have limitless buying-power.
Doubtless there is a growing band of central bankers who believe that with this control they have finally discovered Keynes’s Holy Grail: the euthanasia of the rentier and his replacement by the state as the primary source of business capital. This being the case, last month’s dip in the markets will turn out to be just that, because intervention will simply continue and if necessary be ramped up.
But in the process, all market risk is being transferred from bonds, equities and all other financial assets into currencies themselves; and it is the outcome of their purchasing power that will prove to be the final judgement in the debate of markets versus economic planning.
“I say to all those who bet against Greece and against Europe: You lost and Greece won. You lost and Europe won.” –Jean-Claude Juncker, former prime minister of Luxembourg and president of the Eurogroup of EU Finance Ministers, 2014
“We have indeed at the moment little cause for pride: As a profession we have made a mess of things.” –Friedrich Hayek, Nobel Laureate in Economic Science, 1974
Jean-Claude Juncker is a prominent exception to the recent trend of economic and monetary officials openly expressing doubt that their interventionist policies are producing the desired results. In recent months, central bankers, the International Monetary Fund, the Bank for International Settlements, and a number of prestigious academic economists have expressed serious concern that their policies are not working and that, if anything, the risks of another 2008-esque global financial crisis are building. Thus we have arrived at a ‘Crisis of Interventionism’ as the consequences of unprecedented monetary and fiscal stimulus become evident, fuelling a surge in economic nationalism around the world, threatening the end of globalisation and the outbreak of trade wars. Indeed, a tech trade war may already have started. This is is perhaps the least appreciated risk to financial markets at present. How should investors prepare?
THE FATAL CONCEIT
Friedrich Hayek was the first Austrian School economist to win the Nobel Memorial Prize in Economic Science. Yet Hayek took issue with the characterisation of modern economics as a ‘science’ in the conventional sense. This is because the scientific method requires theories to be falsifiable and repeatable under stable conditions. Hayek knew this to be impossible in the real world in which dynamic, spontaneous human action takes place in response to an incalculable number of exogenous and endogenous variables.
Moreover, Hayek believed that, due to the complexity of a modern economy, the very idea that someone can possibly understand how it works to the point of justifying trying to influence or distort prices is nonsensical in theory and dangerous in practise. Thus he termed such hubris in economic theory ‘The Pretence of Knowledge’ and, in economic policy, ‘The Fatal Conceit’.
History provides much evidence that Hayek was correct. Interventionism has consistently failed either to produce the desired results or has caused new, unanticipated problems, such as in the 1920s and 1930s, for example, an age of particularly active economic policy activism in most of the world. Indeed, as Hayek wrote in his most famous work, The Road to Serfdom, economic officials tend to respond to the unintended consequences of their failed interventions with ever more interventionism, eventually leading to severe restrictions of economic liberty, such as those observed under socialist or communist regimes.
Hayek thus took advantage of his Nobel award to warn the economics profession that, by embracing a flawed, ‘pseudo-scientific method’ to justify interventionism, it was doing itself and society at large a great disservice:
The conflict between what in its present mood the public expects science to achieve in satisfaction of popular hopes and what is really in its power is a serious matter because, even if the true scientists should all recognize the limitations of what they can do in the field of human affairs, so long as the public expects more there will always be some who will pretend, and perhaps honestly believe, that they can do more to meet popular demands than is really in their power. It is often difficult enough for the expert, and certainly in many instances impossible for the layman, to distinguish between legitimate and illegitimate claims advanced in the name of science…
If we are to safeguard the reputation of economic science, and to prevent the arrogation of knowledge based on a superficial similarity of procedure with that of the physical sciences, much effort will have to be directed toward debunking such arrogations, some of which have by now become the vested interests of established university departments.
Hayek made these comments in 1974. If only the economics profession had listened. Instead, it continued with the pseudo-science, full-steam ahead. That said, by 1974 a backlash against traditional Keynesian-style intervention had already begun, led by, among others, Milton Friedman. But Friedman too, brilliant as he no doubt was, was seduced also by the culture of pseudo-science and, in his monetary theories, for which he won his Nobel prize in 1976, he replaced a Keynesian set of unscientific, non-falsifiable, intervention-justifying equations with a Monetarist set instead.
