Are major economies suffering from the deficiency of demand?

In his article “The curse of weak global demand”, Financial Times November 18, 2014, the economics columnist Martin Wolf wrote that today’s most important economic illness is chronic demand deficiency syndrome. Martin Wolf argues that despite massive monetary pumping by the central banks of US and EMU and the lowering policy interest rates to around zero both the US and the EMU economies have continued to struggle.

After reaching 1.0526 in Q1 2006 the US real GDP to its trend ratio fell to 0.966 by Q3 2011. By Q3 2014 the ratio stood at 0.98. The ratio of EMU real GDP to its trend after closing at 1.061 in Q1 2008 fell to 0.954 by Q3 2014.

Real GDP Ratios

Martin Wolf is of the view that what is needed is to raise the overall demand for goods and services in order to revive economies. He also holds that there is a need to revive consumer confidence that was weakened by the severe weakening of the financial system.

He is also of the view that there is a need for the banks to lift their lending in order to revive demand, which in turn, he suggests, will revive the economies in question. He also blames massive debt for the economic difficulties that the US and the EMU economies are currently experiencing.

Martin Wolf views the current economic illness as some mysterious and complex phenomena, which requires complex and non-conventional remedies.

We suggest that the essence of Wolf’s argument is erroneous. Here is why.

There is no such thing as deficiency of demand that causes economic difficulties. The heart of economic growth is the process of real wealth generation.

The stronger this process is the more real wealth can be generated and the stronger so-called economic growth becomes. What drives this process is infrastructure, or tools and machinery. With better infrastructure more and a better quality of goods and services i.e. real wealth, can be generated.

Take for instance a baker who has produced ten loaves of bread. Out of this he consumes one loaf and the other nine he saves.

He can exchange the saved bread for the services of a technician who will enhance the oven. With an improved oven the baker can now produce twenty loaves of bread. Now he can save more and use the larger savings pool to further invest in his infrastructure such as buying other tools that will lift the production and the quality of the bread.

Observe that the key for wealth generation is the ability to generate real wealth. This in turn is dependent on the allocation of the part of wealth towards the buildup and the enhancement of the infrastructure.

Also, note that if the baker were to decide to consume his entire production i.e. keeping his demand strong, then he would not be able to expand the production of bread (real wealth).

As time goes by his infrastructure would have likely deteriorated and his production would have actually declined.

The belief that an increase in the demand for bread without a corresponding increase in the infrastructure will do the trick is wishful thinking.

We suggest that there is no such thing as a scarce demand. Most individuals have unlimited desires for goods and services.

For instance, most individuals would prefer to live in nice houses rather than in small apartments.

Most people would like to have luxuries cars and be able to dine in good quality restaurants. What prevents them in achieving these various desires is the scarcity of means.

In fact as things stand most individuals have plenty of desires i.e. goals, but not enough means.

Unfortunately means cannot be generated by boosting demand. This will only increase goals but not means.

Contrary to the popular way of thinking we can conclude that demand doesn’t create supply but the other way around.

As we have seen by producing something useful i.e. bread, the baker can exchange it for the services of a technician and boost his infrastructure.

By means of the enhanced infrastructure the baker can generate more bread i.e. more means that will enable him to attain various other goals that previously were not reachable by him.

The current economic difficulties are the outcome of past and present reckless monetary and fiscal policies of central banks and governments.

It must be realized that neither central banks nor governments are wealth generating entities. All that they can set in motion is a process of real wealth redistribution by diverting real wealth from wealth generators towards non-wealth generating activities.

As long as the pool of real wealth is expanding the central bank and the government can get away with the myth that their policies can grow the economy.

Once however, the pool of wealth becomes stagnant or starts shrinking the illusion of the central bank and government policies are shattered.

It is not possible to expand real wealth whilst the pool of real wealth is shrinking. Again a shrinking pool of wealth over time can only support a shrinking infrastructure and hence a reduced production of goods and services that people require to maintain their life and well being – real wealth.

The way out of the current economic mess is to close all the loopholes of wealth destruction. This means to severely cut government involvement with the economy. It also, requires closing all the loopholes for the creation of money out of “thin air”.

By curtailing the central bank’s ability to boost money out of “thin air” the exchange of nothing for something will be arrested. This will leave more real wealth in the hands of wealth generators and will enable them to enhance and to expand the wealth generating infrastructure.

Contrary to Martin Wolf the expanding of bank loans as such is not going to revive the economy. As we have seen the key for the economic revival is the buildup of infrastructure that could support an expanding pool of real wealth.

Banks are just the facilitators in the channeling of real wealth. However, they do not generate real wealth as such.

The lending expansion that Martin Wolf suggests is associated with fractional reserve lending i.e. lending out of “thin air” and in this respect it is bad news for the economy – it sets in motion the diversion of real wealth from wealth generators to non wealth generating activities.

We can conclude that the sooner governments and central banks will start doing nothing the sooner economic revival will emerge. We agree with Martin Wolf that the economic situation currently seems to be difficult; however, it cannot be improved by artificially boosting the demand for goods and services.

Summary and conclusion

Some experts are of the view that today’s most important economic illness is chronic demand deficiency syndrome. It is because of this deficiency that world economies are still struggling despite massive monetary pumping by central banks, or so it is held. We suggest that this way of thinking is erroneous. The key problem today is a severe weakening in the wealth generation process. The main reason for this is reckless monetary and government policies. We hold that the sooner central banks and governments start doing nothing the sooner economic revival will occur.


“Smacking a skunk with a tennis racket”

“Finally, as expectations of rapid inflation evaporate, I want to contribute to the debate about the November 15, 2010 letter signed by 23 US academics, economists and money managers warning on the Fed’s QE strategy. Bloomberg News did what I would call a hatchet job on the signatories essentially saying how wrong they have been and seeking their current views. It certainly made for an entertaining read. Needless to say, shortly afterwards Paul Krugman waded in with his typically understated style to twist the knife in still deeper. Cliff Asness, one of the signatories of the original letter, despite observing that “responding to Krugman is as productive as smacking a skunk with a tennis racket. But, sometimes, like many unpleasant tasks, it’s necessary”, penned a rather wittyresponse. Do read these articles at your leisure. But having been one of the few to accurately predict the deflation quagmire into which we have now sunk, I believe I am more entitled than many to have a view on this subject. Had I been asked I would certainly have signed the letter and would still sign it now. The unfolding deflationary quagmire into which we are sinking will get worse and there will be more Fed QE. But do I think QE will solve our problems? I certainly do not. I think ultimately it will make things far, far worse.”


–       SocGen’s Albert Edwards, ‘Is the next (and last) phase of the Ice Age now upon us ?’ (20 November 2014)



On Monday 15th November 2010, the following open letter to Ben Bernanke was published:

“We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued.  We do not believe such a plan is necessary or advisable under current circumstances.  The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.

“We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.”  In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.

“We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.

“The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.”

Among the 23 signatories to the letter were Cliff Asness of AQR Capital, Jim Chanos of Kynikos Associates, Niall Ferguson of Harvard University, James Grant of Grant’s Interest Rate Observer, and Seth Klarman of Baupost Group.

Words matter. Their meanings matter. Since we have a high degree of respect for the so-called Austrian economic school, we will use Mises’ own definition of inflation:

“ increase in the quantity of money.. that is not offset by a corresponding increase in the need for money.”

In other words, inflation has already occurred, inasmuch as the Federal Reserve has increased the US monetary base from roughly $800 billion, pre-Lehman Crisis, to roughly $3.9 trillion today.

