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


The Gold Standard Did Not Cause The Great Depression, Part 1

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,” the demonstrably incorrect proposition that the gold standard caused the Great Depression.  This fallacy is at the root of much confusion in the discourse.

Both these conservatives find themselves, most incongruously, in the company of Professors Paul Krugman, Brad Delong, and Charles Postel; Nouriel Roubini; Thomas Frank; Think Progress’s Marie Diamond; the Roosevelt Institute’s Mike Konczal and other leading thinkers of the left pouring ridicule on the gold standard.  Most recently, Matt O’Brien, of the Washington Post, hyperbolically described the gold standard as “the worst possible case for the worst possible idea,” echoing a previous headline of a blog by Pethokoukis “The case for the gold standard is really pretty awful.”

Mssrs. Pethokoukis and Ponnuru appear to have been misled by an ambient fallacy (reprised recently by Bloomberg View‘s Barry Ritholtz) that there is an inherent deflationary/recessionary propensity of the gold standard. Thus they are being lured into opposition to such respected center-right thought leaders as Lewis E. Lehrman (whose Institute’s monetary policy website I professionally edit); Steve Forbes, Chairman of Forbes Media; Sean Fieler, chairman of American Principles in Action (for which I serve as senior advisor, economics) and the Honorable Steve Lonegan, APIA’s monetary policy director.

They also put themselves sideways with Cato Institute president John Allison; Professors Richard Timberlake, Lawrence White, George Selgin and Brian Domitrovic; Atlas Economic Research Foundation’s Dr. Judy Shelton; Ethics and Public Policy Center’s John Mueller; public figures such as Dr. Ben Carson and, perhaps, Peter Thiel; journalists such as George Melloan and James Grant; and commentators John Tamny, Nathan Lewis, Peter Ferrara, and Jerry Bowyer, among others.

At odds, too, with such esteemed international figures as former Indian RBI deputy governor S.S. Tarapore; former El Salvadoran finance minister Manuel Hinds; and Mexican business titan Hugo Salinas Price. And, at least by way of open-mindedness and perhaps even outright sympathy, The Weekly Standard editor-in-chief William Kristol; Cato’s Dr. James Dorn; Heritage Foundation’s Dr. Norbert Michel; the UK’s Honorable Kwasi Kwarteng and Steve Baker … among many other respected contemporary figures.   Not to mention libertarian lions such as the Honorable Ron Paul.

Gold advocates and sympathizers from the deep past include Copernicus and Newton, George Washington, Alexander Hamilton, Thomas Jefferson, John Witherspoon, John Marshall and Tom Paine, among many other American founders; and, from the less distant past, such important thinkers as Carl Menger, Ludwig von Mises and Jacques Rueff, as well as revered political leaders such as Ronald Reagan and Jack Kemp.

Alan Greenspan recently, in Foreign Affairs, while not discerning gold on the horizon, recently celebrated the “universal acceptability of gold” while raising a quizzical avuncular eyebrow, or two, at what he describes as “fiat” currency.

Let not pass unnoticed the recent statement by Herr Jens Wiedmann, president of the Bundesbank,

Concrete objects have served as money for most of human history; we may therefore speak of commodity money. A great deal of trust was placed in particular in precious and rare metals – gold first and foremost – due to their assumed intrinsic value. In its function as a medium of exchange, medium of payment and store of value, gold is thus, in a sense, a timeless classic.

Nor let pass unnoticed the Bank of England’s 2011 Financial Stability Paper No. 13 assessing the long term performance of the Federal Reserve Note standard and assessing its real outcomes — in every category reviewed, including job creation, economic growth, and inflation — to have proven itself, over 40 years, as deeply inferior in practice to the gold and even gold-exchange standards.

Seems a puzzling mésalliance on the part of Mssrs. Pethokoukis and Ponnuru.The Eichengreen Fallacy — that the gold standard caused and protracted the Great Depression — has led the discourse severely astray. It is imperative to set matters straight.  As I previously have written:

Prof. Eichengreen, author of Golden Fetters, was and remains non-cognizant of a subtle but crucial aspect of world monetary history — and, apparently, of the works of Profs. Jacques Rueff and Robert Triffin elucidating the implications.  Eichengreen blundered by attributing the Great Depression to the gold standard.  This, demonstrably, is untrue.

As Lehrman puts it, the true gold standard repeatedly has proven, in practice, the least imperfect of monetary regimes tried. Robust data actually recommend the gold standard as a powerful force for equitable prosperity.

Just perhaps it can be bettered.  So let the games begin. That said, proposing alternatives to the gold standard is very different from denigrating it.