Economic interventionism did, however, fall out of intellectual favour following the disastrous late-1970s stagflation and subsequent deep recession of the early 1980s—in the US, the worst since WWII. It never really fell out of policy, however. The US Federal Reserve, for example, facilitated one bubble after another in US stock and/or property prices in the period 1987-2007 by employing an increasingly activist monetary policy. As we know, this culminated in the spectacular events of 2008, which unleased a global wave of intervention unparalleled in modern economic history.
THE KEYNESIANS’ NEW CLOTHES
Long out of fashion, Keynesian theory and practice returned to the fore as the 2008 crisis unfolded. Some boldly claimed at the time that “we are all Keynesians now.” Activist economic interventionism became the norm across most developed and developing economies. In some countries, this has taken a more fiscal policy form; in others the emphasis has been more on monetary policy. Now six years on, with most countries still running historically large fiscal deficits and with interest rates almost universally at or near record lows, it is entirely understandable that the economics profession is beginning to ask itself whether the interventions it recommended are working as expected or desired.
While there have always been disputes around the margins of post-2008 interventionist policies, beginning in 2012 these became considerably more significant and frequent. In a previous report, THE KEYNESIANS’ NEW CLOTHES, I focused on precisely this development:
In its most recent World Economic Outlook, the International Monetary Fund (IMF) surveys the evidence of austerity in practice and does not like what it finds. In particular, the IMF notes that the multiplier associated with fiscal tightening seems to be rather larger than they had previously assumed. That is, for each unit of fiscal tightening, there is a greater economic contraction than anticipated. This results in a larger shrinkage of the economy and has the unfortunate result of pushing up the government debt/GDP ratio, the exact opposite of what was expected and desired.
While the IMF might not prefer to use the term, what I have just described above is a ‘debt trap’. Beyond a certain point an economy has simply accumulated more debt than it can pay back without resort to currency devaluation. (In the event that a country has borrowed in a foreign currency, even devaluation won’t work and some form of restructuring or default will be required to liquidate the debt.)
The IMF is thus tacitly admitting that those economies in the euro-area struggling, and so far failing, to implement austerity are in debt traps. Austerity, as previously recommended by the IMF, is just not going to work. The question that naturally follows is, what will work?
Well, the IMF isn’t exactly sure. The paper does not draw such conclusions. But no matter. If austerity doesn’t work because the negative fiscal multiplier is larger than previously assumed, well then for now, just ease off austerity while policymakers consider other options. In other words, buy time. Kick the can. And hope that the bond markets don’t notice.
Now, nearly two years later, the IMF has been joined in its doubts by a chorus of economic officials and academics from all over the world increasingly concerned that their interventions are failing and, in some cases, putting forth proposals of what should be done.
Let’s start with the Bank of England. Arguably the most activist central bank post-2008, as measured by the expansion of its balance sheet, several members of the Banks’ Monetary Policy Committee have expressed concern about the risks to financial stability posed by soaring UK property prices, a lack of household savings and a financial sector that remains highly leveraged. In a recent speech, BoE Chief Economist Charlie Bean stated that:
[T]he experience of the past few years does appear to suggest that monetary policy ought to take greater account of financial stability concerns. Ahead of the crisis, Bill White and colleagues at the Bank for International Settlements consistently argued that when leverage was becoming excessive and/or asset prices misaligned, central bankers ought to ‘lean against the wind’ by keeping interest rates higher than necessary to meet the price stability objective in the short run. Just as central banks are willing to accept temporary deviations from their inflation targets to limit output volatility, so they should also be willing to accept temporary deviations to attenuate the credit cycle. Essentially it is worth accepting a little more volatility in output and inflation in the short run if one can thereby reduce the size or frequency of asset-price busts and credit crunches.
In other words, perhaps central bank policy should change focus from inflation targeting, which demonstrably failed to prevent 2008, and instead to focus on money and credit growth. This is clearly an anti-Kenyesian view in principle, although one wonders how it might actually work in practice. In closing, he offered these thoughts:
I opened my remarks tonight by observing that my time at the Bank has neatly fallen into two halves. Seven years of unparalleled macroeconomic stability have been followed by seven years characterised by financial instability and a deep recession. It was a salutary lesson for those, like me, who thought we had successfully cracked the problem of steering the economy, and highlighted the need to put in place an effective prudential framework to complement monetary policy. Policy making today consequently looks a much more complex problem than it did fourteen years ago.