What the signatories likely meant when they referred to inflation in their original open letter to Bernanke was the popular interpretation of the word – that second-order rise in the prices of goods and services that typically follows aggressive base money inflation. Note, as many of them observed when prodded by Bloomberg’s yellow journalists, that their original warning carried no specific date on which their inflation might arise. To put it in terms which Ben Bernanke himself might struggle to understand, just because something has not happened during the course of four years does not mean it will never happen. We say this advisedly, given that the former central bank governor himself made the following observation in response to a question about the US housing market in July 2005:

“INTERVIEWER: Tell me, what is the worst-case scenario? Sir, we have so many economists coming on our air and saying, “Oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.” Some say it could even cause a recession at some point. What is the worst-case scenario, if in fact we were to see prices come down substantially across the country?

“BERNANKE: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So what I think is more likely is that house prices will slow, maybe stabilize: might slow consumption spending a bit. I don’t think it’s going to drive the economy too far from its full employment path, though.” [Emphasis ours.]

To paraphrase Ben Bernanke, “We’ve never had a decline in house prices on a nationwide basis – therefore we never will.”

One more quote from Mises is relevant here, when he warns about the essential characteristic of inflation being its creation by the State:

“The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague.Inflation is a policy.”

Many observers of today’s financial situation are scouring the markets for evidence of second-order inflation (specifically, CPI inflation) whilst either losing sight of, or not even being aware of, the primary inflation, per the Austrian school definition.

James Grant, responding to Bloomberg, commented:

“People say, you guys are all wrong because you predicted inflation and it hasn’t happened. I think there’s plenty of inflation – not at the checkout counter, necessarily, but on Wall Street.”

“The S&P 500 might be covering its fixed charges better, it might be earning more Ebitda, but that’s at the expense of other things, including the people who saved all their lives and are now earning nothing on their savings.”

“That to me is the principal distortion, is the distortion of the credit markets. The central bankers have in deeds, if not exactly in words – although I think there have been some words as well – have prodded people into riskier assets than they would have had to purchase in the absence of these great gusts of credit creation from the central banks. It’s the question of suitability.”

And from the vantage point of November 2014, only an academic could deny that the signatories were wholly correct to warn of the financial market distortion that ensues from aggressive money printing.

Ever since Lehman Brothers failed and the Second Great Depression began, like every other investor on the planet we have wrestled with the arguments over inflation (as commonly understood) versus deflation. Now some of the fog has lifted from the battlefield. Despite the creation of trillions of dollars (and pounds and yen) in base money, the forces of deflation – a.k.a. the financial markets – are in the ascendancy, testimony to the scale of private sector deleveraging that has occurred even as government money and debt issuance have gone into overdrive. And Albert Edwards is surely right that as the forces of deflation worsen, they will be met with ever more aggressive QE from the Fed and from representatives of other heavily indebted governments. This is not a recipe for stability. This is the precursor to absolute financial chaos.

Because the price of every tradeable financial asset is now subject to the whim and caprice of government, rational macro-economic analysis (i.e. top-down investing and asset allocation) has become impossible. Only bottom-up analysis now offers any real potential for adding value at the portfolio level. We discount the relevance of debt instruments almost entirely, but we continue to see merit in listed businesses run by principled and shareholder-friendly management, where the shares of those businesses trade at a significant discount to any fair assessment of their underlying intrinsic value. A word of caution is warranted – these sort of value opportunities are vanishingly scarce in the US markets, precisely because of the distorting market effects of which the signatories to the November 2010 letter warned; today, value investors must venture much further afield. The safe havens may be all gone, but we still believe that pockets of inherent value are out there for those with the tenacity, conviction and patience to seek them out.


Should economics emulate natural sciences?

Economists have always been envious of the practitioners of the natural and exact sciences. They have thought that introducing the methods of natural sciences such as laboratory where experiments could be conducted could lead to a major break-through in our understanding of the world of economics.
But while a laboratory is a valid way of doing things in the natural sciences, it is not so in economics. Why is that so?
A laboratory is a must in physics, for there a scientist can isolate various factors relating to the object of inquiry.
Although the scientist can isolate various factors he doesn’t, however, know the laws that govern these factors.
All that he can do is hypothesize regarding the “true law” that governs the behaviour of the various particles identified.
He can never be certain regarding the “true” laws of nature. On this Murray Rothbard wrote,
The laws may only be hypothecated. Their validity can only be determined by logically deducing consequents from them, which can be verified by appeal to the laboratory facts. Even if the laws explain the facts, however, and their inferences are consistent with them, the laws of physics can never be absolutely established. For some other law may prove more elegant or capable of explaining a wider range of facts. In physics, therefore, postulated explanations have to be hypothecated in such a way that they or their consequents can be empirically tested. Even then, the laws are only tentatively rather than absolutely valid.1
Contrary to the natural sciences, the factors pertaining to human action cannot be isolated and broken into their simple elements.

However, in economics we have certain knowledge about certain things, which in turn could help us to understand the world of economics.
For instance, we know that an increase in money supply results in an exchange of nothing for something. It leads to a diversion of wealth from wealth generators to non wealth generating activities. This is certain knowledge and doesn’t need to be verified.
We also know that for a given amount of goods an increase in money supply all other things being equal must lead to more money paid for a unit of a good –an increase in the prices of goods. (Remember a price is the amount of money per unit of a good).
We also know that if in the country A money supply grows at a faster pace than money supply in the country B then over time, all other things being equal, the currency of A must depreciate versus the currency of B. This knowledge emanates from the law of scarcity.
Hence for something that is certain knowledge, there is no requirement for any empirical testing.
How this certain knowledge can be applied?
For instance, if we observe an increase in money supply – we can conclude that this resulted in a diversion of real wealth from wealth generators to non-wealth generating activities. It has resulted in the weakening of the wealth generating process.
This knowledge however, cannot tell us about the state of the pool of real wealth and when the so-called economy is going to crumble.
Whilst we can derive certain conclusions from some factors, however, the complex interaction of various factors means that there is no way for us to know the importance of each factor at any given point in time.
Some factors such as money supply – because it operates with a time lag, could provide us with useful information about the future events – such as boom-bust cycles and price inflation.
(Note that a change in money supply doesn’t affect all the markets instantly. It goes from one individual to another individual – from one market to another market. It is this that causes the time lag from changes in money and its effect on various markets).
Contrary to the natural sciences, in economics, by means of the knowledge that every effect must have a cause and by means of the law of scarcity (the more we have of something the less valuable it becomes), we can derive the entire body of economics knowledge.
This knowledge, once derived, is certain and doesn’t need to be verified by some kind of laboratory.


1. Murray N. Rothbard, “Towards a Reconstruction of Utility and Welfare Economics”, On Freedom and Free Enterprise: The Economics of Free Enterprise, May Sennholz, ed. (Princeton, N.J.: D.Van Nostrand, 1956), p3.


That G20 meeting

G20 gatherings of world leaders on the surface are all the same: they conclude with a meaningless anodyne statement that everyone can agree with. But these meetings do serve a purpose: they allow the world leaders to meet informally and exchange views.

Since the last G20 in St Petersburg in 2013 when there was a high degree of conviction that economic growth would return, the global economic outlook has instead deteriorated significantly. Instead of last time’s mutual bonhomie over the prospect of their collective success, the world’s leaders this time are almost certainly worried. They would have learned about the failure of monetary policy everywhere. They would have had this first-hand from Japan’s delegation, which is on its way to financial and currency destruction. The despair in the European delegations would have been obvious as well.

