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Free Trade

Global Free Trade Makes For Mutual Prosperity And World Peace

The recent brutal events in France have reminded us how small the world is that we all share. Violence and conflicts that have their origin in one part of the globe shows itself in another part of our planet. And mass media immediately shares those events to the rest of us, no matter where we are.

The impression that is often created by these events and those images is that the world is a dangerous place. And that the more interconnected we become, the more we face the threat of that violence and those conflicts coming our way.

However, the sensationalism of the pictures and videos capturing such tragic events as those in Paris should not distract us from the much more fundamental and everyday linkages that increasingly bind all of us together for mutual prosperity and possible world peace here on Planet Earth.

The Global Economy and Gains from Trade

I mean, of course, the global economy and the network of supplies and demands, productions and consumptions of goods and services that has been and continues to make us one interdependent market of buyers and sellers regardless of the political lines that appear to divide us into different nations and countries in this common world of ours.

For the last two hundred years the increasing integration of our world has, certainly been, been greatly influenced by new, better, and swifter means of travel and communication.

For example, about 160 years ago, in the 1850s, a journey from Boston, Massachusetts to Charleston, South Carolina took about 15 to 16 days of hard riding by stagecoach, or anywhere between 7 and 25 days by sailing ship, depending upon the winds.

Now, in the 21st century, flying nonstop gets you from Boston to Charleston in less than two and a half hours. Air travel enables us, as well, to circumvent the globe in less than twenty-four hours.

But what has been the prime factor behind the develop of trade and its increasingly global nature is a social and economic setting in which individuals are relatively free to peacefully interact in networks of exchange guided by market prices that inform producers and consumers about potential gains from trade.

More and more parts of the world are being drawn into this nexus of international trade, and reaping benefits from it.

South Carolina’s Place in the Global Economy

Let’s take South Carolina, the state in which I now live, as an example of the impact and significance of global trade on people’s livelihood and well being. South Carolina is part of this global economy no less than the rest of the United States.

In 2013, South Carolina industries exported goods to over 200 countries worth more $26 billion, making up nearly 15 percent of the state’s Gross Domestic Product. Charleston, alone, made up $3.5 billion of those export earnings

If 160 years ago, cotton was “king” in export earnings, today, the state’s leading export sectors are automobiles, machinery, rubber, aircraft, plastics, paper and wood products, optics and organic chemicals. Indeed, South Carolina, in 2013, was the number one state in the export of tires, and number two in the export of automobiles to the global market.

Nearly 30 percent of South Carolina’s manufacturing jobs are connected with its export trade. In fact, out of an employed labor force of over two million, more than 500,000, or one-fourth of the total jobs in South Carolina, are connected with exports, imports, and international shipping. Twenty percent of those half-a-million trade related jobs are supplied from foreign direct investment in the state of South Carolina.

Foreign imported goods into South Carolina in 2013 came to over $32 billion, with the largest share of those goods coming into the state arriving from Germany, China, Canada, and Mexico. Nearly 200,000 South Carolinians are employed where foreign, imported goods are sold in the state.

I wish to highlight the import side of South Carolina’s foreign trade because most discussions over the benefits that the state or America as a whole receives from international commerce focuses on the gains in sales and jobs in the export sectors of the state’s economy.

Imports as the Real Gain from Trade

The only real purpose and benefit from “exporting,” however, is its ability to enable us as individuals or a country to earn the financial means to buy “imports” either from our neighbors next door or from sellers on the other side of the globe, who can produce and supply those goods at a lower cost and/or a better quality than if we tried to manufacture them for ourselves.

As Adam Smith expressed it in his famous book, The Wealth of Nations, in 1776:

“It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor . . .

“What is prudence is the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better to buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.”

A concern is often expressed that the purchasing of any good or service from the producers of another country deprives domestic businesses and workers of employment.

Trade Barriers - Democratic and Republican cartoon

Imports are Paid for with Exports

But we need to remember that, just like ourselves, the foreign seller does not give his goods away for free. He wishes to sell them precisely in order to earn an income that enables him to, then, turn around and purchase other goods that we or some other country’s producers can make better or less expensively than if he made those goods in his own home country.

When manufacturers in Germany, China, Canada, or Mexico sell some of their goods in South Carolina or some other part of the United States, they earn dollars. Since U.S. dollars are not the currency of use in any of these countries, they will either spend those earned dollars back in the United States demanding American goods in exchange for what they have sold to us, or will sell those dollars on the foreign exchange market for some other currency they wish to use to buy desired goods and services.

If, for example, an export producer in Canada would prefer to buy goods made in Germany than those produced in the U.S., he will sell his earned dollars for Euros. But why would some holder of Euros have sold them for U.S. dollars other than that he, instead, wishes to buy goods made in America or even in South Carolina?

Ultimately, it is goods that trade for goods through the medium of one type of money or another. And what we buy from other countries must, finally, be paid for through part of our own output as individuals and as a nation.

It is true that if American consumers find it more attractive to purchase a foreign version of some product, the domestic American producer(s) may experience declines in their sales, market share, and profitability. Some U.S. firms in this part of the economy may reduce output or even go out of business, with a matching loss of some jobs in this sector of the domestic market.

Those businesses and jobs will have to shift into other areas of enterprise. To where will these businesses and workers “migrate”? Some will find alternative profitability or employment in the export industries with which South Carolina’s and America’s imports are paid.

Imports and Cost-Efficient Trade Improve Our Standard of Living

Others will find new profits and employments satisfying different domestic demands. For instance, suppose that a foreign import costs $10, while the domestic version of this product that Americans or South Carolinians used to buy costs $15. Consumers in America now pay $10 for what used to cost them $15. They have the desired good, plus they have saved $5 on the price. The less expensive foreign product has “freed up” $5 of purchasing power in each consumer’s pocket that now enables them to increase their demand for other things that previously they could not afford when they were paying the higher American-made price for this good.

No doubt, in the short-run this requires some people to change what products they produce or where they are employed. But this is the price of economic progress from which we all gain in the long-run: new, better, and less expensive goods and services available to improve our standard of living as well as the quality of our life.

The fact that more commercial airplanes and automobiles are now manufactured in South Carolina has, no doubt, resulted in the loss of some business and jobs in other states in America where these planes and cars were previously being produced. (Or, if nothing else, a loss of greater business and jobs that might have come to those other states, if factories had not been built in South Carolina, instead.)

But in the long run everyone in America is better off with those planes and cars being produced where they could be manufactured most cost-efficiently to the gain of all of us as consumers. When goods that we, the consumers, want are produced in the most least costly manner, which includes the comparative advantage of the manufacturing location as well, all in society benefit from the resources available to people being used in the ways that enable getting the most out of them that is possible in both physical and value terms.

Finally, I would emphasize another gain from international trade and commerce that goes beyond its more narrowly “economic” benefits to all participants.

Europe's Trade Walls Cartoon

Ends in Ourselves, and Means to Each Other’s Ends

I am referring to the fact that trade is a means and a method for people who may live very differently from each other, based on widely diverse beliefs and values, to cooperate and mutually benefit from free and voluntary association.

The nature of the market economy, both domestic and international, is that it leaves each individual and voluntary group free to follow whatever ends, goals or purposes they may find desirable to pursue, given their values and belief-systems. Each serves others in society as the means to their own ends, with little concern or consideration as to why and for what purpose those who fulfill our demands want the income they earn by selling us the goods we desire.

For example, how much do any of us know about those who earn a living making commercial planes or automobiles at the Boeing or BMW factories in South Carolina, and how they use their incomes in their own role as consumers? The answer is, virtually nothing.

In some cases, no doubt, if we knew how some of them spend the income they have earned by producing and selling us automobiles, we would be shocked and disturbed because of, maybe, radically differing views about what values and ends people should pursue in their lives.

But the beauty of the market system is that we use each other as means, while each of us is free to follow the ends that give meaning, purpose and value to our individual lives. Whether a vocal minority or a substantial majority disapproves of how you furnish your home, select your wardrobe, decide on the church to go to, or contribute to some charitable cause, you are at liberty to make your own decisions in these matters as a sovereign consumer in a free market, given your success as a producer in fulfilling and satisfying the ends and goals of others with whose choices you may have no agreement or even respect.

Political Decentralization and Market Freedom Make for Diversity

It is this aspect or element of a, now, global market, that makes for, and even fosters the social and cultural “diversity” about which many often speak, but about which they frequently have little understanding concerning how it is only made possible through a competitive, open, and free market order.

A Muslim in Kuwait who makes his living in his country’s oil fields may use his income to contribute to his mosque and maintain a standard of living for his two-wife family. The American Christian family that drives to church on Sunday with gasoline that has been refined from Kuwaiti crude oil may tithe for significantly different reasons than that Muslim half-way around the world, and consider having more than one wife morally and legally unacceptable.