Indeed. Policy making does look increasingly complex. And not only to the staff of the IMF and to Mr Bean, but also to the staff at the Bank for International Settlements, to which Mr Bean referred in his comments. In a recent speech, General Manager of the BIS, Jaime Caruana, taking a global view, expressed fresh concern that:
There is considerable evidence that, for the world as a whole, policy interest rates have been persistently below traditional benchmarks, fostering unbalanced expansions. Policy rates are comparatively low regardless of the benchmarks – be these trend growth rates or more refined ones that capture the influence of output and inflation… Moreover, there is clear evidence that US monetary policy helps explain these deviations, especially for small open and emerging market economies. This, together with the large accumulation of foreign exchange reserves, is consistent with the view that these countries find it hard, economically or politically, to operate with rates that are considerably higher than those in core advanced economies. And, alongside such low rates, several of these economies, including some large ones, have been exhibiting signs of a build-up of financial imbalances worryingly reminiscent of that observed in the economies that were later hit by the crisis. Importantly, some of the financial imbalances have been building up in current account surplus countries, such as China, which can ill afford to use traditional policies to boost domestic demand further. This is by no means new: historically, some of the most disruptive financial booms have occurred in current account surplus countries. The United States in the 1920s and Japan in the 1980s immediately spring to mind.
The above might not sound terribly controversial from a common-sense perspective but to those familiar with the core precepts of the neo-Keynesian mainstream, this borders on economic heresy. Mr Caruana is implying that the Great Depression was not caused primarily by the policy failures of the early 1930s but by the boom preceeding it and that the stagnation of Japan in recent decades also has its roots in an unsustainable investment boom. In both cases, these booms were the product of economic interventions in the form of inappropriately easy monetary policy. And whence does current inappropriate policy originate? Why, from the US Federal Reserve! Mr Caruana is placing the blame for the renewed, dangerous buildup of substantial global imbalances and associated asset bubbles specifically on the Fed!
Yet Mr Caruana doesn’t stop there. He concludes by noting that:
[T]he implication is that there has been too much emphasis since the crisis on stimulating demand and not enough on balance sheet repair and structural reforms to boost productivity. Looking forward, policy frameworks need to ensure that policies are more symmetrical over the financial cycle, so as to avoid the risks of entrenching instability and eventually running out of policy ammunition.
So now we have had the IMF observing that traditional policies aren’t working as expected; BoE Chief Economist Bean noting how policy-making has become ‘complex’; and BIS GM Caruana implying this is primarily due to the boom/bust policies of the US Federal Reserve. So what of the Fed itself? What have Fed officials had to say of late?
Arguably the most outspoken recent dissent of the policy mainstream from within the Fed is that from Jeffrey Lacker, President of the regional Richmond branch. In a recent speech, he voiced his clear opposition to growing central bank interventionism:
There are some who praise the Fed’s credit market interventions and advocate an expansive role for the Fed in promoting financial stability and mitigating financial system disruptions. They construe the founders of the Federal Reserve System as motivated by a broad desire to minimize and prevent financial panics, even beyond simply satisfying increased demand for currency. My own view, which I must note may not be shared by all my colleagues in the Federal Reserve System, favors a narrower and more restrained role, focused on the critical core function of managing the monetary liabilities of the central bank. Ambitious use of a central bank’s balance sheet to channel credit to particular economic sectors or entities threatens to entangle the central bank in distributional politics and place the bank’s independence at risk. Moreover, the use of central bank credit to rescue creditors boosts moral hazard and encourages vulnerability to financial shocks.
By explicitly referencing moral hazard, Mr Lacker is taking on the current leadership of the Federal Reserve, now headed by Janet Yellen, which denies that easy money policies have had anything to do with fostering financial instability. But as discussed earlier in this report, the historical evidence is clear that Fed activism is behind the escalating boom-bust cycles of recent decades. And as Mr Caruana further suggests, this has been a global phenomenon, with the Fed at the de facto helm of the international monetary system due to the dollar’s global reserve currency role.
EURO ‘MISSION ACCOMPLISHED’? UH, NO
As quoted at the start of this report, Jean-Claude Juncker, prominent Eurocrat and politician, recently claimed victory in the euro-crisis. “Greece and Europe won.” And who lost? Why, those who bet against them in the financial markets by selling their debt and other associated assets.
But is it really ‘mission accomplished’ in Europe? No, and not by a long shot. Yes, so-called ‘austerity’ was absolutely necessary. Finances in many EU countries were clearly on an unsustainable course. But other than to have bought time through lower borrowing costs, have EU or ECB officials actually achieved anything of note with respect to restoring economic competitiveness?