The problem is that post-war monetary theories have failed to deliver. Lower interest rates and increased quantities of money in order to promote economic growth no longer work. The abandonment of the laws of the markets in favour of stimulating consumer demand by monetary means has turned out to be a blind alley. Time will tell, but if the global economy is heading for a slump, the banking system will become overburdened with defaulting borrowers, and government deficits will rise uncontrollably, especially in the welfare nations. This cannot be permitted to happen under any circumstances. It is therefore quite likely that the alternative to monetary-driven policy, accelerated government deficit spending as a pre-emptive measure, will be tried instead. And in this respect the relative success of the British and American economies will be attributed to their large budget deficits, while the misery of austerity is identified with the problems in France and the southern Eurozone.

These are bad and confused arguments, but they will be emotionally attractive to the political class, while the central bankers probably feel it is time the politicians took responsibility for economic management. Furthermore, it is surely becoming obvious that monetary solutions only enrich the bankers. And the most effective way of countering deflation, economists will argue, will be for demand-led price rises for consumer products, which have a better chance of coming about through increased government spending. And do not be surprised if economists argue that governments need to take over the debt-creation process to kick-start the business cycle.

We might look back on Brisbane as a milestone in global economic policy, when governments and central banks changed the emphasis of economic management from monetary stimulation through the financial system towards a greater emphasis on direct government intervention. In the process two things are likely to happen: currencies will begin to lose their purchasing power with respect to everyday goods, and government bond yields are likely to rise, undermining financial asset valuations.

This will certainly puff up GDP, because government spending is a significant part of it. But the idea that controlled price inflation can be engineered flies in the face of all experience. If the emphasis does shift from monetary solutions towards more aggressive government spending the risk will also shift towards an uncontrollable decline in purchasing power for currencies. It will be very good for inflation hedges like gold.


Bank gearing in the Eurozone

According to the ECB’s Bank Lending Survey for October banks eased their credit standards in the last quarter, while their risk perceptions increased.

This apparent contradiction suggests that the 137 banks surveyed were at the margin competing for lower-quality business, hardly the sign of a healthy lending market. Furthermore, the detail showed enterprises were cutting borrowing for fixed investment sharply and required more working capital instead to finance inventories and perhaps to cover trading losses.

This survey follows bank lending statistics since the banking crisis to mid-2014, which are shown in the chart below (Source: ECB).

Euro bank lending 14112014

It is likely that some of the contraction in bank lending has been replaced with bond finance by the larger credit-worthy corporations, and Eurozone banks have also preferred buying sovereign bonds. Meanwhile, the Eurozone economy obviously faces a deepening crisis.

There are some global systemically important banks (G-SIBs) based in the Eurozone, and this week the Financial Stability Board (FSB) published a consultation document on G-SIBs’ capital ratios in connection with the bail-in procedures to be considered at the G20 meeting this weekend. The timing is not helpful for the ECB, because the FSB’s principle recommendation is that G-SIBs’ Tier 1 and 2 capital should as a minimum be double the Basel III level. This gives operational leverage of between 5 and 6.25 times risk-weighted assets, compared with up to 12.5 times under Basel III.

The FSB expects the required capital increase to be satisfied mostly by the issue of qualifying debt instruments, so the G-SIBs will not have to tap equity markets. However, since Eurozone G-SIBs are faced with issuing bonds at higher interest rates than the returns on sovereign debt, they will be tempted to scale back their balance sheets instead. Meanwhile bank depositors should note they are no longer at the head of the creditors’ queue when their bank goes bust, which could affect the non-G-SIB banks with higher capital ratios.

If G-SIBs can be de-geared without triggering a bank lending crisis the world of finance should eventually be a safer place: that’s the intention. Unfortunately, a bail-in of a large bank is unlikely to work in practice, because if an important bank does go to the wall, without the limitless government backing of a bail-out, money-markets will almost certainly fail to function in its wake and the crisis could rapidly become systemic.

Meanwhile, it might appear that the ECB is a powerless bystander watching a train-wreck in the making. Businesses in the Eurozone appear to only want to borrow to survive, as we can see from the October Bank Lending Survey. Key banks are now being told to halve their balance sheet gearing, encouraging a further reduction in bank credit. Normally a central bank would respond by increasing the quantity of narrow money, which the ECB is trying to do despite the legal hurdles in its founding constitution.

However, it is becoming apparent that the ECB’s intention to increase its balance sheet by up to €1 trillion may not be nearly enough, given that the FSB’s proposals look like giving an added spin to contraction of bank credit in the Eurozone.


Brave new world

“Sir, Adair Turner suggests some version of monetary financing is the only way to break Japan’s deflation and deal with the debt overhang (“Print money to fund the deficit – that is the fastest way to raise rates”, Comment, November 11). This was precisely how Korekiyo Takahashi, Japanese finance minister from 1931 to 1936, broke the deflation of the 1930s. The policy was discredited because of the hyperinflation that followed.”

–       Letter to the Financial Times, 11th November 2014. Emphasis ours. Name withheld to protect the innocent.



“Don’t need to read the book – here is the premise. Business dreams are nothing more than greed. And you greedy business people should pay for those who are not cut out to take risk. You did not build your business – you owe everyone for your opportunity – you may have worked harder, taken more risk and even failed and picked yourself up at great personal risk and injury     (yes we often lose relationships and loved ones fall out along the way). However, none the less you are not entitled to what you make. Forget the fact that the real reason we have massive wealth today is we can now reach the global consumers – not just local – so the numbers are larger. Nonetheless the fact is that is not fair – and fair is something life now guarantees – social engineers demand that you suspend the laws of nature and reward all things equally. 2 plus 2 = 5 so does 3 plus 3 = 5; everything is now levelled by social engineers.  We need to be responsible for those who choose not to take risk, want a 9 to 5 job and health benefits and vacation. The world is entitled to that – it is only right – so you must be taxed to make up for those who are too lazy to compete, simply don’t try, or fail. In short the rich must mop up the gap for the also ran’s. Everyone gets a ribbon. There are exceptions – if you are Google, BAIDU, Apple or someone so cool or cute or a liberal who will tell people they should pay more taxes – you aren’t to be held to the same standard as everyone else.”

–       ‘cg12348’ responds to the FT’s announcement that Thomas Piketty’s ‘Capital’ has won the FT / McKinsey Business Book of the Year Award, 11th November 2014.
“@cg12348, I think you succeeded in discrediting yourself comprehensively. You didn’t read the book. You do not in fact know what is in it. But you just “know” what is in it. One can only hope that you do a little more work in your business ventures.”

–       Martin Wolf responds to ‘cg12348’.

“Socialism in general has a record of failure so blatant that only an intellectual could ignore or evade it..”


“Since this is an era when many people are concerned about ‘fairness’ and ‘social justice,’ what is your ‘fair share’ of what someone else has worked for?”


–       Thomas Sowell.



Forbes recently published an article suggesting that Google might be poised to enter the fund management sector. The article in question linked to an earlier FT piece by Madison Marriage (‘Google study heightens fund industry fears’, 28.9.2014) reporting that the company had, two years ago, commissioned a specialist research firm for advice about initiating an asset management offering. An unnamed US fund house reportedly told FTfm that Google entering the market was its “biggest fear”. An executive from Schroders was reported to be “concerned” and senior executives at Barclays Wealth & Investment Management were reported to perceive the arrival of the likes of Google and Facebook on their turf as a “real threat”. Campbell Fleming of Threadneedle was quoted in the FT piece as saying,

“Google would find the fund management market more difficult than it thinks. There are significant barriers to entry and it’s not something you could get into overnight.”