But each can live his own life as he chooses without a “conflict of visions” about a moral and right life leading to violence and bloodshed between them. What makes this possible at an international level is that fact that we live in a world of global anarchy.

That is, there is no single and unified political authority that controls the world and imposes the political and ideological values of one society on all the rest. It is that decentralization of political power among many governments rather than one global united nation that leaves people free in their international dealings from the values and preferences of others in other parts of the world with which they may disagree.

When governments do not intrude into international trading affairs for either economic or ideological reasons through political or military intervention, there is often the potential for greater peace and mutual harmony than within a country, where different groups and individuals vie for control over their own government to impose their particular values, beliefs and desires on their fellow citizens.

This is why on the mundane, everyday level, the people of South Carolina and those of the United States as a whole are able to trade and associate with the other people of the world through buying and selling, importing and exporting, with all the participants gaining and benefiting from the talents, skills, and specializations of others in faraway places.

All of this happens for everyone’s mutual betterment without having to accept or have imposed on them the values, beliefs and ideals of others in those faraway lands. If we understand this better and leave markets and people free in this manner, there would be a greater chance for both world peace and material and cultural prosperity for all.

(The text is based on a talk given at the Charleston Rotary Club of South Carolina on January 13, 2015.)

Money

More euro-tragedy

Despite the uncertainties ahead of the Greek general election, the European Central Bank (ECB) went ahead and announced quantitative easing (QE) of €60bn per month from March to at least September 2016.

What makes this interesting is the mounting evidence that QE does not bring about economic recovery. Even Jaime Caruana, General Manager of the Bank for International Settlements and who is the central bankers’ central banker, has publicly expressed deep reservations about QE. However, the ECB ploughs on regardless.

The Keynesians at the ECB are unclear in their thinking. They are unable to answer Caruana’s points, dismissing non-Keynesian economic theory as “religion”, and they sweep aside the empirical evidence of Keynesian policy failures. Instead they are panicking at the spectre of too little price inflation, the continuing fall in Eurozone bank lending and now falling commodity prices. To them, it is a situation that can only be resolved by monetary stimulation of aggregate demand applied through increased government deficit spending.

This is behind the supposed solution of the ECB’s QE, most of which will involve national central banks in the euro-system propping up their own national governments’ finances.

The increased socialisation of the weaker Eurozone economies, especially those of France, Greece, Italy, Spain and Portugal, will inevitably lead to unnecessary economic destruction. QE always transfers wealth from savers to financial speculators and other early receivers of the new money. Somehow, the impoverishment of the working and saving masses for the benefit of the central bankers’ chosen few is meant to be good for the economy.

Commercial banks will be corralled into risk-free financing of their governments instead of lending to private enterprise. This is inevitable so long as the Single Supervisory Mechanism (the pan-European banking regulator) with a missionary zeal is discouraging banks from lending to anyone other than governments and government agencies. So the only benefit to employment will come from make-work programmes. Otherwise unemployment will inevitably increase as the states’ shares of GDP grow at the expense of their private sectors as the money and bank credit shifts from the former to the latter: this is the unequivocal lesson of history.

It may be that by passing government financing to the national central banks, the newly-elected Greek government can be bought off. It will be hard for this rebelling government to turn down free money, however angry it may be about austerity. But this is surely not justification for a Eurozone-wide monetary policy. While the Greek government might find it easier to appease its voters, courtesy of easy money through the Bank of Greece, hard-money Germans will be horrified. It may be tempting to think that the ECB’s QE relieves Germany from much of the peripheral Eurozone’s financing and that Germans are therefore less likely to oppose the ECB’s QE. Not so, because the ECB is merely the visible head of a wider euro-system, which includes the national central banks, through which there are other potential liabilities.

The principal hidden cost to Germany is through the intra-central bank settlement system, TARGET2, which should only show minor imbalances. This was generally true before the banking crisis, but since then substantial amounts have been owed by the weaker southern nations, notably Italy, to the stronger northern countries. Today, the whole of the TARGET2 system is being carried on German and Luxembourg shoulders as creditors for all the rest. Germany’s Bundesbank is owed €461bn, a figure that is likely to increase as the debtors’ negative balances continue to accumulate.

The currency effect

The immediate consequence of the ECB’s QE has been to weaken the euro against the US dollar, and importantly, it has forced the Swiss franc off its peg. The sudden 20% revaluation of the Swiss franc has generated significant losses for financial institutions which were short of the franc and long of the euro, which happens to have been the most important carry-trade in Europe, with many mortgages in Central and Eastern Europe denominated in Swiss francs as well. The Greek election has produced a further problem with a developing depositor run on her banks. Doubtless both the carry-trade and Greek bank problems can be resolved or covered up, but problems such as these are likely to further undermine international confidence in the euro, particularly against the US dollar, forcing the US’s Fed to defer yet again the day when it permits interest rates to rise.

This was the background to the Fed’s Open Market Committee (FOMC) meeting this week, and the resulting press release can only be described as a holding operation. Statements such as “the Committee judges that it can be patient in beginning to normalise the stance of monetary policy” are indicative of fence-sitting or lack of commitment either way. It is however clear that despite the official line, the US economy is far from “expanding at a solid pace” (FOMC’s words) and external events are not helping either. For proof of that you need look no further than the slow-down of America’s overseas manufacturing and production facility: China.

The consequences for gold

Until now, central banks have restricted monetary policy to domestic economic management; this is now evolving into the more dangerous stage of internationalisation through competitive devaluations. We now have two major currencies, the yen and the euro, whose central banks are set to weaken them further against the US dollar. Sterling, being tied through trade with the euro, should by default weaken as well. To these we can add most of the lesser currencies, which have already fallen against the dollar and may continue to do so. The Fed’s 2% inflation target will become more remote as a consequence, and this is bound to defer the end of zero interest rate policy. So from all points of view competitive devaluations should be good for gold prices.

This is so far the case, with gold starting to rise against all major currencies, including the US dollar, with the price above 200-day and 50-day moving averages in bullish formation. To date from its lows gold has risen by up to 13% against the USD, 18% against the pound, 30% against the euro, and 32% against the yen. The rise against weaker emerging market currencies is correspondingly greater, fully justifying Asian caution about their government currencies as stores of value.

We know that Asian demand for bullion has absorbed all mine production, scrap and net selling of investment gold from advanced economies for at least the last two years. Indeed, the bear market in gold has been a process of redistribution from weak western into stronger eastern hands. So if there is a revival in physical demand from the public in these advanced economies it is hard to see how it can be satisfied at anything like current prices, with physical bullion now in firm hands.

The gold price is an early warning of future monetary and currency troubles, and it is now becoming apparent how they may transpire. The ECB move to give easy money to profligate Eurozone politicians is likely to have important ramifications well beyond Europe, and together with parallel actions by the Bank of Japan, can now be expected to increase demand for physical gold in the advanced economies once more.

Money

European Central Bank plan to unleash massive pumping is likely to further undermine the process of wealth generation

The European Central Bank (ECB) is planning to pump 1.1 trillion euro’s into the banking system to fend off price deflation and revive economic activity. The ECB president and his executive board are planning to spend 60 billion euro’s a month from March 2015 to September 2016.

Most experts hold that the ECB must start acting aggressively against the danger of deflation. The yearly rate of growth of the consumer price index (CPI) fell to minus 0.2% in December last year from 0.3% in November and 0.8% in December 2013.

Many commentators are of the view that the ECB should initiate an aggressive phase of monetary pumping along the lines of the US central bank. Moreover the balance sheet of the ECB has in fact been shrinking. On this the yearly rate of growth of the ECB balance sheet stood at minus 2.1% in January against minus 8.5% in December. Note that in January last year the yearly rate of growth stood at minus 24.4%.

EMU CPI

EMU CPI

Why is a declining rate of inflation bad for economic growth? According to the popular way of thinking declining price inflation sets in motion declining inflation expectations. This, so it is held, is likely to cause consumers to postpone their buying at present and that in turn is likely to undermine the pace of economic growth.

In order to maintain their lives and well being individuals must buy present goods and services, so from this perspective a fall in prices as such is not going to curtail consumer outlays. Furthermore, a fall in the growth momentum of prices is always good for the economy.

An expansion of real wealth for a given stock of money is going to manifest in a decline in prices (remember a price is the amount of money per unit of real stuff), so why should this be regarded as bad for the economy?

After all, what we have here is an expansion of real wealth. A fall in prices implies a rise in the purchasing power of money, and this in turn means that many more individuals can now benefit from the expansion in real wealth.