There is some evidence to this effect, for example in Ireland, Portugal and Spain, comprising some 15% of the euro-area economy. However, there is also evidence to the contrary, most clearly seen in France, comprising some 20% of the euro-area. So while those countries under the most pressure from the crisis have made perhaps some progress, the second-largest euro member country is slipping at an accelerating rate into the uncompetitive abyss. Italy, for many years a relative economic underperformer, is not necessarily doing worse than before, but it is hard to argue it is doing better. (Indeed, Italy’s recent decision to distort its GDP data by including estimates for non-taxable black-market activities smacks of a desperate campaign to trick investors into believing its public debt burden is more manageable than it really is.)
There is also a surge in economic nationalism throughout the EU, as demonstrated by the remarkable surge in support for anti-EU politicians and parties. It is thus far too early for Mr Juncker to claim victory, although politicians are naturally given to such rhetoric. The crisis of interventionism in the euro-area may is not dissipating; rather, it is crossing borders, where it will re-escalate before long.
THE SHORT HONEYMOON OF ‘ABENOMICS’
Turning to developments in Japan, so-called ‘Abenomics’, the unabashedly interventionist economic policy set implemented by Prime Minister Abe following his election in late 2012, has already resulted in tremendous disappointment. Yes, the yen plummeted in late 2012 and early 2013, something that supposedly would restore economic competitiveness. But something happened on the way, namely a surge in import prices, including energy. Now Japan is facing not just economic stagnation but rising inflation, a nasty cocktail of ‘stagflation’. Not that this should be any surprise: Devaluing your way to prosperity has never worked, regardless of when or where tried, yet doing so in the face of structural economic headwinds is guaranteed to produce rising price inflation, just as it did in the US and UK during the 1970s.
With reality now having arrived, it will be interesting to see what Mr Abe does next. Will he go ‘all-in’ with even more aggressive yen devaluation? Or will he consider focusing on structural reform instead? Although I am hardly a Japan expert, I have travelled to the country regularly since the late 1990s and my sense is that the country is likely to slip right back into the ‘muddle through’ that characterised the economy during most of the past decade. Of course, in the event that another major global financial crisis unfolds, as I regard as inevitable in some form, Japan will be unable to avoid it, highly integrated as it is.
THE BUCK STOPS HERE: A ‘BRIC’ WALL
In my book, THE GOLDEN REVOLUTION, I document how the BRIC economies (Brazil, Russia, India, China, now joined by South Africa to make the BRICS) have been working together for years to try and reorient themselves away from mercantilist, dollar-centric, export-led economic development, in favour of a more balanced approach. Certainly they have good reasons to do so, as I described in a 2012 report, THE BUCK STOPS HERE: A BRIC WALL:
[T]he BRICS are laying the appropriate groundwork for their own monetary system: Bilateral currency arrangements and their own IMF/World Bank. The latter could, in principle, form the basis for a common currency and monetary policy. At a minimum it will allow them to buy much global influence, by extending some portion of their massive cumulative savings to other aspiring developing economies or, intriguingly, to ‘advanced’ economies in need of a helping hand and willing to return the favour in some way.
In my new book, I posit the possibility that the BRICS, amid growing global monetary instability, might choose to back their currencies with gold. While that might seem far-fetched to some, consider that, were the BRICS to reduce their dependence on the dollar without sufficient domestic currency credibility, they would merely replace one source of instability with another. Gold provides a tried, tested, off-the-shelf solution for any country or group of countries seeking greater monetary credibility and the implied stability it provides.
Now consider the foreign policy angle: The Delhi Declaration makes clear that the BRICS are not at all pleased with the new wave of interventionism in Syria and Iran. While the BRICS may be unable to pose an effective military opposition to combined US and NATO military power in either of those two countries, they could nevertheless make it much more difficult for the US and NATO to finance themselves going forward. To challenge the dollar is to challenge the Fed to raise interest rates in response. If the Fed refuses to raise rates, the dollar will plummet. If the Fed does raise interest rates, it will choke off growth and tax revenue. In either case, the US will find it suddenly much more expensive, perhaps prohibitively so, to carry out further military adventures in the Middle East or elsewhere.