Bluntly, faced with backing Google or a large fund management incumbent, we’d be inclined to back Google. Perhaps most surprising, though, were the remarks by Catherine Tillotson of Scorpio Partnership, who said,

“There probably is a subsection of investors who would have confidence in Google, but I think the vast majority of investors want a relationship with an entity which can supply them with high quality information, market knowledge and a view on that market. I think it is unlikely they would turn to Google for those qualities.”

We happen to think that many investors would turn precisely to Google for those qualities – assuming they found those qualities remotely relevant to their objective in the first place. So what, precisely, do we think investors really want from their fund manager ? All things equal, it’s quite likely that investment performance consistent with an agreed mandate is likely to be high on the list; “high quality information, market knowledge and a view on that market” are, to our way of thinking, almost entirely subjective attributes and largely irrelevant compared to the fundamental premise of delivering decent investment returns.

After roughly 20 years of the Internet slowly achieving almost complete penetration of the investor market across the developed world, fund management feels destined to get ‘Internetted’ (or disintermediated) in the same way that the music and journalism industries have been. The time is ripe, in other words, for a fresh approach; the pickings for incumbents have been easy for far too long, and investors are surely open to the prospect of dealing with new entrants with a fundamentally different approach.

Another thing prospective digital entrants into the fund management marketplace have going for them is that they haven’t spent the last several years routinely cheating their clients, be it in the form of the subprime mortgage debacle, payment protection insurance mis-selling, Libor rigging, foreign exchange rigging, precious metals rigging.. Virtually no subsidiary of a full service banking organisation can say the same.

Sean Park, founder of Anthemis, suggests (quite fairly, in our view) that the demand for a fresh approach to financial services has never been stronger. In part, this is because

“..the global wealth management and asset allocation paradigm is fundamentally broken.  Or rather it’s a model that is past its sell-by date and is increasingly failing its ultimate customers. The “conventional wisdom” has disconnected from its “source code” meaning that the industry has forgotten the original reasons why things were initially done in a certain way and these practices have simply taken on quasi-mystical status, above questioning.. which means that the system is unable and unwilling to adapt to fundamentally changed conditions (technological, economic, financial, cultural, demographic..)

“And so opportunities (to take a step back and do things differently) abound..

“Coming back to the.. “broken asset allocation paradigm” – the constraints (real, i.e. regulatory and imagined, i.e. convention) and processes around traditional asset management and allocation (across the spectrum of asset classes) now mean that it is almost impossible to do anything but offer mediocre products and returns if operating from within the mainstream framework. (Indeed the rise and rise of low cost ETF / passive products is testimony to this – if you can’t do anything clever, at least minimise the costs as much as possible..)  The real opportunities arise when you have an unconstrained approach – when the only thing driving investment decisions is, well, analysis of investment opportunities – irrespective of what they may be, how they may be structured, and how many boxes in some cover-my-ass due diligence list they may tick (or not)..”

As we have written extensively of late, one of those practices that have taken on “quasi-mystical status” is benchmarking, especially with reference to the bond market. This is an accident waiting to happen given that we coexist with the world’s biggest bond market bubble.

Another problem is that low cost tracking products are fine provided that they’re not flying off the shelf with various asset markets at their all-time highs. But they are, and they are.

We have a great deal of sympathy with the view that the fundamental nature of business became transformed with the widespread adoption of the worldwide web. There is no reason why fund management should be exempt from this trend. What was previously an almost entirely adversarial competition between a limited number of gigantic firms has now become a more collaborational competition between a much more diverse array of boutique managers who also happen to be fighting gigantic incumbents. Here is just one example. Last week we came across a tweet from @FritzValue (blog: that touched on the theme of ‘discipline in an investment process’. With his approval we republish it here:

“Daily checklist:

8am – 10am: Read trade journals and regional newspapers for ideas on companies with 1) new products, 2) new regulation, 3) restructurings, 4) expansions, 5) context for investment ideas

10am – 6pm: Find new ideas. Read 1) company announcements.. 2) annual reports from A-Z or 3) annual reports of companies screened for buybacks / insider buying / dividend omission, etc.

7pm – 10pm: Read books to understand the world / improve forecasts / fine tune investment process

Before each investment:

1)    What do you think will happen to the company and by consequence the stock price ?

2)    Go through a personal investment checklist

3)    Use someone else or yourself as a devil’s advocate to disprove your own investment theses

4)    Have we reached “peak negativity” / has narrative played out ?

5)    Are fundamentals improving ?

6)    Why is it cheap ? Especially if it screens well in the eyes of other investors – i.e. exciting story, other investors, low P/E, etc.

7)    Decide what will be needed for you to admit defeat / sell the position

If you lose focus, sell all the positions, take a break and start again.

Only expose yourself to serious and intelligent people on Twitter / investor letters / media and avoid the noise that other investors expose themselves to.”

Fabulous advice, that has the additional advantage of being completely free. While we spend quite a bit of time agonising over the State’s ever more desperate attempts to keep a debt-fuelled Ponzi scheme on the road, we take heart from the fact that – through social media – an alternative community exists that doesn’t just know what’s going on but is perfectly happy to share its informed opinions with that community at no cost to users whatsoever. O brave new world, that has such people in it !


Interview with Martin Wolf on Monetary Reform, Part 2

Martin Wolf wrote an excellent article earlier this year on monetary reform, which can be found here .

Martin’s new book, “The Shifts and the Shocks: What we’ve learned – and have still to learn – from the financial crisis“, is available now. Martin Wolf is Chief Economics Commentator at the Financial Times. He has been visiting professor at Oxford and Nottingham universities, a fellow of the World Economic Forum in Davos, and a member of the UK’s Vickers Commission on Banking, which reported in 2011. His books include Why Globalization Works and Fixing Global Finance. In 2000, he was awarded the CBE for services to financial journalism, and in 2012 he received the Ischia International Journalism Award.

IBM recently put out a video asking, “Could Bitcoin be as transformational as the World Wide Web?” and many Silicon Valley investors are now saying similar things. What are your thoughts on digital currencies, and do you see them playing a prominent role in global commerce over the coming years and decades?

I think the honest answer to this is that I’m agnostic to sceptical. But I can’t tell you that I’m sure they’re wrong. Let me just consider the different aspects of it. So first of all, the first element as I understand, you can break Bitcoin into – it seems to me – into three aspects. There’s a new way of creating money which is depoliticised as it were which is exogenous as it were, like gold. Like mining gold. And so if you want, either a private sector or a public sector as it were. If you say the public sector wanted to create money in the way that I described, you could imagine that your worry about– so that is it, this is a technology. It’s not money it’s a technology.

It’s like gold money, it’s a technology for creating money but control its magnitude. So you could imagine and that doesn’t seem to me at all implausible, that in the future let’s suppose even the Government creating money in the way that I’ve described but the Government instead of handing in those to the Central Bank, has an algorithm. And the algorithm is known in public as it were and money is created in accordance with this algorithm and you can only change it by changing the algorithm, which is a very formal process.