Now, if we observe a decline in prices on account of an economic bust, which eliminates various non-productive bubble activities, why is this bad for the economy?

The liquidation of non-productive bubble activities – which is associated with a decline in the growth momentum of prices of various goods previously supported by non-productive activities – is good news for wealth generation.

The liquidation of bubble activities implies that less real wealth is going to be diverted from wealth generators. Consequently, this will enable them to lift the pace of wealth generation. (With more wealth at their disposal they will be able to generate more wealth).

So as one can see a fall in price momentum is always good news for the economy since it reflects an expansion or a potential expansion in real wealth.

Hence a policy aimed at reversing a fall in the growth momentum of prices is going to undermine and not strengthen economic growth.

We hold that the various government measures of economic activity reflect monetary pumping and have nothing to do with true economic growth.

An increase in monetary pumping may set in motion a stronger pace of growth in an economic measure such as gross domestic product. This stronger growth however, should be regarded as a strengthening in the pace of economic impoverishment.

It is not possible to produce genuine economic growth by means of monetary pumping and an artificial lowering of interest rates. If this could have been done by now world poverty would have been erased.

Summary and conclusion

The European Central Bank (ECB) is planning to pump 1.1 trillion euro’s into the banking system to fend off price deflation and revive economic activity in the Euro-zone. Most experts are supportive of the ECB’s plan. We question the whole logic of the monetary pumping.

A fall in the growth momentum of prices either on account of real wealth expansion or on account of the demise of bubble activities is always good news for wealth producers.

Hence any policy that is aimed at preventing a fall in prices is only likely to strengthen bubble activities and undermine the process of wealth generation.

Money

Monetary Politics: The Biggest Money Player In Politics Is The Fed

Washington finally shows signs of coming to grips with the importance of money to politics. This is not about mere campaign finance. Recently there was a breakthrough in bringing the money policy issue out of the shadows and to center stage … where it belongs.

The real issue of money in politics is about the Fed, not the Kochs. The Fed’s political impact is orders of magnitude greater than all the billionaires’ money, bright and dark, left and right, combined.

There was a real breakthrough in the discourse last week. This breakthrough deserves far more attention than it yet has received.

The Washington Post’s Matt O’Brien, one of the smartest cats in the (admittedly small and dark, but crucial) monetary policy alley, published a column at the Post’s Wonkblog entitled Yes the Federal Reserve has enormous power over who is president. 

O’Brien states:

The arc of the political universe is long, but it bends towards monetary policy.

That’s the boring truth that nobody wants to hear. Forget about the gaffes, the horserace, and even the personalities. Elections are about the economy, stupid, and the economy is mostly controlled by monetary policy. That’s why every big ideological turning point—1896, 1920, 1932, 1980, and maybe 2008—has come after a big monetary shock.

Think about it this way: Bad monetary policy means a bad economy, which gives power back to the party that didn’t have it before. And so long as the monetary problem gets fixed, the economy will too, and the new government’s policies will, whatever their merits, get the credit. That’s how ideology changes.

O’Brien’s column may, just possibly, represent a watershed turn in the political conversation. Game on.

O’Brien demolishes not one but two myths. The first myth is of the Fed as politically independent. The second is that monetary policy properly resides outside the electoral process.

As I wrote here in a column Dear Chair Yellen: Mend the Fed:

As journalist Steven Solomon wrote in his indispensable exploration of the Fed, The Confidence Game: How Unelected Central Bankers Are Governing the Changed World Economy (Simon & Schuster, 1995):

Although they strained to portray themselves as nonthreatening, nonpartisan technician-managers of the status quo, central bankers, like proverbial Supreme Court justices reading election returns, used their acute political antennae to intuit how far they could lean against the popular democratic winds. “Chairmen of the Federal Reserve,” observes ex-Citibank Chairman Walter Wriston, “have traditionally been the best politicians in Washington. The Fed serves a wonderful function. They get beat up on by the Congress and the administration. Everyone knows the game and everyone plays it. But no one wants their responsibility.”

Moreover, as to the political delicacy of this position, I wrote:

To consistently be in what iconic Fed Chairman William McChesney Martin called “the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up” is just asking too much of most mere mortals.  It asks too much even of officials of such admirable integrity, intellect, and heart as Janet Yellen (and Chair Yellen’s deeply admirable Vice Chair Stanley Fischer, most recently seen talking with protestors at Jackson Hole).

Monetary policy has been relegated to the Fed and largely excluded from the formal electoral process for almost two generations. This is, at it happens, and as O’Brien states forthrightly, a historical anomaly.

Monetary policy was a white hot topic at the Constitutional Convention of 1787. Thereafter, it was crucial to the success of George Washington’s administration, one of the few matters in which cabinet members Thomas Jefferson and Alexander Hamilton concurred.

Monetary policy — in the North, “Greenbacks” — was a huge (and later litigated) issue during and after the Civil War.

Monetary policy was a fundamental issue for Grover Cleveland.

Monetary policy was the issue that propelled the young William Jennings Bryan to national prominence and three presidential nominations, beginning with his famous “cross of gold” speech.

Monetary policy was a, perhaps the, prime issue on which William McKinley campaigned (and won).

After the Panic of 1907 monetary policy was a central issue for U.S. Senator Nelson Aldrich, then called America’s “General Manager.” Aldrich chaired the National Monetary Commission.  He wittily noted, in a 1909 speech, that “[T]he study of monetary questions is one of the leading causes of insanity.”

Thereafter — with the creation of the Fed — monetary policy became a key issue for Woodrow Wilson. As recorded in Historical Beginnings. The Federal Reserve by Roger T. Johnson, (published by The Federal Reserve Bank of Boston, revised 2010)

On December 23, just a few hours after the Senate had completed action, President Wilson, surrounded by members of his family, his cabinet officers, and the Democratic leaders of Congress, signed the Federal Reserve Act. “I cannot say with what deep emotions of gratitude… I feel,” the President said, “that I have had a part in completing a work which I think will be of lasting benefit to the business of the country.”

FDR’s revaluing gold, on the advice of agricultural economist George Warren, was crucial to lifting the Depression. This was a matter so politically dramatic as to land Warren on the cover of Time Magazine.

The importance of FDR’s action cannot be minimized. As I have elsewhere written:

As (conservative economic savant Jacques) Rueff observed in The Monetary Sins of the West (The Macmillan Company, New York, New York, 1972, p. 101):

“Let us not forget either the tremendous disaster of the Great Depression, carrying in its wake countless sufferings and wide-spread ruin, a catastrophe that was brought under control only in 1934, when President Roosevelt, after a complex mix of remedies had proved unavailing, raised the price of gold from $20 to $35 an ounce.”

As investment manager Liaquat Ahamed wrote in his Pulitzer Prize winning history Lords of Finance: The Bankers Who Broke the World (The Penguin Press, New York, 2009, pp. 462-463):

“But in the days after the Roosevelt decision, as the dollar fell against gold, the stock market soared by 15%.  Even the Morgan bankers, historically among the most staunch defenders of the gold standard, could not resist cheering.  ‘Your action in going off gold saved the country from complete collapse,’ wrote Russell Leffingwell to the president.”

“Taking the dollar off gold provided the second leg to the dramatic change in sentiment… that coursed through the economy that spring. … During the following three months, wholesale prices jumped by 45 percent and stock prices doubled.  With prices rising, the real cost of borrowing money plummeted. New orders for heavy machinery soared by 100 percent, auto sales doubled, and overall industrial production shot up 50 percent.”

Of course, FDR did not take the dollar off gold.  He revalued.  That FDR did not have a firm grasp on the implications of his own policy is evidenced by his Treasury’s sterilization of gold inflows, arguably a leading factor leading to the 1937 double dip back into Depression.

Monetary policy figured more than tangentially in President Nixon’s “New Economic Policy,” announced in a national address on August 15, 1971. The inflationary consequences of Nixon’s closing of the gold window — and the easy money policy he bullied out of the Fed — figured prominently in the Ford and Carter administrations. The symptom of bad monetary policy — runaway inflation — was a major contributing factor in the election of Ronald Reagan.

A period that has been called the Great Moderation — under Fed Chairman Paul Volcker and the first two terms of Chairman Greenspan — followed. This saw the creation of almost 40 million new jobs, and economic mobility.  This tookmonetary policy largely off the political agenda for almost two generations.

Then, of course, came the unexpected financial meltdown of 2008.  That event — and the ensuing soggy recovery — helped propel monetary policy back into the realm of electoral politics.

The Republican Party national platform of 2012 called for the establishment of a monetary “commission to investigate possible ways to set a fixed value for the dollar.” This is something for which American Principles in Action (which I professionally advise) was and is a leading advocate.