While the ongoing US confrontations with Iran and Syria have been of concern to the BRICS for some time, of acute concern to member Russia of late has been the escalating crisis in Ukraine. The recent ‘Maidan’ coup, clearly supported by the US and possibly some EU countries, is regarded with grave concern by Russia, which has already taken action to protect its naval base and other military assets in the Crimea. Now several other Russian-majority Ukrainian regions are seeking either autonomy or independence. The street fighting has been intense at times. The election this past weekend confirming what Russia regards as an illegitimate, NATO-puppet government changes and solves nothing; it merely renders the dipute more intractable and a further escalation appears likely. (Russia is pressing Kiev as I write to allow it to begin providing humanitarian assistance to the rebellious regions, something likely to be denied.)
US economic sanctions on Russia have no doubt helped to catalyse the most recent BRICS initiative, in this case one specific to Russia and China, who have agreed a landmark 30-year gas deal while, at the same time, preparing the groundwork for the Russian banking system to handle non-dollar (eg yuan) payments for Russian gas exports. This is a specific but nevertheless essential step towards a more general de-dollarisation of intra-BRICS trade, which continues to grow rapidly.
The dollar’s international role had been in slow but steady decline for years, with 2008 serving to accelerate the process. The BRICS are now increasingly pro-active in reducing their dollar dependence. Russia has been dumping US dollar reserves all year and China is no longer accumulating them. India has recently eased restrictions on gold imports, something that is likely to reduce Indian demand for US Treasuries. (Strangely enough, and fodder for conspiracy theorists, tiny Belgium has stepped in to fill the gap, purchasing huge amounts of US Treasuries in recent months, equivalent to some $20,000 per household! Clearly that is not actually Belgian buying at all, but custodial buying on behalf of someone else. But on behalf of whom? And why?)
As I wrote in my book, amid global economic weakness, the so-called ‘currency wars’ naturally escalate. Competitive devaluations thus have continued periodically, such as the Abenomics yen devaluation of 2012-13 and the more recent devaluation of the Chinese yuan. As I have warned in previous reports, however, history strongly suggests that protracted currency wars lead to trade wars, which can be potentially disastrous in their effects, including on corporate profits and valuations.
THE END OF GLOBALISATION?
Trade wars are rarely labelled as such, at least not at first. Some other reason is normally given for erecting trade barriers. A popular such reason in recent decades has been either environmental or health concerns. For example, the EU and China, among other countries, have banned the import of certain genetically modified foods and seeds.
Rather than erect formal barriers, governments can also seek ways to subsidise domestic producers or exporters. While the World Trade Organisation (WTO) aims to prevent and police such barriers and subsidies, in practice it can take it years to effectively enforce such actions.
Well, there is now a new excuse for trade barriers, one specific to the huge global tech and telecommunications industry: Espionage. As it emerges that US-built and patented devices in widespread use around the world contain various types of ‘backdoors’ allowing the US National Security Agency to eavesdrop, countries are evaluating whether they should ban their use. Cisco’s CEO recently complained of losing market share to rivals due to such concerns. Somewhat ominously, China announced over the past week that it would prohibit public entities from using Microsoft Windows version 8 and would require banks to migrate away from IBM computer servers.
There has also been talk amongst the BRICS that they should build a parallel internet infrastructure to avoid routing information via the US, where it is now assumed to be automatically and systematically compromised. Given these concerns, it is possible that a general tech trade war is now breaking out under an espionage pretext. What a convenient excuse for protecting jobs: Protecting secrets! What do you think the WTO will have to say about that?
Imagine what a tech trade war would do to corporate profits. Name one major tech firm that does not have widely dispersed global supply chains, manufacturing operations and an international customer base. Amid rising trade barriers, tech firms will struggle to keep costs down. Beyond a certain point they will need to pass rising costs on to their customers. The general deflation of tech in recent decades will go into reverse. Imagine what that will do to consumer price inflation around the world.
Yes, a tech trade war would be devastating. Household, ‘blue-chip’ tech names might struggle to survive, much less remain highly profitable. And the surge in price inflation may limit the ability of central banks to continue with ultra-loose monetary policies, to the detriment also of non-tech corporate profits and financial health. This could lead into a vicious circle of reactionary protectionism in other industries, a historical echo of the ‘tit-for-tat’ trade wars of the 1930s that were part and parcel of what made the Great Depression such a disaster.