Now I wouldn’t personally favour that because I think it may take serious instability because the demand for money is not stable. And because the demand for money is not stable, when people really want money, really, really want money and the algorithm is exogenous – so you can’t change it – then you’re going to have a depression. That’s of course why people like me worry about the details of the creation of money. But if you leave aside that, that’s one thing you could have a process which is automatic in that way. And it could be for private money or public money. So that’s a very interesting idea. And it clearly makes more sense than digging up– gold out of the Earth. I mean, you’ve got vast real resources, making people live a terrible life as gold miners in order to dig money out of the Earth has always struck me as basically an irrational waste of resources. So if you can do it in this other way, free, I mean, it’s digital coinage can be created freely, obviously, without any real resources. And that’s the first aspect, and I think that’s very interesting.

The second aspect is that it’s private. Now, here we get into a philosophical discussion. What is money? And there’s a tremendous debate about what makes things money. Money is, in my view, a social contrivance. I think that’s pretty clear. And which people agree to use for certain purposes. But I am quite sympathetic to the view that at least in the modern world, if we can go back the last 3,000 years I think it’s always been true by the way. But that’s another matter. That money has been state-based for a reason, which is the most important– probably the single most important use of money.

The single most important use of money is to pay your taxes in. States insist that people pay taxes in their own money. That creates a huge demand for the money of the state one lives under, and to which one owes one’s taxes. Now my view is that states are not going to hand over that function to a private entity because it loses too much for them. So they are going to insist that whatever money is, it’s something that they create and that is nation-specific. And it’s because the state will always expect money that you know that all your other fellow citizens will accept money. That’s what makes money something everybody will accept in a given society under a given state. And that’s what makes it completely– you can have complete confidence if you go out into the state, into the market with a pound, that you can buy things with pounds because everybody wants to hold pounds because it’s what allows them to play at the same level with everybody else.

Now, displacing– imagine going out into the world and trying to sell to pay with Bitcoin, the next question, will everybody accept it? It’s only money if everybody will accept it. And there has to be some basis for this trust and universal acceptability. And I’m not sure that any organ other than the state can guarantee that. So it’s a question in my mind whether a privately created money can replace state money within a given jurisdiction. And the State, I think for sure, is not going to say, “If you can pay us in Bitcoins.” They’re not going to say that. They’re going to say, “You’re going to pay us in pounds because that’s what we create and control and that defines the State.” So I understand the libertarians hope that they can overthrow the State, I understand that very well. I don’t believe there is the slightest possibility of overthrowing the State as an institution. To me, it’s a core institution of the world. It’s been a core institution of the world for about 7,000 years, minimum, and it isn’t going away.

But then I’m not a libertarian. But that’s a very fundamental issue. The third point, which is related to the second, as I said, these are questions is obviously it is possible to create money because it’s free to create, anybody can create an algorithm which allows payment in a digital coin. There is an infinite, literally infinite number of possible digital coins, digital currency. Everybody can create a digital currency and Bitcoin is the first. I can imagine that China will create one and Russia will create one, and then there might be entrepreneur but maybe sooner or later there’ll be a million of them or 10 million of them. How does one of them win?

With gold you can understand it, going back since the old way, gold had unique properties, it was scarce. It was valuable, because it was scarce it was relatively valuable. It seemed mutable, I mean in the sense it’s easy to stamp into coins. But it doesn’t tarnish and it lasts for a very long time. So it’s an incredibly attractive metal for making into a money. The only real rival over the years has been – in relatively valuable coinage – has been silver. So you’ve got gold and silver, the two– and then copper for the low-value coins. But it’s not scarce enough, so it can never go to higher-value commodities. So you’ve got really just gold and silver. But in this case, with the digital coins, as I say, they could be infinite numbers. And as soon as it becomes popular, I’d probably like to set up a business saying, “Well, I’ve got a little seigniorage. I’m going to create this and you pay me a tiny fee for it.” Or whatever it might be. So I don’t see how you stabilise on one.

The only way you could stabilise on one is – coming back to my second point – is if States do decide that’s the money. So I don’t see how a given digital coin wins. There are too many potential digital coins and it seems pretty clear to me that people and States will try to create others. So these are my three issues about digital coinage and the possibilities thereof. But as I said in the beginning I’m agnostic, I’ll be interested to see but I certainly don’t expect digital coinage to replace state created money in the near future. In the last resort, states won’t permit it.

Now I know there’s a romantic view, I wrote to Parliament about this 14 years ago , an article for Foreign Affairs, which is I still think one of the best things I’ve ever done. This is back in the late ’90s when everybody said the new cyber economy will mean that we’ll all be liberated from the heavy hand of the State, we’re going to be free, the cyber economy is beyond State control. This is the end of the State blah blah blah and I said this is utter nonesense for two reasons.

First, it is going to be a fantastic way for the State to find out what we’re doing and my god that’s true as we now know. Second more importantly, we may do commerce in cyber-space but we are physical and the State is about physical control. The State is always about physical control, it controls wherever we are, there’s a State. In some places it collapses, there’s a mess but we’re at least in the as it were, “civilised world,” there’s a state which is sort of a collective structure. And because we’re physical that State controls us. We may dislike the fact and I understand very well what people dislike which is just the reality.

Now the control exercise by the State depends on obtaining resources in order to run their legal systems and all the other things it does. Police, armies, provide people with goodies, all these other things States do. After that they need taxes and for that they need control of the monetary system. And they are not going to give it up without fighting. I mean fighting metaphorically but maybe fighting literally. So to me the idea that the State will just sort of quietly wither away and let money be taken away from it, is sort of like Marx’s fantasy that the State will wither away. And then they created Communism and never has a State been more visible. I think it’s just romantic. So at the most profound level as I said, I’m agnostic but I think that the more utopian views about what this will mean are almost certainly going to be disappointed.

Going back to the article on Positive Money. If money is created to be used for Government spending rather than largely created through the credit system then banks would essentially become intermediaries,  which implies that the central bank cannot control interest rates in the same manner as they do now. Do you have any sympathies with the idea that interest rates should be left to market forces rather being set by central bankers? I.e. the ideas of von Hayek and von Mises and that school. That they should be a purely a function of the market.

I think it follows logically. I mean von Mises and Hayek had different views as I understand it and I know something about Austrian monetary economics, but Austrian monetary economics. Well, the Austrians, I don’t follow the more contemporary ones, well some of them I do. There’s a marvellous Spanish economist who I admire greatly, but Rothbard was sort of crazy. But von Mises would go along with exactly this. Von Mises wanted to get rid of fractional reserve banking. He was actually in favour of full reserve banking, so he’s one of the people– it’s one of the interesting things about full reserve banking, the left and the right can agree on it. Different reasons. Hayek, on the other hand thought you should create private money which brings us back to the Bitcoin thing. He would be quite sympathetic to the Bitcoin, I think, though of course these ideas emerged after he died.

So Hayek and von Mises reached diametrically opposing principles from not terribly different starting points, mainly the instability of the fractional reserve system. Which of course most economists have thought about these things recognise the fraction reserve system is unstable. The banking system that we have, fractional reserve is I think a misleading way of describing it, but anyway the banking system we have is unstable. That’s just how it is. We’ve known that for more than 100 years, we just pretended in the run up to the crisis we didn’t know it and we didn’t focus on– I didn’t focus on this enough. So it was unstable. If you go the von Mises route, if you go the 100% reserve type route or state money type route, then of course the central bank controls the quantity of money, not this price. If it has a discretionary role, it could adjust the quantity in the light of what’s happening to the price. You can do it either way of course.

You could also set an interest rate and just expand money to meet the demand created by that interest rate. The setting of price and the quantity or a quantity is just– they’re just dual. It just depends which you work on. Do you work on the quantity or work on the price? You could do either, but I’m assuming that if you went for a quantity limit you let the price you set freely in the market. Where I differ from some Austrians or some commentators when they say, they say, “The price of money should be set in the market,” fine, but they seem to assume that having said that, that gets Government out of money. That’s not true at all.