Pethokoukis (whose writings I regularly follow and with appreciation) recently presented, at AEIdeas, The gold standard is fool’s gold for Republicans. This was a riposte to my here calling him to task for insinuating a connection between the gold standard and the rise of the Nazis and Hitler.  And to task for making statements in another of his AEIdea blogs taking Professors Beckworth and Tyler Cowen out of context.  He also therein conflated the “weight of the evidence” with “weight of opinion.”  It appears that he has fallen prey to the Eichengreen Fallacy.

In self-defense Pethokoukis cites scholarly materials which tend to prove the innocence of the gold standard rather than his insinuation.  For example: he cites Prof. Beckworth’s statement that “the flawed interwar gold standard … probably … led to the Great Depression which, in turn, guaranteed the rise of the Nazis….”

Prof. Beckworth’s characterization “flawed” is entirely consistent with the characterization by the great French monetary official and savant Jacques Rueff, whose work informs my own, of the gold-exchange standard as “a grotesque caricature” of the gold standard.

Similarly, his reference to Prof. Sumner overlooks the obvious fact that Prof. Sumner would appear fully to grasp the key distinction.  Sumner, as quoted by Pethokoukis:

The gold standard got a bad reputation after the Great Depression, when it was seen as contributing to worldwide deflation.  Kurt Schuler points out that the interwar gold standard didn’t follow the rules of the game, which is true.

Pethokoukis speculates,

Perhaps advocates are so sensitive to charges that the gold standard played a key role in the Great Depression, that nuance gets lost in their knee-jerk counterattacks. After all, many gold bugs think their moment is approaching once again. As Ron Paul wrote in his 2009 book “End the Fed”: ” … we should be prepared for hyperinflation and a great deal of poverty with a depression and possibly street violence as well.”  And when the stuff hits the fan, nations will again return to the gold standard for stability. Or so goes the theory over at Forbes.

Notwithstanding my high regard for Dr. Ron Paul I have not shared in prognostications of hyperinflation, poverty, and possible street violence.  If such sentiments have occurred at, whose columnists trend to the classical liberal rather than Austrian model preferred by Dr. Paul, they are vanishingly rare.  To indict by imputing Dr. Paul’s views here suggests a lack of familiarity with these publications.  There are some crucial distinctions to which his attention hereby is invited.

There are some civil disputes amongst various camps of gold standard proponents.  They are far less material than the demonstrably incorrect fallacy that the authentic gold standard has deflationary tendencies which precipitated the Great Depression.  Once this fallacy is dispelled, James Pethokoukis and Ramesh Ponnuru may find it congenial to adopt a different posture in the — steadily rising — debate over the gold standard.  They, as do Profs. Beckworth and Sumner, might find themselves arguing for their version of a better policy rather than denigrating the case for gold standard as, in Pethokoukis’s words, “pretty awful.”

To be continued.

Originating at


Road to nowhere

Spring 2010: A gradual recovery
Autumn 2010: A gradual and uneven recovery
Spring 2011: European recovery maintains momentum amid new risks
Autumn 2011: A recovery in distress
Spring 2012: Towards a slow recovery
Autumn 2012: Sailing through rough waters
Winter 2012: Gradually overcoming headwinds
Spring 2013: Adjustment continues
Autumn 2013: Gradual recovery, external risks
Winter 2013: Recovery gaining ground
Spring 2014: Growth becoming broader-based
Autumn 2014: Slow recovery with very low inflation.. ”

European Commission economic headlines, as highlighted by Jason Karaian of Quartz, in ‘How to talk about a European recovery that never arrives’.

“Well we know where we’re going
But we don’t know where we’ve been
And we know what we’re knowing
But we can’t say what we’ve seen
And we’re not little children
And we know what we want
And the future is certain
Give us time to work it out
We’re on a road to nowhere..”

‘Road to nowhere’ by Talking Heads.

In 1975, Charles Ellis, the founder of Greenwich Associates, wrote one of the most powerful and memorable metaphors in the history of finance. Simon Ramo had previously studied the strategy of one particular sport in ‘Extraordinary tennis for the ordinary tennis player’. Ellis went on to adapt Ramo’s study to describe the practical business of investing. His essay is titled ‘The loser’s game’, which in his view is what the ‘sport’ of investing had become by the time he wrote it. His thesis runs as follows. Whereas the game of tennis is won by professionals, the game of investing is ‘lost’ by professionals and amateurs alike. Whereas professional sportspeople win their matches through natural talent honed by long practice, investors tend to lose (in relative, if not necessarily absolute terms) through unforced errors. Success in investing, in other words, comes not from over-reach, in straining to make the winning shot, but simply through the avoidance of easy errors.
Ellis was making another point. As far back as the 1970s, investment managers were not beating the market; rather, the market was beating them. This was a mathematical inevitability given the over-crowded nature of the institutional fund marketplace, the fact that every buyer requires a seller, and the impact of management fees on returns from an index. Ben W. Heineman, Jr. and Stephen Davis for the Yale School of Management asked in their report of October 2011, ‘Are institutional investors part of the problem or part of the solution ?’ By their analysis, in 1987, some 12 years after Ellis’ earlier piece, institutional investors accounted for the ownership of 46.6% of the top 1000 listed companies in the US. By 2009 that figure had risen to 73%. That percentage is itself likely understated because it takes no account of the role of hedge funds. Also by 2009 the US institutional landscape contained more than 700,000 pension funds; 8,600 mutual funds (almost all of whom were not mutual funds in the strict sense of the term, but rather for-profit entities); 7,900 insurance companies; and 6,800 hedge funds.