Given these facts, it is difficult to imagine that the outbreak of a global tech trade war would not result in a major equity market crash. Current valuations are high in a historical comparison and imply continued high profitability. Major stock markets, including the US, could easily lose half their value, even more if a general price inflation led central banks to tighten monetary conditions by more than financial markets currently expect. Of all the ‘black swans’ out there, a tech trade war is not only taking flight; it is also potentially one of the largest, short of a shooting war.
A SILVER LINING TO THE GLOOM AND DOOM
With equity valuations stretched and complacency rampant—the VIX volatility index dipped below 12 this week, a rare event indeed—now is the time to proceed with extreme caution. The possible outbreak of a tech trade war only adds to the danger. Buying the VIX (say, via an ETF) is perhaps the most straightforward way to insure an equity portfolio, but there are various ways to get defensive, as I discussed in my last report.
Where there is risk, however, there is opportunity, and right now there is a silver lining: With a couple of exceptions, metals prices are extremely depressed relative to stock market valuations. Arguably the most depressed is silver. Having slipped below $20/oz, silver has given up all of its previous, relative outperformance vs other metals from 2010-11. It thus appears cheap vs both precious and industrial metals, with silver being something of a hybrid between the two. Marginal production capacity that was brought on line following the 2010-11 price surge is now uneconomic and is shutting down. But the long slide in prices has now attracted considerable speculative short interest. If for any reason silver finds a reason to recover, the move is likely to be highly asymmetric.
Investors seeing an opportunity in silver can, of course, buy silver mining shares, either individually or through an ETF. A more aggressive play would be to combine a defensive equity market stance—say buying the VIX—with a long position in the miners or in the metal itself. My view is that such a position is likely to perform well in the coming months. (Please note that volatility of the silver price is normally roughly double that of the S&P500 index, so a market-neutral, non-directional spread trade would require shorting roughly twice as much of the S&P500 as the purchasing of silver. Also note, however, that correlations are unstable and thus must be dynamically risk-managed.)
As famed distressed-debt investor Howard Marks says, investing is about capturing asymmetry. Here at Amphora we aim to do precisely that. At present, there appears no better way to go about it than to buy silver, either outright or combined with a stock market short/underweight. From the current starting point, this could well be one of the biggest trades of 2014.
“Let us learn our lessons. Never, never, never believe any war will be smooth and easy, or that anyone who embarks on that strange voyage can measure the tides and hurricanes he will encounter. The statesman who yields to war fever must realise that once the signal is given, he is no longer the master of policy but the slave of unforeseeable and uncontrollable events.
“Antiquated War Offices, weak, incompetent or arrogant commanders, untrustworthy allies, hostile neutrals, malignant fortune, ugly surprises, awful miscalculations – all take their seats at the Council Board on the morrow of a declaration of war. Always remember, however sure you are that you can easily win, that there would not be a war if the other man did not think he also had a chance.”
Winston Churchill, ‘My Early Life’, quoted by Charles Lucas in a letter to the FT, 23rd July 2014.
And there is a war being conducted out there in the financial markets, too, a war between debtors and creditors, between governments and taxpayers, between banks and depositors, between the errors of the past and the hopes of the future. How can investors end up on the winning side ? History would seem to have the answers.
For history, read in particular James O’Shaughnessy’s magisterial study of market data, ‘What Works on Wall Street’ (hat-tip to Abbington Investment Group’s Peter Van Dessel). O’Shaughnessy offers rigorous analysis of innumerable equity market strategies, but we are instinctively and philosophically drawn most strongly towards the value factors highlighted hereafter.
The chart below shows the results accruing to various strategies across the All Stocks universe – all companies in the Standard & Poor’s Compustat database with market capitalisations above $150 million, a dataset which comprises between 4,000 and 5,000 individual companies. The analysis takes in over half a century’s worth of data.
Making the (fairly reasonable) assumption that the data in this study is sufficiently broad to mitigate the effects of shorter term market “noise”, the results are unequivocal. Buying stocks with high price-to-sales (PSR) ratios; buying stocks with high price / cashflow ratios; buying stocks with high price / book ratios; buying stocks with high price / earnings (PE) ratios; all of these are disastrous strategies relative to the performance of the broad index itself. Caution: these all happen to be ‘growth’ strategies.