This plank, widely noted around the world, directly led to the introduction, by Joint Economic Committee chairman Kevin Brady (R-Tx), of Centennial Monetary Commission legislation, which attracted 40 House and two Senate co-sponsors.  It is expected to be reintroduced early in the 114th Congress.

The monetary commission legislation meticulously is bipartisan in nature.  It includes  ex-officio commissioners to be appointed by the Fed Chair and Treasury Secretary. It has been widely, and universally, praised in the financial press … including the FT, the Wall Street Journal, and Forbes.com. It is purely empirical in intent and has attracted the public support of many important civic leaders in the policy and political arena.

Last winter the commission received a unanimous resolution of support from the Republican National Committee. Democrats and progressives, of the kind of progressive Democrat President Cleveland, also well can support it.

There are a number of things about which one might quibble in O’Brien’s column. (O’Brien, for instance, reflexively opposes the gold standard. Yet the facts and analysis on which he rests his objections are incomplete.)

That said, O’Brien gets the big thing right: “The arc of the political universe is long, but it bends towards monetary policy.” Such an important columnist for the Post getting the big thing right is in and of itself a Big Thing.

Good money — and how to make our money good — is a matter that belongs at the center of our national, and, especially, presidential, politics. Good money is central to restoring job creation, economic mobility, equitable prosperity, the integrity of our savings and the solvency of our banks.

We are in what trenchantly has been called “uncharted territory.” Among issues which deserve a “national conversation” good money deserves the place at the head of the line. Fed Chair Yellen has been described, astutely, by Politico as having the Toughest job in Washington.  It is high time for our elected officials — and presidential aspirants — to shoulder more responsibility. It is high time for monetary policy, after being in political near-hibernation for almost two generations, to enter the 2016 presidential debate.

Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2015/01/19/monetary-politics-the-biggest-money-player-in-politics-is-the-fed/

Economics

A Slow Boat in China

Still struggling to move from its ‘Three Overlay’ period – essentially the indigestion added by the post-GFC ‘stimulus’ burst to the already unbalanced economic structure – to its vaunted ‘New Normal’ – slower headline growth but growth of much higher quality, to be concentrated not in building steel mills, metal smelters, and dormitory towns just for the sake of it but on high-tech and clean energy and all sorts of other touchy-feely, Googleworld concepts – China nonetheless managed to eke out a face saving final quarter GDP number of 7.4% yoy and an industrial production uptick to 7.9%.

Taking the data at face value, annualized GDP for the quarter actually did not fare as well, coming in at 6.1% (the worst since QI’12) with IP up 7.5% and overall these numbers – together with those for nominal output – were the weakest in a quarter of a century which has included, one might recall, both 2008-9’s GFC and 1997-8’s Asian Contagion. Within them, the service sector continued to shine – with a nominal increase of 11.1%, a real one of 8.1%, and an increase in electricity consumption of 6.4% – but secondary industry slowed to 5.7% nominal with a price drop of 1.5% ostensibly boosting the real output component to a 7.3% rate which was nevertheless somewhat at odds with the lacklustre 3.7% pick-up in energy use. Primary industry was also sickly, recording scores of 5.4% nominal, 4.1% real, and -0.2% electricity.

As for real estate, let no-one tell you there is not a genuine bust underway. Investment has slowed from 2013’s final quarter gain of 20.1% over 2012’s like period all the way down to QIV-14’s miserly 5.4%. Even that masks the extent of the deceleration, for the last two months of the year were only 5.6% ahead of the preceding equivalent, while the total for December itself was 2.9% lower than Dec’13. The NBS figures from new construction area make grim reading, too, being off 10.7% overall and down 14.4% for the residential sector. As for sales area – a 9.1% drop in RE was not only outmatched by the 13.4% drop in office sales, but the latter also came with an average price drop of 9.2% which made for a precipitous revenue decline of 21.4%.

No wonder the debt default by developers Kasai in Shenzhen is causing both creditors and stock market punters to look askance at the sector. Indeed, given that Reuters is reporting a freeze in new onshore lending to some of Kasai’s peers and that Bloomberg has a story about how yields on some debt in the sector are hitting distressed levels, one might well expect the situation to deteriorate further. This is all the more likely since much of the trouble is bound up with local conformity with President Xi’s ongoing anti-corruption campaign and may well be encountering additional complications from the findings of the as-yet unreleased results of the latest audit of local government financing practices.

None of this had done much to dampen enthusiasm for the stock market – at least not until the powers- that- be decided that the spectacular rise in margin loans had the potential to vitiate the whole thrust of a policy seems to have been aimed at getting people to move their savings from bricks and mortar and into shares, thus not only alleviating the pressure on RE but also promoting a gradual shift away from over-reliance on short-term credit instruments and inculcating a renewed emphasis on the role of within the capital structure.

Nor is at any real wonder the authorities did feel compelled to do something to stop the rise – however welcome in principle – from going ballistic. According to data from the Shanghai Stock Exchange, quoted by the FT, margin debt on just that one board had shot from $71bln equivalent at the end of October to $123bln last week. To put this in context, the NYSE has only managed to add a matching sum of $50bln or more in a similar period twice in its history. No prices for guessing that these records were set right at the peak of the Tech Bubble and again add the very crest of the CDO Supercycle in 2007. For a sense of the scale of what is afoot in China today, also note that the US examples took place in a market whose total capitalization was then around four times that of which the Shanghai Comp can boast today.

Coincident with the three month ban on opening new accounts imposed by the CSRC on Citic, Haitong, and Guotai Junan Securities (handed down to accompany sanctions visited upon nine smaller brokerages) for a range of regulatory infractions which included violations of the stipulation that loans are not supposed to be rolled at the end of their limited term – the bankers’ regulator, the CBRC, made it a double-whammy by issuing a much broader directive prohibiting the use of the widely-abused entrusted loans – a kind of corporate fiduciary credit – for the purposes of financing bonds, futures, derivatives, financial products, equities or other investment vehicles.

Entrusted loans, you may be aware were one of the stand-out components of December’s above-forecast increase in Total Social Financing where they made a sudden jump to a record high of Y455billion which was roughly 135% of the past four years’ norm and which made up approximately twice the usual percentage of the total TSF itself.

15-01-20 ChiNext (2)
Courtesy of Bloomberg

 

Lest anyone think that the rally itself was been frowned upon, however, CSRC spokesman Deng Ge was quick to dispel any such interpretation, saying soothingly that: ‘…Investors’ interpretation that regulators are suppressing the stock market is not accurate.’ Stocks duly obliged by recouping around a quarter of their 9%+ intraday swoon, as did the ChiNext index which soared to a 20 day high, just a couple of percent from mid-December’s all-time peak.

Thus is the eternal dilemma of the central monetary authority: if the real-side is not open to a useful and profitable expansion of activity, the minute some new means of raising the table stakes is offered by the policymakers, the greater the energy becomes which is directed to playing the financial casino instead.

15-01-21 PBOC

In fact, the PBOC has been relatively blameless in this of late, with its total assets increasing at an 18-month low pace of 7.1% as forex reserve additions dwindled (revaluation effects, capital flight, or the use of IPO proceeds to pay down offshore debt?) and domestic reserve additions of only 8.1% per annum took place – a number which, you might observe, is nigh on indistinguishable from that pertaining to nominal GDP and, like that datum is something only undercut in decidedly less vibrant times (explicitly, in mid-2003 and 2009 when we consider the behaviour of the money supply alone).

15-01-21 CHI Hot

Indeed, it might be worth noting that the rate of monetary increase in once-booming China has fallen to less than half of that obtaining in a supposedly ‘deflationary’ Europe – 3.2% YOY versus 6.9%. Unlike in Europe, moreover, there is none of that necessary re-equilibration between money and credit taking place.

15-01-21 TSF

Though the two are not strictly comparable, the annual increment to Chinese M1 is no higher than it was in 2002 when NGDP was only a fifth of its present value and the addition was fully 15-16 times less than the tally of new levels laid out atop the pyramid of credit piled up above it. In Europe, by contrast, M1 growth (allowing for the breaks in the series caused by new entrants to the Zone) was only once briefly higher than it is now – a surge which came in the wake of Lehman’ collapse, of course.

15-01-21 ChiM1

Contrary to the Chinese case, new money per unit of NGDP is thus two-thirds higher than it was in 2002 and, furthermore, the system is becoming ever more liquid, again in contrast to what is happening in China, with the ratio of M1 (the base) to M3 ex-M1 (the pyramid) rising from 72% in 2008 to 133% today.

Regardless of all this, a sagging European economy is no handicap for those wishing to use the unwholesome fruits of easy money by putting them to work boosting asset prices, which are rising without overmuch concern being expressed as to the relation of those latter valuations to the amount of wealth being generated by the entities upon which these represent claims and to which they constitute capital inputs.