As long as Government ultimately creates money – which it does, backs it through the Central Bank in our current model – then Government is always in the business. It’s only a question of how the Government agencies responsible with the Central Bank exercises its influence over monetary policy and monetary conditions or the supply of money, whatever you want call it. And the proposal we’re making is that we move to quantitative controls away from price controls. But as I said, you could personally imagine the full money policy which is indicated by what you see in the market.

So the Central Bank could look at short term interest rates in the market. It’s not setting them and it could say, “Well, short term interest rates in the market are at the moment are far too high. We’re going to expand money in by more. We’re going to have discretionary expansion of money and if short term interest rates go too low, then we’ll cut it back.” They could do that instead of having a fixed monetary rule which is the sort of Friedman view of what might be done in such a system. So the actual rule followed by the Central Bank in determining how much money to create, well that’s open. It could be a quantity rule, as I said, it could be a price rule, it could be a combination of the two.

It could be influenced by what they see in inflation, there are a lot of ways you could then– in a sense, you could run this system in many different ways and I haven’t discussed that at length nor indeed does Positive Money really. They’ve got more on this, but there are many different ways you might run such a system, even if you decide that transactions money should be essentially Government created. There’s still a question. There will be other assets in the system which are money like in some ways and they will have interest rates and you can still be very interested in what happens to them. Indeed, I think it’s all most conceivable to me that the government wouldn’t be a bit interested in what happens to them.

In a completely Austrian world, where you say the government really doesn’t care what happens in the private sector once it’s decided on 100% reserve, money and banks, then yeah. You have to follow an absolute rule of some kind and the interest rate goes wherever it goes and the government ignores it. Well, that’s a possible way of running it. The Hayekian view, I’ve never fully understood how private money would work. Well, there are various models where you could imagine private money working. They’re very tricky. The state has really withdrawn from money completely. The Central Bank has closed down, and monetary type increments, financial assets, are created by the private sector.

You can imagine that, it’s not a world as far as I can see we’ve ever lived in. That anybody has ever lived in. Even as far back as when coins were created, they always had a government role back in the– 3,000 years ago. Now I think this will be a very problematic world because I do believe there is such a thing as a natural monetary area. That is to say you have to be confident if you– you hold money because other people will accept it, that’s basically why you hold money. And that means that in a given area where you are, you need to be absolutely confident that people will accept it.

Now of course it’s true, you could imagine many moneys being use side-by-side. In some countries they have several different State moneys, especially in Switzerland you can pay with euros, you can pay with francs. You can I think probably pay in dollars. But, there’s still a limited number. How exactly it would work if we wandered around this country, and I would own NatWest pounds and somebody else has Barclay’s pounds and they will be floating freely against each other, presumably on the basis of what we thought was the soundness of NatWest or Barclay’s or whatever other bank.

I mean, I think that would turn out pretty soon to be a quite a nuisance and people would start gravitating to one of them and it would start pushing out the others and it would begin to become a monopolist. Let’s call it the Bank of England, as it were. The safest bank in the country would become the money issuer, I think, which is basically what happened with the Bank of England. That’s easily through the Bank of England. And then, of course, because it was the safest bank, all the other banks wanted to bank with it. So it’s again, Central Bank. It didn’t start off being the Central Bank, it became so. But I tend to the view– well, as I said, I don’t regard myself as expert in this. But in a world of competing private monies, you’d end up with a monopolist. And I cannot imagine, I just cannot imagine, that the state would ultimately allow this monopolist to operate freely.

It becomes too important for the whole stability of the state. Let’s suppose the monopolists, behave very well for 100 years and then falls into the hands of crooks (You might say that’s exactly what’s happened with our money, perfectly reasonable), and who start exploiting their incredibly valuable seigniorage opportunities. For their own gain. Well, if that started to happen, it would create the monstrous– it would be the possibility of the complete collapse of money, but driven by the private sector rather than the public sector. I think sooner or later, that would it wouldn’t be– people wouldn’t notice in time, the new moneys wouldn’t replace this one quickly enough, the government would intervene. I’m not personally persuaded, that’s why it’s a bit like the Bitcoin thing but in a different way. I’m not personally persuaded that a world of private moneys would be safe. A world of free banking, well that’s actually an interesting other possibility which we haven’t discussed. The free bank is always based a sovereign money of some kind. In that case, it was based on the gold standards as established by the state.

I just had one question from Steve Baker as well: he’s been discussing monetary reform for some time now and he said, in his words, “Why should the man on the Clapham omnibus care about this issue?”

That’s a very, very good question and I think the answer to that is the monetary and financial systems that we have, have malfunctioned quite seriously, well actually in a sense, forever. But if you look back over the last century, we’ve had depressions, high inflations, proto-depressions, I mean we’ve had extraordinary monetary and financial instability. And we’ve still got much more prosperous.

There’s tremendous progress going on. But we have had tremendous instability. And I think it is reasonable to ask – obviously what I’m trying to do in my book – but can’t we do better? These are man-made calamities. It’s not like the bad harvest or the plague that afflicted our ancestors so terribly, so suddenly if one portion of the population dies or the harvest, because of famine or illness. This is completely man-made calamity, the Great Depression, the inflation of the ’70s, the massive financial crises of the last six, seven years. These are man-made calamities. And they affect everybody.

Everybody whose incomes haven’t grown the way they thought they would, who are poorer than they expected to be. All these sorts of deep– all this. This affects every ordinary person. So the desire for a less unstable monetary system, monetary and financial system, is completely natural. Now, as I said at the beginning, I do think it’s always about choosing among imperfect opportunities, imperfect solutions, because the problem we’re really confronted with, in my view, is the profound reality of fundamental uncertainty. And that can’t go away. But creating a money that we can trust, and that we can trust we can use this money in any circumstances which gives us confidence, important confidence about daily life.

Whatever happens we still have some money that allows us to buy things, that’s pretty important, isn’t it? That seems to me very important, and it seems to me very important that the monetary system not be abused for private gain, or indeed public gain. That the public certainly gain in a way that exploits people. I think this is pretty important for those reasons. I’m not saying we have perfect answers. We don’t have perfect answers, but I’m absolutely sure it’s a fundamental question and it’s a duty of people interested in the issues to think about it.


Interview with Martin Wolf on Monetary Reform, Part 1

Martin Wolf wrote an excellent article earlier this year on monetary reform, which can be found here .

Martin’s new book, “The Shifts and the Shocks: What we’ve learned – and have still to learn – from the financial crisis“, is available now. Martin Wolf is Chief Economics Commentator at the Financial Times. He has been visiting professor at Oxford and Nottingham universities, a fellow of the World Economic Forum in Davos, and a member of the UK’s Vickers Commission on Banking, which reported in 2011. His books include Why Globalization Works and Fixing Global Finance. In 2000, he was awarded the CBE for services to financial journalism, and in 2012 he received the Ischia International Journalism Award.

How long has monetary reform been an interest of yours?

I cover more or less everything in a strange sort of way, its a slightly weird job. At least everything, predominately macro-economics to global trade development, those sort of things rather than more strictly micro-economics things. I’ve obviously always been interested in macro-economic policy and as long as I’ve done this job, anyway which is now, I’ve been at the FT for 27 years so I’ve obviously been interested.