Value of $10,000 invested in various strategies using the All Stocks universe, from January 1951 to December 2003
(Source: What Works on Wall Street by James P. O’Shaughnessy, Third Edition, McGraw-Hill 2005)
But the converse is also true – in spades. Buying stocks with low price-to-sales ratios; buying stocks with low price / book ratios; these are both outstandingly successful strategies over the longer term, converting that initial $10,000 into over $22 million in each case. Buying stocks on low price / cashflow ratios is also a winning strategy. The relatively simple ‘high yield’ and ‘low p/e’ strategies also comfortably outperform the broad market. Note that these are all ‘value’ strategies.
This leads O’Shaughnessy to question the legitimacy of the so-called Capital Asset Pricing Model, in which investors are compensated for taking more risk:
“..the higher risk of the high P/Es, price-to-book, price-to-cashflow, and PSRs went uncompensated. Indeed, each of the strategies significantly underperformed the All Stocks Universe.”
Perhaps the market is indeed less efficient than certain academics would have us believe. The world’s most successful investor, Warren Buffett, would seem to think so. As he was quoted in a 1995 issue of Fortune magazine,
“I’d be a bum on the street with a tin cup if the markets were always efficient.”
And note that careful addition of the word “always”. Buffett wasn’t even going so far as to suggest that the markets are never efficient, but rather that the patient investor can take advantage of Mr. Market’s occasional lapses into the realms of absurdity, whether in the form of bullishness or outright despair.
O’Shaughnessy frames the returns from these various ‘growth’ and ‘value’ strategies more explicitly in the chart below.
Compound average annual rates of return across various strategies for the 52 years ending in December 2003
(Source: What Works on Wall Street by James P. O’Shaughnessy, Third Edition, McGraw-Hill 2005)
Special pleaders on the part of ‘growth at any cost’ might argue that the time series is insufficient. But if 52 recent years – easily an investor’s lifetime – taking in at least two grinding bear markets are not enough, how much would be ?
Again, the conclusions are clear. Buying stocks on low price-to-sales ratios is a winner, tying with stocks on a low price-to-book ratio with an annualised return over the longer term of 15.95%. Low price-to-cashflow is also a stellar performer. Buying stocks with a high yield also beats the broad market, as does buying stocks with low price / earnings ratios. Again, these are all explicit ‘value’ strategies.
Since we appear to be living through something of a speculative bubble (a bubble inflated quite deliberately by explicit central bank action), it is worth recalling one prior instance of ‘growth’ outperforming. As O’Shaughnessy points out,
“Between January 1, 1997 and March 31, 2000, the 50 stocks from the All Stocks universe with the highest P/E ratios compounded at 46.69 percent per year, turning $10,000 into $34,735 in three years and three months. Other speculative names did equally as well, with the 50 stocks from All Stocks with the highest price-to-book ratios growing a $10,000 investment into $33,248, a compound return of 44.72 percent. All the highest valuation stocks trounced All Stocks over that brief period, leaving those focusing on the shorter term to think that maybe it really was different this time. But anyone familiar with past market bubbles knows that ultimately, the laws of economics reassert their grip on market activity. Investors back in 2000 would have done well to remember Horace’s Ars Poetica, in which he states: “Many shall be restored that are now fallen, and many shall fall that are now in honour.”
“For fall they did, and they fell hard. A near-sighted investor entering the market at its peak in March of 2000 would face true devastation. A $10,000 investment in the 50 stocks with the highest price-to-sales ratios from the All Stocks universe would have been worth a mere $526 at the end of March 2003..
“You must always consider risk before investing in strategies that buy stocks significantly different from the market. Remember that high risk does not always mean high reward. All the higher-risk strategies are eventually dashed on the rocks..”
This might seem to imply that there is safety simply in the avoidance of explicitly high-risk strategies, but we would go further. We would argue today that central bank bubble-blowing has made the entire market high-risk, with a broad consensus that with interest rates at 300-year lows and bonds hysterically overpriced and facing the prospect of interest rate rises to boot, stocks are now “the only game in town”. We concede that by a process of logic and elimination, selective stocks look way more attractive than most other traditional assets, but the emphasis has to be on that word “selective”. We see almost no attraction in stock markets per se, and we are interested solely in what might be called ‘special situations’ (notably, in ‘value’ and ‘deep value’ strategies) wherever they can be identified throughout the world. We note, in passing, that markets such as those of the US appear to be virtually bereft of such ‘value’ opportunities, whereas those in Asia and Japan seem to offer them in relative abundance. In this financial war, we would prefer to be on the side of the victors. If history is any guide, the identity of the losers seems to be self-evident.