For its part, China, however belatedly, seems to have seen the error of its ways and while it will not be immune to the temptations of fine-tuning and top-down meddling as the vice starts to tighten, it has trumpeted its recognition that micro-economic and institutional reform pave the only sure route to a renewed heightening of general well-being. Thus, though progress is currently being made, the road ahead is undoubtedly a rocky one along which there is no guarantee either that the viaduct which spans the deep ravine ahead will not collapse under the weight of the locomotive as it passes or else that the train’s engine drivers will not be frightened into abandoning their course well short of their final goal.

In Europe, alas, the opposite is still very much the case. Only allow the central bank to introduce some new and yet more heavy-handed means of hammering at interest rates, asset prices and currency parities – while the politicians sit idly by, still pampering themselves and their fellow office holders with the proceeds of a threadbare public purse – and all will soon be made right. That is, at least, what most outside the Bundesbank appear to believe. Widely held the supposition may be: if only it were true as well.

Instead, as Premier Li himself admitted, the Chinese economy faces ‘relatively large downside pressure’ in coming months and so, he insisted, it is vitally important to continue the attempt at restructuring. As President Draghi seems unable to admit, it will be just such a restructuring that eventually alleviates Europe’s pain, not his prestidigitations, however crowd-pleasing they may at first appear.

Economics

On Money And Society: An Exclusive Interview With Steve Baker MP

A former RAF aviation engineer and software engineer in the financial sector, Steve Baker has been the Conservative MP for Wycombe, Buckinghamshire since 2010. Recently he was elected by his colleagues to the Treasury Select Committee, where he has put questions to Bank of England Governor Mark Carney, and he has also sponsored a Parliamentary debate on ‘Money Creation and Society’. He is an outspoken follower of the Austrian Economic School, and is an advocate of ‘free banking’ and the de-nationalisation of money. In this interview, Steve shares his views on money, banking and economics generally; why he chose to enter into politics; his plans for the next Parliament; and the prospects for sound money and banking in the UK and around the world.

BY WAY OF BACKGROUND…

Steve Baker has been fascinated by machines since his youth growing up in Cornwall. He studied Aerospace Engineering at Southampton University through a University Cadetship programme, entering the RAF on graduation, and served his country in multiple international locations for 10 years.

Also fascinated by information technology, on leaving the RAF in 1999 he studied towards a degree in Computer Science at St Cross College, Oxford. He then worked in a number of IT roles, including at Lehman Brothers in 2006-08, leading into the global financial crisis. His personal website (here) makes plain that, “My work at Lehman Brothers particularly informs my present work on reforming the financial system.” He decided to enter politics in 2007 and was elected to Parliament on his first attempt in 2010.

Steve is hardly the only sitting MP to focus on financial and banking issues. But he is the only Conservative MP to openly advocate for fundamental reform of not just banking, but of money itself. This is due to his outspoken belief in the key tenets of the Austrian Economic School, which teaches that activist monetary and fiscal policies undermine long-term economic health. To begin our discussion, we explore how Steve experienced the 2008 financial crisis and the impression it made.

JB: Steve, you had been working at Lehman Brothers for about two years when the financial crisis hit in 2008. Did you ever have a sense that the firm was dangerously exposed to a potential crisis? That the firm’s high leverage and a reliance on short-term financing could bring it down? That the financial system in general was as fragile as it demonstrably was?

SB: Back when Lehman was posting record quarter after record quarter, I was focussed on delivering value through software and I still believed our masters understood the institutional superstructure of the economy. It was only when the bust came that I realised the Austrian School had crucial insights to offer which were missing from the mainstream.

JB: How exactly did you come to believe that the Austrian Economic School provided the best explanation for the 2008 financial crisis and also for understanding economics more generally? Was this a gradual process or rather something more like a sudden epiphany?

SB: It was a long process. I first read Mises’ The Causes of the Economic Crisis and Hayek’s Monetary Theory and the Trade Cycle in 2000 during my MSc in Computer Science. I was planning to make my fortune in software, but then the dot-com bust happened. I wanted an explanation and found it in these books. However, my priority was business and I didn’t have the confidence to start telling economists where they were going wrong. It was only after working for banks and their regulators that I realised key insights about epistemology and method were absent from mainstream economics in important ways. That caused me to read more deeply, co-found The Cobden Centre with Toby Baxendale and then use my Parliamentary position to promote better economic policies.

JB: Please describe what it is you mean by free banking and money. Most people just take national fiat money and heavily-regulated banking for granted. Of course this was not always the case. But then have free banking and money really ever been the norm? Why is this topic of such importance to you?

SB: By ‘free-banking’ I mean money and a banking system produced by the spontaneous co-operation of free individuals in markets. It is what Hayek proposed in his Denationalisation of Money and HM Treasury briefly worked in that direction as an alternative to the euro. Usually, free banking means gold (or silver) as the base money and banking conducted under the ordinary commercial law, usually with unlimited strict liability. Canada and Scotland historically came closest to free banking. In a future free-banking system, cryptocurrencies or blockchain technologies of some sort are likely to have a role. Sound money is crucial to the justice of social processes.

JB: When and how did it occur to you that, by entering politics, you could contribute to changing the terms of debate around money and banking, when neither major UK party seemed to have any interest in doing so?

SB: Originally, it was the scandal of the Lisbon Treaty – the mangled EU Constitution – which prompted me to seek election to deliver an in/out referendum. It seems I may have played my part in reaching that objective but that decision was reached in 2007, before the crash. Once the crash came, when I had no realistic expectation of being elected, I decided to establish an Austrian School think tank. My surprise selection for a Conservative-held seat and election to Parliament changed everything.

JB: Please describe your experience in Parliament to date. What is it like to be something of a ‘maverick’ MP on the issues of money and banking? Is it encouraging? Discouraging?

SB: It’s hugely encouraging but hard work and I always appreciate support. As far as I am aware, I have no original ideas in this field and, being wary of the fringes of debate, I keep close to established literature. As a result, I seem to be attracting colleagues to at least consider the possibility that the Austrian School has a better answer to the question—famously asked by HM the Queen—of how the financial crisis could have happened. People know I am unorthodox but they also know I am grounded in credible literature. They also recognise the call for lower taxes, balanced budgets and sound money as distinctively Conservative. I suppose the difference is I really mean it; I don’t just say such things in hope of being elected.

JB: You recently sponsored a Parliamentary debate on ‘Money Creation and Society’? What was the purpose of the debate and do you believe that it achieved your objectives?

SB: Prominent Constitutional fiat money advocates Positive Money were agitating for a debate and they have strong national support. Despite disagreeing on many things, I am one of their best contacts in Parliament. The timing of the debate corresponded with their campaigning activity. However, of course I have spoken many times in the same vein, beginning with my maiden speech. Positive Money had created sufficient support for a debate in the main chamber to be possible and I was glad to lead it. We meant to move the debate forward and we did: I have received messages of support from around the world.

JB: Having recently achieved selection to the Treasury Select Committee, you have now had the opportunity to engage with Bank of England governor Mark Carney on multiple occasions. While he is obliged to answer your questions, do you find his answers satisfactory? Or evasive? Does it seem to you that the Bank of England is properly accountable to Parliament? Or is it able more or less to set policy on its own? If you could change anything about the existing governance of the Bank of England—other than abolishing it—what would that be?

SB: It is always a huge pleasure and privilege to ask questions of the Governor, who also chairs the G20 Financial Stability Board. Mark Carney is undoubtedly the central banker of his generation, full of talent and statesmanship. He knows where I stand. Perhaps our good-natured jousting can sometimes be seen in the sessions. His answers are mainstream and remember he has a dreadful power to shift markets with every word. He is sometimes breathtakingly honest—for example in relation to the shortcomings of mathematical models—but it is right that he has regard to the potential for his words to reverberate through markets. This factor has no place in a free society, of course, but we are where we are. The Bank is accountable to Parliament and the officials evidently take this seriously. The Bank operates within its mandate and that means it reaches policy decisions independently of politicians.

Given that, like Walter Bagehot [ed. note- Bagehot was Editor-in-Chief of The Economist from 1860 to 1877 and wrote extensively on fundamental economic and financial issues], I think the ideal system would not include central banks, your last question is hard to answer. I would have the Bank produce research that questions their groupthink and they are doing so. It will be a long time yet before we win the argument but having the Bank itself challenge orthodoxy may be an important breakthrough.

JB: Assuming that you and the Conservatives are re-elected in the coming months, what plans do you have for the next Parliament? What goals are realistic? And if you’re optimistic, what might be achieved over the next five years?