But I suppose I was one of those people who thought by and large, and I wouldn’t wish to exaggerate this, that the system we had evolved, though very peculiar in many respects, was stable enough that one didn’t need to worry about it, and therefore didn’t need to think through the possibility of radical change. So I’ve always– I’ve been interested ever since I was a student of economics back in the ’60s, but I didn’t think that we had to go back to first principles at all. And of course, the crisis of 2007 to 12, which is still ongoing to some degree – well, it’s still ongoing – has obviously made one, almost everybody I think, ask questions about the right way to manage the economy and therefore inevitably to start thinking about monetary economics. And that’s what happened to me, along with many others.

And in your experience, is this an area that central bankers take seriously?

Most central bankers are, to the extent that they’re economists, and there are only a limited number, though far more than used to be the case, (that’s one of the big changes by the way, without much notice, they’ve increasingly– the top central bankers are actually professional economists. That wouldn’t have been true 30 years ago. It’s a very big change.) The professional economists, so we’re thinking people like Ben Bernanke and Janet Yellen and Mervyn King before that in the UK, Draghi now. They are all quite academic economists, though they have of course also some practical experience. They tend still largely to work within standard models so their radicalism is limited. However, it’s well known that at least one or two of them, Mervyn King most notably in his speeches was profoundly critical of the modern monetary and financial system.

Though there are people in the academic end who think about these things more academically, who are more radical. Another person – who actually was never a professional academic as far as I know, I am sure he wasn’t – who was also very very interested in this set of questions is Adair Turner, Chairman of the Financial Services Authority, although never a central banker. So there is some interest, but still the orthodoxy – or what I call the new orthodoxy in my new book – is still dominant. You also have to remember so that sort of discussion of intellectual background and thinking among academics. You also have to remember that most central bankers are more or less practical people, who are forced rightly to deal with the problems in front of them. Most of them have been – well, mostly in the west, or all of them – have been dealing with exceptional and unexpected problems for seven years now.

So that doesn’t allow them a great deal of time for philosophical discussion of what a completely different world might look like. And so, on the whole, they don’t do that and if they did publicly of course it would be quite destabilising because they would be suggesting that what they’re doing, they don’t believe in. Well, that is not a very sensible thing for a policy maker to say, even if they should think it. So, by and large of course, they are bound to carry out their tasks, they’re public servants, within the framework of institutions and ideas that their masters – as it were, the public, the politicians – have set for them, rather than ask these rather fundamental questions.

In your article you mentioned positive money as a possible model for monetary reform. Are there risks in giving seigniorage powers to government agencies? Do you think that the temptations to overprint may become too much for them if they were given these powers?

There are a number of dangers. And one of the lessons I’ve learned and I think it’s a fundamental lesson, it’s the way I think at the moment is a modern monetary economy, and in a way I think it’s probably the most important lesson I now think one should now draw from Keynes’ work. But it goes back further in the history, back to Wicksell I think. Is that the modern monetary economy is a very complicated animal. It cannot be seen I think just as a sort of barter economy which is the way the orthodox economics tended to think about it. Money enters into it in very complicated and difficult ways. And it’s always– I think money exists because we live in an inherently uncertain world and money is the stuff you hold because the world is uncertain. It’s a reserve of absolutely reliable purchasing power that you need beyond just transaction – it’s not just about transactions – it’s stuff you can buy things with whatever happens as it were. Money is inherently linked I think to uncertainty, the fact the we don’t know what’s going to happen.

This is, therefore, a very imperfect world compared with the sort of complete market neo-classical paradigm which is of course an artificial and non existing world. In this situation, it’s always about choosing between imperfect solutions. Highly imperfect solutions. And I think there are a number of problems with reallocating seigniorage to the Government and I think there are two fundamental ones. One is the one you mentioned that the Government will be irresponsible, and the Government irresponsibility will be bigger than the private sector’s irresponsibility which we’ve already seen. The private sector can also, as we know, push back fundamentals, create credit and debt essentially without limit as long as it’s backed by the state. And that’s exactly what has happened all across the west before the crisis. We had this giant explosion in the private sector driven leverage and it created huge problems. And I’ve argued frequently but unfortunately it tends to end up with the public sector and indeed pressure on the public sector to inflate. It’s extremely likely that in the very long run, we will end up with inflation in the developed world. To get out of the debt that the private sector ultimately created, which then became public sector debt when the private sector and financial sector imploded and the economy collapsed. So, it’s very difficult to separate out what the private sector does and what the public sector does, when you have such an interlinked, interconnected public private monetary partnership which is what we’ve had now for a long time and it’s become greater.

But there is a risk of course as you said, in handing over the power to government to create money and that’s why, I would hand – if I would do this – I would hand over the authority to create money to the central bank as defenders of government given a mandate by government to create money in a non-inflatory way. The second problem which I actually think is more important than this first one, is what happens to the financial sector in this world, and there are two problems about that. First, which is perhaps later, the first is – and they’re related – is that the private sector, financial sector which would not now be creating money narrowly, might still create, well not might but certainly would try to create near money or money substitutes. As indeed happened in the 19th century, how we got bank money and not just gold money, as it were. We got bank notes and then bank deposits as near money because what Wicksell noticed in the late 19th century and that’s because the private sector just created it.

So the question is, if the private sector creates it, won’t you just re-establish the fragility we’ve seen, likened that the huge question or problem. The second question is and I think Charles Goodhart – a very distinguished scholar in these matters at the LSE – has stressed, the second really big problem is of course private sector money, particularly the ability of banks to create advances for people to create money as it were and credit it simultaneously, gives people flexibility in the economy. It means that if they need money temporarily, they can borrow at once and offset the bank and just create it for them. Well of course, the state isn’t flexible in that way. And it allows people to economise on their money holdings. It allows people to have much less money then they might need in the course of their business activities.

So there are, I think quite profound questions about what would happen and that’s why in my book, I’ve recommended that I would like to see countries experiment with it. I’m not suggesting and indeed experimentation is – in my view – one of the most important lessons of this crisis. We don’t know what the optimal monetary and financial system is, we simply don’t. Nobody can say with confidence that they do know how it should be structured and what are the laws and regulations it should have. So I actually think instead of promoting one side of banking model fits all, that sort of Basel approach, that we should encourage countries to experiment and perhaps, a few small countries to try this sort of model and see what happens.


Understanding the Money Creation and Society Debate

Together with colleagues spanning four parties – Michael Meacher (Lab), Caroline Lucas (Green), Douglas Carswell (UKIP) and David Davis (Con) – I have secured a debate on Money Creation and Society for Thursday 20 November. Here’s a quick guide to understanding the debate.

First, we have a system of paper or “fiat” money: it exists due to legal mandate as opposed to being a physical commodity like gold. Reserves, notes and coins are created by the state but claims on money are created by the banks when they lend. Most of the money we have was created by banks lending.

This excellent video from Dominic Frisby is a great place to begin:

There was once a time when the literature about money creation was sufficiently off the mainstream to be dismissed. The Bank of England now explains:

I published a short paper on what is wrong with the current system and what to do about it, first inBanking 2020 and then Jesús Huerta de Soto kindly republished it in his journal Procesos De Mercado Vol.X nº2 2013. A further monetary economist privately reviewed the paper but errors and omissions remain my own. You can download it here:

Recent emergency monetary policy has been dominated by Quantitative Easing: the Bank of England has provided a report on The distributional effects of asset purchases (PDF). However, the financial system has been chronically inflationary throughout my lifetime, ever since the Bretton Woods currency system ended.