Perhaps the most pernicious characteristic of active fund management is the tendency towards benchmarking (whether closet or overt). Being assessed relative to the performance of an equity or bond benchmark effectively guarantees (post the impact of fees) the institutional manager’s inability to outperform that benchmark – but does ensure that in bear markets, index-benchmarked funds are more or less guaranteed to lose money for their investors. In equity fund management the malign impact of benchmarking is bad enough; in bond fund management the malign impact of ‘market capitalisation’ benchmarking is disastrous from the get-go. Since a capitalisation benchmark assigns the heaviest weightings in a bond index to the largest bond markets by asset size, and since the largest bond markets by asset size represent the most heavily indebted issuers – whether sovereign or corporate – a bond-indexed manager is compelled to have the highest exposure to the most heavily indebted issuers. All things equal, therefore, it is likely that the bond index-tracking manager is by definition heavily exposed to objectively poor quality (because most heavily indebted) credits.

There is now a grave risk that an overzealous commitment to benchmarking is about to lead hundreds of billions of dollars of invested capital off a cliff. Why ? To begin with, trillions of dollars’ worth of equities and bonds now sport prices that can no longer be trusted in any way, having been roundly boosted, squeezed, coaxed and manipulated for the dubious ends of quantitative easing. The most important characteristic of any investment is the price at which it is bought, which will ultimately determine whether that investment falls into the camp of ‘success’ or ‘failure’. At some point, enough elephantine funds will come to appreciate that the assets they have been so blithely accumulating may end up being vulnerable to the last bid – or lack thereof – on an exchange. When a sufficient number of elephants start charging inelegantly towards the door, not all of them will make it through unscathed. Corporate bonds, in particular, thanks to heightened regulatory oversight, are not so much a wonderland of infinite liquidity, but an accident in the secondary market waiting to happen. We recall words we last heard in the dark days of 2008:

“When you’re a distressed seller of an illiquid asset in a market panic, it’s not even like being in a crowded theatre that’s on fire. It’s like being in a crowded theatre that’s on fire and the only way you can get out is by persuading somebody outside to swap places with you.”

The second reason we may soon see a true bonfire of inanities is that benchmarked government bond investors have chosen collectively to lose their minds (or the capital of their end investors). They have stampeded into an asset class historically and euphemistically referred to as “risk free” which is actually fraught with rising credit risk and systemic inflation risk – inflation, perversely, being the only solution to the debt mountain that will enable the debt culture to persist in any form. (Sufficient economic growth for ongoing debt service we now consider impossible, certainly within the context of the euro zone; any major act of default or debt repudiation, in a debt-based monetary system, is the equivalent of Armageddon.) As Japan has just demonstrated, whatever deflationary tendencies are experienced in the indebted western economies will be met with ever greater inflationary impulses. The beatings will continue until morale improves – and until bondholders have been largely destroyed. When will the elephants start thinking about banking profits and shuffling nervously towards the door ?

Meanwhile, central bankers continue to waltz effetely in the policy vacuum left by politicians. As Paul Singer of Elliott Management recently wrote,

“Either out of ideology or incompetence, all major developed governments have given up (did they ever really try?) attempting to use solid, fundamental policies to create sustainable, strong growth in output, incomes, innovation, entrepreneurship and good jobs. The policies that are needed (in the areas of tax, regulatory, labour, education and training, energy, rule of law, and trade) are not unknown, nor are they too complicated for even the most simple-minded politician to understand. But in most developed countries, there is and has been complete policy paralysis on the growth-generation side, as elected officials have delegated the entirety of the task to central bankers.”

And as Singer fairly points out, whether as workers, consumers or investors, we inhabit a world of “fake growth, fake money, fake jobs, fake stability, fake inflation numbers”.