SB: Nationally, we must balance the budget. In all the circumstances, this will remain a tough problem. Personally, I would like to be re-elected by my colleagues to the Treasury Committee so I can continue to work on changing the terms of debate.

JB: How do you feel about the growing UK independence movement? Do you believe that the UK is more likely to fundamentally reform money and banking inside or outside the EU?

SB: People across the political spectrum are awakening to the reality that state power has escaped democratic control and that awakening is a good thing. The challenge is to hold politics together while a coalition for democracy and liberty is built, especially bearing in mind that it is the classical liberal and conservative family that is awakening first. A further fragmentation of the centre-right would be bad news for democrats and advocates of liberty.

Realistically, monetary reform is likely to come from either spontaneous market action or global reform of the post Bretton-Woods system. I don’t think the UK is likely to reform sterling unilaterally but this could happen provided we retain our own currency. I imagine Switzerland is culturally better-placed to reform independently, especially now they have decoupled from the euro. Maybe Russia will dramatically disrupt geopolitics with the reform you describe in your book. [Ed. note- I have suggested that Russia might respond to escalating international tensions by backing the rouble with gold. See here.]

JB: Do you regard the government’s ‘austerity’ policies to have been a success? How would you define ‘success’?

SB: Success would be a balanced budget. More work is required and the longer I spend in politics, the clearer it becomes that turning around a democracy is not like turning around a private company. The Chancellor has been more successful than most other finance ministers. I will continue to support him in so far as I can.

JB: To expand on the above, you are more aware than most about the deteriorating state of UK public finances and of the large imbalances in the economy more generally, such as the excessive reliance on property and financial services, and the chronic trade deficit with the rest of the world. Is it hard to be optimistic for the future when history suggests that the UK economy is going to remain weak for many years even in a relatively benign, non-crisis scenario in which these imbalances and excesses are worked off?

SB: In truth, it is often hard to be optimistic when you have “taken the red pill” of Austrian School economics. On the one hand, I am glad so many more people are now in private sector employment but on the other, as I have explained many times, the trajectory of debt and the continuing abuse of currencies is of grave concern. The future of our civilisation may be at stake.

JB: You co-founded the Cobden Centre, the leading sound money and banking think-tank in the UK. What do you see as the CC’s core mission? How exactly do you see the CC making a difference in future? Through education? Practical policy recommendations?

SB: The Cobden Centre’s core mission is to promote classical liberalism and specifically the Austrian School, that is, social progress through honest money, free trade and peace. It does not do politics but ideas and education. There is much more to do. Those interested in learning more can visit the website at www.cobdencentre.org and potential donors are welcome to send an email to staff@cobdencentre.org!

JB: Thanks so much for your time Steve. Before we conclude, are there any other thoughts you would like to share with our readers, many of whom work in the financial industry and would be profoundly affected by the sort of money and banking policies you advocate. What sort of impression would you hope they would take away from our discussion today?

SB: I hope readers will read your reports and your book, The Golden Revolution, and Detlev Schlichter’s complimentary work Paper Money Collapse. I hope they will read Mises and Hayek. If financial professionals cease opposing honest money and banking will we achieve the greatest institutional reform of our age: money and banking subject to competition and free of ruinous state control.

JB: Thank you so much Steve for your time.

POST-SCRIPT: REAL REFORMS REQUIRE

REAL LEADERSHIP

The value of Steve’s prominent role in promoting sound money and banking cannot be overstated. His leadership is an inspiration to all who would seek a better economic future. The best hope for real reform is to pressure the system both from within and from without. I encourage all readers to support Steve in his efforts in Parliament; through the educational resources of the Cobden Centre; and through their own private initiatives, whatever they might be.

Care to comment on this Report? Please contact me at john.butler@amphora-alpha.com.

Follow me on twitter! @butlergoldrevo

Economics

Swiss National Bank abandons franc’s cap against the euro

On January 15th 2015 the Swiss National Bank (SNB) has announced an end to its three year old cap of 1.20 franc per euro. (The SNB introduced the cap in September 2011). The SNB has also reduced its policy interest rate to minus 0.75% from minus 0.25%. The Swiss franc appreciated as much as 41% to 0.8517 per euro following the announcement, the strongest level on record – it settled during the day at around 0.98 per euro.

EuroCHF
We suggest that the key factor in determining a currency rate of exchange is relative monetary pumping. Over time, if the rate of growth of money supply in country A exceeds the rate of growth of money supply in country B then that country’s currency rate of exchange will come under pressure versus the currency of B, all other things being equal.
Whilst other variables such as the interest rate differential or economic activity also drive the currency rate of exchange, they are of a transitory and not of a fundamental nature. Their influence sets in motion an arbitrage that brings the rate of exchange in line with the influence of the money growth differential.
We hold that until now the rise in the money growth differential between Switzerland and the EMU during July 2011 and April 2012 was dominating the currency rate of exchange scene. (It was pushing the franc down versus the euro).The setting of a cap of 1.20 to the euro to supposedly defend exports was an unnecessary move since the franc was in any case going to weaken. The introduction of the cap however prevented the arbitrage to properly manifest itself thereby setting in motions various distortions. (Note again the money growth differential was weakening the franc versus the euro).
A fall in the money growth differential between April 2012 and April 2013 is starting to dominate the currency scene at present i.e. it strengthens the franc against the euro. So from this perspective it is valid to remove the cap and allow the arbitrage to establish the “true” value of the franc. (This reduces the need to pump domestic money in order to defend the cap of 1.20). Observe that as opposed to 2011, this time around, by allowing the franc to find its “correct” level the SNB it would appear has decided to trust the free market.
Note that since April 2013 the money growth differential has been rising – working towards the weakening of the franc versus the euro – and this raises the likelihood that the SNB might decide again some time in the future on a new shock treatment.

 

AMSSwissVsEuroGrowth

We hold that by tampering with the foreign exchange market the SNB sets in motion fluctuations in the growth momentum of money supply (AMS) and this in turn generates the menace of the boom/bust cycles. (Note the close correlation between the fluctuations in the growth momentum of foreign exchange reserves, the SNB’s balance sheet and AMS).

 

SNBAssetsVsForeignReserves

Also, observe that by introducing the cap and then removing it the SNB, contrary to its own intentions, has severely shocked various activities such as exports. Note that the SNB is supposedly meant to generate a stable economic environment.

Money

Swiss National Bank Throws Banks, Self Under Bus

In 1985, Arnold Schwarzenegger played John Matrix in the action movie, Commando. One line stands out. While dangling a bad guy over the edge of a cliff Matrix said, “Remember, Sully, when I promised to kill you last?” The frantic man replied, and Matrix added, “I lied.” He let Sully go.

Thomas Jordan, Chairman of the Governing Board of the Swiss National Bank (SNB), must be channeling John Matrix. On December 18, 2014 Jordan said, “The SNB remains committed to purchasing unlimited quantities of foreign currency to enforce the minimum exchange rate with the utmost determination.” Last Thursday, not even a month later—he said, “The Swiss National Bank (SNB) has decided to discontinue the minimum exchange rate…”

Schwarzenegger said it better. Besides, Commando was just a work of fiction. Central bankers toy with people’s livelihoods. Several currency brokers have already failed, only one day after this reversal.

When a central bank attempts to peg its currency, it’s usually trying to stave off collapse. The bank must sell its foreign reserves—typically dollars—to buy its own currency. Recently, the Central Bank of Russia tried this with the ruble. It never lasts long. The market can see the dwindling dollar reserves, and pounces when the bank is vulnerable.

The SNB attempted the opposite, selling its own currency to buy euros. It faced no particular limit on how many francs it could sell. Despite that, the market kept testing its willpower. Here is a graph showing the price of the euro in Switzerland. The SNB’s former line in the sand, is drawn in red, a euro price of 1.2 francs.

Euro Priced in Swiss Francs

 

The price of the euro was falling the whole year. Jordan’s promise caused but a blip. The pressure must have been intense. So he tried one last trick, familiar to any gambler.

Thomas Jordan bluffed.

He said the SNB is committed and tossed around words like unlimited. The market saw his bet, and raised. That forced him to fold.

I wrote about why the SNB pegged the franc. It wasn’t about exporters, but commercial banks. They borrow francs from their depositors, but lend many euros outside Switzerland. This means they have franc liabilities mismatched with euro assets. When the euro falls, they take losses.

The SNB inflicted this same problem on itself with its intervention. It borrowed in francs, creating a franc liability. This borrowing funded its purchase of euros, which are its asset.

As of November, its balance sheet showed 462 billion francs worth of foreign currencies, and it has disclosed that euros represent just under 50% of that. This puts their euro assets around 230B francs (which probably increased after that). The euro has fallen from 1.2 francs to just under 1.0, or 17%.