If QE has distributional effects, why not all money creation?

Here is a historic price index from the Office for National Statistics and House of Commons Library: Consumer Price Inflation since 1750 (PDF).

Price Index 1750-2003

And here is the growth of broad money from 1982 to date via the Bank of England (series LPMAUYM). Note that the money supply stopped accelerating in the course of the crisis, during the period of QE:

M4: 1982-2014

No one can argue prosperity has not increased over the period but if distributional effects matter at all, one must ask “Who benefits?” Via Positive Money, here’s where the new money went:

Sectoral lending

As I said in debate on 6 Dec 2011:

Why are we in this debt crisis? I have just checked the M4 money supply figures—I am sorry to return to aggregates, but needs must. When Labour came to power the money supply was about £700 billion and it is now about £2.1 trillion, so it has tripled over the past 14 years. Unfortunately, most economists talk about money flowing into the economy as if it were water poured into a tank that found its own level immediately, but what if it is like treacle or honey? What if it builds up in piles when poured into the economy and takes a while to spread out? What if that money was loaned into existence in response to individual choices led by the excessively low interest rates pushed by the central bank? What if it was loaned into existence in particular sectors, such as the housing sector, where prices have more than doubled over the same period, and what if it was the financial sector that received the benefit of that new money first? Would that not explain why financiers and bankers are so much wealthier than everyone else, and why economic activity and wealth has been reorientated towards the south-east?

This debate will explore the effects on society of long-term money creation by private banks’ lending in the context of the present financial system.

Further reading:


The Gold Standard Did Not Cause The Great Depression, Part 2

As noted in my previous column, AEI’s James Pethokoukis and National Review‘s Ramesh Ponnuru — among many others — appear to have fallen victim to what I have called the “Eichengreen Fallacy.”  This refers to the demonstrably incorrect proposition that the gold standard caused the Great Depression.

Pethokoukis proves exactly right in observing that “Benko is a gold-standard advocate and apparently doesn’t much like the words ‘Hitler’ or ‘Nazi’ to be in the same area code of any discussion of once again linking the dollar to the shiny yellow metal.”  “Doesn’t much like” being falsely linked with Hitler?  Perhaps an apology is more in order than an apologia.

My objecting to a demonstrably false implication of the (true) gold standard in the rise of Nazism does not constitute a display of ill will but rather righteous indignation.  To give Pethokoukis due credit he thereupon generously devoted anAEIdea blog to reciting Peter Thiel’s praise for the gold standard, praise which triggered a hysterical reaction from the Washington Post‘s Matt O’Brien.

Pethokoukis’s earlier (and repeated) vilification of gold was followed by a column in the Washington Times by a director of the venerable Committee for Monetary Research and Education Daniel Oliver, Jr., Liberty and wealth require sound money. In it, Oliver states:

What if liberty and riches at times diverge, though? A shibboleth of mainstream economists, repeated recently in The National Review, of all places, is that countries recovered from the Great Depression in the order that they abandoned the gold standard. … No doubt, money printing — the modern equivalent of leaving the gold standard — can plug the holes in banks’ balance sheets when the demand deposits at the base of the credit structure are withdrawn. This is the policy recommended by National Review Senior Editor Ramesh Ponnuru and other “market monetarists” such as the American Enterprise Institute’s James Pethokoukis ….

I am not in complete accord with all of Oliver’s propositions therein. Ponnuru is on solid ground in contradicting Oliver’s imputation of sentiments to him he does not hold and does not believe.  Yet Ponnuru weakens his defense by citing, among other things, a

recent summary of the history of gold standards in the United States that George Selgin wrote for the Cato Institute. It is a very gold-friendly account, but it ‘concludes that the conditions that led to the gold standard’s original establishment and its successful performance are unlikely to be replicated in the future.’

“Unlikely to be replicated in the future?”  Prof Selgin is a brilliant economist, especially in the elite field of monetary economics.  Yet as Niels Bohr reportedly once said, “Prediction is very difficult, especially about the future.” This citation in no way advances Ponnuru’s self-defense.

Let it be noted that Cato Institute recently announced a stunning coup in recruiting Prof. Selgin to head its impressive new Center For Monetary and Financial Alternatives. As stated in its press release, “George Selgin, a Professor Emeritus of Economics at the University of Georgia and one of the foremost authorities on banking and monetary theory and history, gave up his academic tenure to join Cato as director of the new center.” Cato’s recruitment, from the Mercatus Institute, of a key former House subcommittee aide, the formidable Lydia Mashburn, to serve as the Center’s Manager also shows great sophistication and purpose.

Prof. Selgin hardly would give up a prestigious university post to engage in a quixotic enterprise.  I, among many, expect Selgin rapidly to emerge as a potent thought leader in changing the calculus of what is, or can be made, policy-likely.  Also notable are the Center’s sterling Council of Economic Advisors, including such luminaries as Charles Calomiris; its Executive Advisory Council; Senior Fellows; and Adjunct Scholars.  It is, as Prof. Selgin noted in a comment to the previous column, “a rather … diverse bunch.”

The Center presents as an array of talent metaphorically reminiscent of the 1927 Yankees. These columns do not imply Cato to be a uniform phalanx of gold standard advocates but rather a sophisticated group of thought leaders committed to monetary and financial alternatives, of which the classical gold standard is one, respectable, offering.  Prof. Selgin’s own position frankly acknowledging the past efficacy of the true gold standard represents argument from the highest degree of sophistication.

Ponnuru is on the weakest possible ground in citing the “commonplace observation that countries recovered from the Great Depression in the order they left gold.”  This is as misleading as it is commonplace. Ponnuru, too, would do well to break free of the Eichengreen Fallacy and assimilate the crucial fact that a defective simulacrum, not the true gold standard, led to and prolonged the Great Depression.

The perverse effects of the interwar “gold” standard led to a significant rise in commodities prices … and the ensuing wreckage of a world monetary system by the, under the circumstances, atavistic definition of the dollar at $20.67/oz of gold.  The breakdown of the system meticulously is documented in a narrative history by Liaquat Ahamed, Lords of Finance: The Bankers Who Broke The World, which received the Pulitzer Prize in history.  That road to Hell tidily was summed up in a recent piece in The Economist, Breaking the Rules: “The short-lived interwar gold standard … was a mess.”  As EPPC’s John Mueller recently observed, in, “the official reserve currencies which Keynes advocated fed the 1920s boom and 1930s deflationary bust in the stock market and commodity prices.”

The predicament — caused by the gold-exchange standard adopted in Genoa in 1922 — required a revaluation of the dollar to $35/oz, duly if eccentrically performed by FDR under the direction of commodities price expert economistGeorge Warren.  That revaluation led to a dramatic and rapid lifting of the Great Depression.  Thereafter, as Calomiris, et. al, observe in a publication by the Federal Reserve Bank of St. Louis, the Treasury sterilized gold inflows.  That sterilization, together with tax hikes, most likely played a major role in leading to the double dip back into Depression.

The classical gold standard — an early casualty of the First World War — was not, indeed could not have been, the culprit.  There is a subtle yet crucial distinction between the gold-exchange standard, which indeed precipitated the Great Depression, and the classical gold standard, which played no role.There is much to be said for the classical gold standard as a policy conducive to equitable prosperity.  It commands respect, even by good faith opponents.

For the discourse to proceed we first must lay to rest the Eichengreen Fallacy (and all that is attendant thereon). Once having dispelled that toxic fallacy let the games begin and let the best monetary policy prescription win.

Originating at