Top down macro-economic analysis is all well and good, but in an investment world beset by such profound fakery, only bottom-up analysis can offer anything approaching tangible value. In the words of one Asian fund manager,

“The owner of a[n Asian] biscuit company doesn’t sit fretting about Portuguese debt but worries about selling more biscuits than the guy down the road.”

So there is hope of a sort for the survival of true capitalism, albeit from Asian biscuit makers. Perhaps even from the shares of biscuit makers in Europe – at the right price.


Means-ends and consumer choices

A major problem with the mainstream framework of thinking is that people are presented as if a scale of preferences were hard-wired in their heads.
Regardless of anything else this scale remains the same all the time.
Valuations however, do not exist by themselves regardless of the things to be valued. On this Rothbard wrote,

There can be no valuation without things to be valued.1

Valuation is the outcome of the mind valuing things. It is a relation between the mind and things.
Purposeful action implies that people assess or evaluate various means at their disposal against their ends.

An individual’s ends set the standard for human valuations and thus choices. By choosing a particular end an individual also sets a standard of evaluating various means.
For instance, if my end is to provide a good education for my child, then I will explore various educational institutions and will grade them in accordance with my information regarding the quality of education that these institutions are providing.

Observe that the standard of grading these institutions is my end, which is to provide my child with a good education.
Or, for instance, if my intention is to buy a car then there is all sorts of cars available in the market, so I have to specify to myself the specific ends that the car will help me achieve.
I need to establish whether I plan to drive long distances or just a short distance from my home to the train station and then catch the train.

My final end will dictate how I will evaluate various cars. Perhaps I will conclude that for a short distance a second hand car will do the trick.
Since an individual’s ends determine the valuations of means and thus his choices, it follows that the same good will be valued differently by an individual as a result of changes in his ends.
At any point in time, people have an abundance of ends that they would like to achieve. What limits the attainment of various ends is the scarcity of means.
Hence, once more means become available, a greater number of ends, or goals, can be accommodated—i.e., people’s living standards will increase.

Another limitation on attaining various goals is the availability of suitable means.
Thus to quell my thirst in the desert, I require water. Any diamonds in my possession will be of no help in this regard.

1. Murray N. Rothbard, Towards a Reconstruction of Utility and Welfare Economics.


Deflation comes knocking at the door

There is little doubt that deflationary risks have increased in recent weeks, if only because the dollar has risen sharply against other currencies.

Understanding what this risk actually is, as opposed to what the talking heads say it is, will be central to financial survival, particularly for those with an interest in precious metals.
The economic establishment associates deflation, or falling prices, with lack of demand. From this it follows that if it is allowed to continue, deflation will lead to business failures and ultimately bank insolvencies due to contraction of bank credit. Therefore, the reasoning goes, demand and consumer confidence must be stimulated to ensure this doesn’t happen.

We must bear this in mind when we judge the response to current events. For the moment, we have signs that must be worrying the central banks: the Japanese economy is imploding despite aggressive monetary stimulation, and the Eurozone shows the same developing symptoms. The UK is heavily dependent on trade with the Eurozone and there is a feeling its strong performance is cooling. The chart below shows how all this has translated into their respective currencies since August.

Major CCYs vs USD 07112014

Particularly alarming has been the slide in these currencies since mid-October, with the yen falling especially heavily. Given the anticipated effect on US price inflation, we can be sure that if these major currencies weaken further the Fed will act.

Central to understanding the scale of the problem is grasping the enormity of the capital flows involved. The illustration below shows the relationship between non-USD currencies and the USD itself.

Total World Money 07112014

The relationship between the dollar’s monetary base and global broad money is leverage of over forty times. As Japan and the Eurozone face a deepening recession, capital flows will naturally reverse back into the dollar, which is what appears to be happening today. Economists, who are still expecting economic growth for the US, appear to have been slow to recognise the wider implications for the US economy and the dollar itself.

The Fed, bearing the burden of responsibility for the world’s reserve currency, will be under pressure to ease the situation by weakening the dollar. So far, the Fed’s debasement of the dollar appears to have been remarkably unsuccessful at the consumer price level, which may encourage it to act more aggressively. But it better be careful: this is not a matter susceptible to fine-tuning.

For the moment capital markets appear to be adapting to deflation piece-meal. Analysts are revising their growth expectations lower for Japan, the Eurozone and China, and suggesting we sell commodities. They have yet to apply the logic to equities and assess the effect on government finances: when they do we can expect government bond yields to rise and equities to fall.

The fall in the gold price is equally detached from economic reality. While it is superficially easy to link a strong dollar to a weak gold price, this line of argument ignores the inevitable systemic and currency risks that arise from an economic slump. The apparent mispricing of gold, equities, bonds and even currencies indicate they are all are ripe for a simultaneous correction, driven by what the economic establishment terms deflation, but more correctly is termed a slump.