On Thursday, the SNB lost at least 38B francs, or 6 percent of Swiss GDP.

Why on earth did it choose to take this loss? It threw the commercial banks under the bus, and got tire tracks on its own back too. Without being privy to its internal discussions, we can make an educated guess.

The SNB hit its stop loss.

As traders kept buying francs, the SNB was obliged to keep increasing its bet. Its exposure to euro losses was growing. To continue meant more euro exposure on the same capital base—rising leverage. It chose to realize a big loss now, rather than continue marching towards insolvency.

The market is much bigger than the Swiss National Bank. If the citizens of insolvent states like Greece want to sell their euros for francs to deposit in Swiss banks, and if hedge funds and currency traders want to bet on the franc then the SNB can’t stop that freight train.

Everyone who holds francs is happy, because the franc went up. However, the fallout has just begun. Franc holders will discover that they are creditors. They can’t rejoice for long at their debtors’ pain. Pain will one day morph into defaults. Soon enough the franc will abruptly reverse. Who will bid on a defaulted bond, or a currency backed by it?

The game of floating paper currencies is not zero-sum, but negative-sum. Every move destroys someone’s capital. On Thursday, the SNB admitted it lost 38B francs. How much did commercial banks, pension funds, and other debtors in Switzerland lose in addition?

Economics

Should a Bank in Difficulties Receive Assistance?

This was the question put to me by Treasury Committee Chairman Andrew Tyrie MP when I appeared before the Committee on January 6th to give evidence on the Bank of England’s latest Financial Stability Report.

This is a question to which many of us on our side have given much thought and I believe it to be the single most important question in the whole field of bank regulatory policy.

I was nonetheless caught off-guard when Mr. Tyrie asked it at the beginning of the session – I was expecting questions on the Bank’s latest nonsense, the results of its new stress tests – and my initial response was less than it should have been. But no excuse: it was a perfectly reasonable and entirely foreseeable question – the obvious question, even – and I still didn’t see it coming. Reminds me of the blunders I would occasionally make when I played competitive chess: I obviously haven’t improved much.

Thankfully, he asked me the same question again at the close of the session, and his doing so allowed me to give the correct answer clearly, an emphatic ‘No’. However, by this point there was no time to elaborate on the reasons why a bank in difficulties should be denied assistance.

These reasons go straight to the whole can of worms and my follow-up letter to Mr. Tyrie should, I hope, help to set the record straight.

My message to other advocates of free markets is that leaving aside the usual bailouts-are-bad stuff, we really should give more thought to what an Armageddon Plan B might look like: Yes, no bailouts would be best, even in our intervention-infested system, but in that case why do we humour lender-of-last-resort and, more to the point, if the government is even considering intervention in what it (rightly or wrongly) sees as an emergency in which something-really-ought-to-be-done-NOW, then what should we advise it to do – other than ‘Don’t’?

Mark my words: if we don’t give the government constructive advice, it will do what it always does when a crisis breaks out: it will panic and the chances of any sensible policy response will be zero.

So here is the text of the letter, dated January 12th:

“Dear Mr. Tyrie,

I would like to thank you for the opportunity to give evidence to the Treasury Committee at its meeting on January 6th.

At that meeting you asked me if the authorities should assist a bank that gets into difficulties.

My answer is ‘No’ but I should like to elaborate.

Consider first a free or laissez-faire banking system in which there is no central bank, no financial regulation and no other state interventions such as deposit insurance. In such a system, competitive pressures would force the banks to be financially strong; bankers who ran down their banks’ capital ratios or took excessive risks would eventually lose their depositors’ confidence and be run out of business, so losing their market share to more conservative and better-run competitors. Bankers themselves would have serious skin in the game and therefore have strong incentives to keep their banks sound: for them, bank failure would be personally costly. Banks would then be tightly governed and conservatively risk-managed, and the banking system as a whole would be highly stable.

There would still be occasional failures due to the incompetence of individual bankers, but these would be few and far between, and not pose systemic threats.

These claims from free-banking theory are broadly confirmed by the historical experiences of the many free or loosely regulated banking systems of the past, most notably the experiences of Scotland pre-1845 and 19th century Canada.

In such a system, there is no good case for official assistance to any bank in difficulties. A bank failure would be painful to those involved, but the possibility of bankruptcy is unavoidable in any industry in a healthy capitalist economy, and this includes the banking industry. Letting a badly run bank fail also sends out the right signals – it encourages other bankers to avoid the same mistakes, it encourages depositors to be careful with the banks they choose and it avoids the moral hazards inevitably created by any policy of assistance.

Modern banking systems differ from these systems because of the presence of extensive systems of state intervention, including a central bank, a central bank lender of last resort function, deposit insurance, capital adequacy regulation and other forms of financial regulation. In different ways, each of these interventions makes the banking system less stable: central banks through erratic and usually loose monetary policies, which create inflation and fuel asset price cycles, and generally destabilise the macroeconomy; the lender of last resort and deposit insurance by creating moral hazards that lead to excessive risk-taking by bankers; capital regulation by creating short-termist incentives for banks to reduce their capital (e.g., by playing games with risk models and risk weights); and financial regulation generally by its large compliance costs and its stifling of innovation. Over time, these interventions have made the banking system weaker and weaker, even though their usual stated intention was to strengthen the banking system rather than to weaken it.

However, even with the banking system already seriously weakened by a long history of misguided government interventions, the best policy response is still to refuse assistance to banks in difficulties. I say this for two main reasons:

  • the systemic effects of bank difficulties tend to be exaggerated even in a systemic crisis, sometimes grossly so; and

  • interventionist policy responses tend to make matters even worse.

The ideal response by policymakers is to refuse assistance point-blank – and to announce such a policy in advance so the bankers know where they stand.

Policymakers should follow the advice of Lord Liverpool, who was PM at the time of the last systemic banking crisis pre-2007, that of December 1825. In May that year, he foresaw the looming crisis and warned the House of Lords about the “general spirit of speculation, which was going beyond all bounds and was likely to bring about the greatest mischief on numerous individuals.” He wished it to be “clearly understood” that those involved “entered on their speculations at their own peril and risk” and he thought it his duty to declare that he would “never advise the introduction of any bill for their relief; on the contrary, if any such measure were proposed, he would oppose it” and he hoped Parliament would reject it.

In our current system such a response would require political leadership with uncommon vision and nerves of steel. When the next crisis occurs, it will explode unexpectedly, taking policymakers off guard. They will be under extreme pressure to respond quickly – probably within hours – on the basis of inadequate information, whilst bankers lobby intensely for immediate assistance: if we don’t get bailed out, the world will end, etc., the usual scare mongering. Under such circumstances, it would be extremely difficult for even the best political leadership to avoid being dragged into making the same mistakes made repeatedly in previous crises.

These mistakes include:

  • panicky rescues, which are later shown to be unnecessary, ill-judged and in some cases illegal;

  • the abandonment of previous ‘commitments’ to let badly run institutions fail;

  • bankers being rewarded for their failures by being made personally better off than they would have been had their banks been allowed to fail; and

  • more regulation or regulatory reshuffles accompanied by the usual empty promises that ‘it’ won’t happen again, made by the very people who had no idea what they were doing when they were in charge the last time round.

So how can we avert such outcomes? A good start would be an Act to prohibit future assistance: as much as possible within the confines of our constitution, we should seek to tie the government to the mast. “Much as I would like to help you”, the PM can say, “my hands are tied.”

But even with this Act in place, there is still the difficult question: if the government does respond to the next crisis, then what should it do?

To that question I would propose a publicly disclosed Plan B, whose main features would include:

  • a programme to keep the banking system as a whole operating at a basic level to prevent widespread economic collapse;

  • fast-track bankruptcy processes to resolve problem banks and, where possible, return them to operation as quickly as possible;

  • a prohibition of cronyist sweetheart deals for individual banks or bankers;

  • provisions to ensure that senior managers of any failed banks are made strictly liable to severe personal financial penalties;

  • a holding-to-account of senior bankers, regulators and policymakers, including the opening of criminal investigations into the activities of any banks that fail;

  • the establishment of a legal regime that imposes high standards of personal liability on senior bankers;

  • the restoration of sound accountancy standards; and

  • a radical programme to deregulate the banking industry.

This programme would include the abolition of the current regulatory structure including the PRA and FCA, the ending of deposit insurance, the UK’s withdrawal from the Basel system of capital regulation, and the reform (and preferably, abolition) of the Bank of England. These reforms would rein-in the out-of-control moral hazards that permeate our current banking system and restore the personal responsibility, tight governance and conservative risk-taking that are the keys to a sound banking system.

Contingency planning for the next crisis should also provide for only two possible responses by the authorities: either Plan A (i.e., do nothing) or Plan B as just set out. Any intermediate response should be prohibited, as that would merely open the door to the usual mistakes that the authorities are prone to make in such circumstances.

In short, in response to your question about whether a bank should receive assistance, my answer would be ‘No’, but if we are to avoid another bungled policy response when the next crisis occurs it would be wise to have a credible Plan B in place to address upfront the Armegeddon scenario of a possible systemic collapse. And if it does intervene, the government should use the opportunity to clean up banksterism once and for all and restore a sound banking system based on the principles of personal responsibility and laissez-faire.

Yours Sincerely

Kevin Dowd,

Durham University/Cobden Partners [etc.]”

There is a lot more to say on this subject, but one of the points that emerges most clearly for me is the pressing need for free-market narratives of the financial crisis, blow-by-blow accounts of how it should and might have been. In this context – and off the top of my head – I would particularly recommend the following (with apologies to those whose work I have overlooked):

John A. Allison, The Financial Crisis and the Free Market Cure, McGraw-Hill 2013, esp. chapters 14-17.

Richard Kovacevich, “The Financial Crisis: Why the Conventional Wisdom has it All Wrong”, Cato Journal Vol. 34, No. 3 (Fall 2014): 541-556.

Vern McKinley, “Run, Run, Run: Was the Financial Crisis Panic over Institution Runs Justified?Cato Policy Analysis 747, April 10, 2014

George A. Selgin, “Operation Twist-the-Truth: How the Federal Reserve Misrepresents its History and Performance”, Cato Journal Vol. 34, No. 2 (Spring/Summer 2014): 229-263.

These are all US-oriented of course and we badly need to work on similar narratives for the UK, Ireland and Europe.

But going back to the Treasury Committee, most of the discussion was on the regulatory risk models – or more precisely, on what is wrong with regulatory risk modelling and in particular, the Bank’s stress tests. I have to say, too, that I was greatly heartened to see the skepticism of the MPs towards the models and their openness towards our ideas, much of which is obviously down to the pathbreaking work that Steve Baker is doing on the Committee. But let me come to all that in another posting.

Money

Money worries

“I hold all idea of regulating the currency to be an absurdity; the very terms of regulating the currency and managing the currency I look upon to be an absurdity; the currency should regulate itself; it must be regulated by the trade and commerce of the world; I would neither allow the Bank of England nor any private banks to have what is called the management of the currency.”

–       Richard Cobden.

 

“Raj, 33, a London-based photographer and amateur commodities trader who has used Alpari since 2009, said he currently had about £24,000 trapped in his account at the company.

‘It was completely out of the blue, a total shock,’ he said. ‘I’ve never had any issues with them. I’ve been calling and I just keep getting their answerphone.’”

–       From ‘Forex brokers suffer escalating losses in fallout from Swiss ditching franc cap’, The Financial Times, 17 January 2015.

 

“I don’t know what to say. I’ve been investing since January and I’ve never seen anything like it.”

–       Unnamed Hong Kong housewife during the Asian financial crisis, 1997/8.

 

“But the Swiss, not being as smart as the Italians, do not believe in devaluations. You see, in Switzerland, they have never believed in the ‘euthanasia of the rentier’, nor have they believed in the Keynesian multiplier of government spending, nor have they accepted that the permanent growth of government spending as a proportion of gross domestic product is a social necessity.

 

“The benighted Swiss, just down from their mountains where it was difficult to survive the winters, have a strong Neanderthal bias and have never paid any attention to the luminaries teaching economics in Princeton or Cambridge. Strange as it may seem, they still believe in such queer, outdated notions as sound money, balanced budgets, local democracy and the need for savings to finance investments. How quaint!

 

“Of course, the Swiss are paying a huge price for their lack of enlightenment. For example, since the move to floating exchange rates in 1971, the Swiss franc has risen from CHF4.3 to the US dollar to CHF0.85 and appreciated from CHF10.5 to the British pound to CHF1.5. Naturally, such a protracted revaluation has destroyed the Swiss industrial base and greatly benefited British producers. Since 1971, the bilateral ratio of industrial production has gone from 100 to 175… in favour of Switzerland.

 

“And for most of that time Switzerland ran a current account surplus, a balanced budget and suffered almost no unemployment, all despite the fact that nobody knows the name of a single Swiss politician or central banker (or perhaps because nobody knows a single Swiss politician or

central banker, since they have such limited power? And that all these marvellous results come from that one simple fact: their lack of power).

 

“The last time I looked, the Swiss population had the highest standard of living in the world—another disastrous long term consequence of not having properly trained economists of the true faith.”

–       Charles Gave of Gavekal, ‘Swexit !’.

 

 

“An increase in the quantity of money only serves to dilute the exchange effectiveness of each franc or dollar; it confers no social benefit whatever. In fact, the reason why the government and its controlled banking system tend to keep inflating the money supply, is precisely because the increase is not granted to everyone equally. Instead, the nodal point of initial increase is the government itself and its central bank; other early receivers of the new money are favoured new borrowers from the banks, contractors to the government, and government bureaucrats themselves. These early receivers of the new money, Mises pointed out, benefit at the expense of those down the line of the chain, or ripple effect, who get the new money last, or of people on fixed incomes who never receive the new influx of money. In a profound sense, then, monetary inflation is a hidden form of taxation or redistribution of wealth, to the government and its favoured groups, and from the rest of the population.. every change in the supply of money stimulated by government can only be pernicious.”

–       Murray Rothbard.

 

 

“The longer the boom of inflationary bank credit continues, the greater the scope of  malinvestments in capital goods, and the greater the need for liquidation of these unsound  investments. When the credit expansion stops, reverses, or even significantly slows down, the  malinvestments are revealed. Mises demonstrated that the recession, far from being a strange, unexplainable aberration to be combated, is really a necessary process by which the market  economy liquidates the unsound  investments of the boom, and returns to the right consumption /  investment proportions to satisfy consumers in the most efficient way.

 

“Thus, in contrast to the interventionists and statists who believe that the government must  intervene to combat the recession process caused by the inner workings of free market capitalism,  Mises demonstrated precisely the opposite: that the government must keep its hands off the  recession, so that the recession process can quickly eliminate the distortions imposed by the government-created inflationary boom.”

–       Murray Rothbard, again.

 

 

“I don’t know what’s going to happen in Europe but there is one thing I am certain about – eventually, someone is going to take a big loss.  As investors, the most important thing we can do is to make sure that we aren’t the parties taking that loss.”

–       Jeffrey Gundlach, cited by Joshua Brown, September 2011.

 

 

“The designers of the good ship euro wanted to create the greatest liner of the age. But as everybody now knows, it was fit only for fair-weather sailing, with an anarchic crew and no lifeboat. Its rules of economic seamanship were rudimentary, and were broken anyway. When it  struck a reef two years ago, the water flooded one compartment after another.. European officials now recognise the folly of creating the euro without preparing for trouble. It would be wise to be  planning now for what to do if it sinks.. Even now, after decades of “European construction”, many Eurocrats cannot conceive of the euro as a wreck. Those who have worked hardest to keep it afloat are exhausted and know it is not in their power to save it anyway.”

–       Charlemagne in ‘The Economist’, November 2011.

 

 

“Sir, It was a very cruel joke to publish Richard Barwell‟s recent letter (“Exit from first round of QE now seems premature”), particularly as it followed hot on the heels of Fed chairman Ben Bernanke’s announcement of so much more of the stuff. It was certainly a delicious coinage of Mr Barwell’s to suggest that this argument “makes no sense in theory”. This reminded me of those scientists who also contend that bumble bees cannot fly – in theory. Can I suggest that the FT letters page imposes some kind of moratorium on self-interested and highly conflicted “advice” from an academic school – economics – that having brought us to the brink, is now in danger of theorising itself into total absurdity ? To read that Mr Barwell is employed by the one organisation that has done more than any other to destabilise if not destroy the UK financial system – RBS – was the icing on this particularly ironic cake.

 

“QE does nothing more than put yet more capital into the hands of bankers who can then either play in the markets with it, or sit on it. In doing so, it also devalues its practitioners’ currencies versus those of regimes that have fundamentally sound economic policy. If our government and central bank wanted to do something properly constructive with all this newly created money, perhaps it could invest it into our country’s jaded infrastructure, rather than inflating further asset bubbles, the “wealth effect” of which is likely to be wholly illusory.”

–       Tragically unpublished letter to the Financial Times from the author, November 2010.

 

“What really broke Germany was the constant taking of the soft political option in respect of money.”

–       Adam Fergusson, ‘When Money Dies’.

 

Still think QE is the answer for the euro zone ?