Western central banks have tried to shake off the constraints of gold for a long time, which has created enormous difficulties for them. They have generally succeeded in managing opinion in the developed nations but been demonstrably unsuccessful in the lesser-developed world, particularly in Asia. It is the growing wealth earned by these nations that has fuelled demand for gold since the late 1960s. There is precious little bullion left in the West today to supply rapidly increasing Asian demand. It is important to understand how little there is and the dangers this poses for financial stability.
An examination of the facts shows that central banks have been on the back foot with respect to Asian gold demand since the emergence of the petrodollar. In the late 1960s, demand for oil began to expand rapidly, with oil pegged at $1.80 per barrel. By 1971, the average price had increased to $2.24, and there is little doubt that the appetite for gold from Middle-Eastern oil exporters was growing. It should have been clear to President Nixon’s advisers in 1971 that this was a developing problem when he decided to halt the run on the United States’ gold reserves by suspending the last vestiges of gold convertibility.
After all, the new arrangement was: America issued the petrodollars to pay for the oil, which were then recycled to Latin America and other countries in the West’s sphere of influence through the American banks. The Arabs knew exactly what was happening; gold was simply their escape route from this dodgy deal.
The run on U.S. gold reserves leading up to the Nixon Shock in August 1971 is blamed by monetary historians on France. But note this important passage from Ferdinand Lips’ book GoldWars:
Because Arabs did not understand bonds and stocks they invested their surplus funds in either real estate and/or gold. Since Biblical times, gold has been the best means to keep wealth and to transfer it from generation to generation. Gold therefore was the ideal vehicle for them. Furthermore after their oil reserves are exhausted in the distant future, they would still own gold. And gold, contrary to oil, could never be wasted.
According to Lips, Swiss private bankers, to whom many of the newly-enriched Arabs turned, recommended that a minimum of 10% and even as much as 40% should be held in gold bullion. This advice was wholly in tune with Arab thinking, creating extra demand for America’s gold reserves, some of which were auctioned off in the following years. Furthermore, Arab investors were unlikely to have been deterred by high dollar interest rates in the early eighties, because high interest rates simply compounded their rapidly-growing exposure to dollars.
Using numbers from BP’s Statistical Review and contemporary U.S. Treasury 10-year bond yields to gauge dollar returns, we can estimate gross Arab petrodollar income, including interest from 1965 to 2000, to total about $4.5 trillion. Taking average annual gold prices over that period, ten percent of this would equate to about 50,500 tonnes, which compares with total mine production during those years of 62,750 tonnes, over 90% of which went into jewellery.
This is not to say that 50,000 tonnes were bought by the Arabs; it could only be partly accommodated even if the central banks supplied them gold in very large quantities, of which there is some evidence that they did. Instead, it is to ram the point home that the Arabs, awash with printed-for-export petrodollars, had good reason to buy all available gold. And importantly, it also gives substance to Frank Veneroso’s conclusion in 2002that official intervention – i.e., undeclared sales of significant quantities of government-owned gold – was effectively being used to manage the price in the face of persistent demand for physical gold as late as the 1990s.
Transition from Arab demand
Arabs trying to invest a portion of their petrodollars would have left very little investment gold for the advanced economies. As it happened, U.S. citizens had been banned from holding bullion until 1974, and British citizens were banned until 1971. Instead, they invested mainly in mining shares and Krugerrands, continuing this tradition by using derivatives and unbacked unallocated accounts with bullion banks in preference to bullion itself. This meant that, until the mid-seventies, investment in physical gold in the West was minimal, almost all gold being held in illiquid jewellery form. Western bullion investors were restricted to mainly Germans, French, and Italians, mostly through Swiss banks. The 1970s bull market was therefore an Arab affair, and they continued to absorb gold through the subsequent bear market.
By the late-nineties, a new generation of Swiss investment managers, schooled in modern portfolio theory and less keen on gold, persuaded many of their European clients to reduce and even eliminate bullion holdings. At the same time, a younger generation of Western-educated Arabs began to replace more conservative patriarchs, so it is reasonable to assume that Arab demand for gold waned somewhat, as infrastructure spending and investment in equity markets began to provide portfolio diversification. This was therefore a period of transition for bullion, driven by declining Western investment sentiment and changing social structures in the Arab world.
It also marked the beginning of accelerating demand in emerging economies, notably India, but also in other countries such as Turkey and those in Southeast Asia, which were rapidly industrialising. In 1990, the Indian Government freed up the gold market by abolishing the Gold Control Act of 1968, paving the way for Indians to become the largest officially-recognised importers of gold until overtaken by China last year.
Lower prices in the 1990s stimulated demand for jewellery in the advanced economies, with Italy becoming the largest European manufacturing centre. At the same time, gold leasing by central banks increased substantially, as bullion banks exploited the differential between gold lease rates and the yield on short-term government debt. This leased gold satisfied jewellery demand as well continuing Asian demand for gold bars.
So, despite the fall in prices between 1997-2000, all supply was absorbed into firm hands. When gold prices bottomed out, Western central banks almost certainly had less gold than publicly stated, the result of managing the price until 1985, and through leasing thereafter. This was the background to the London Bullion Market Association, which was founded in 1987.
In 1987, the unallocated account system became formalized under London Bullion Market Association (LBMA) rules, allowing the bullion banks to issue gold IOUs to their customers, making efficient use of the bullion available. The ability to expand customer business in the gold market without having to acquire physical bullion is the chief characteristic of the LBMA to this day. Futures markets in the U.S. also expanded, and so derivatives and unallocated accounts became central to Western investment in gold. Today the only significant bullion held by Western investors is likely to be a small European residual plus exchange-traded fund (ETF) holdings. In total (including ETFs), this probably amounts to no more than a few thousand tonnes.
The LBMA was established in 1987 in the wake of the Financial Services Act in 1986. Prior to that date, the twice-daily gold fix had become the standard pricing mechanism for international dealers, whose ranks grew on the back of the 1970s bull market. This meant that international banks established their bullion dealing activities in London in preference to Zurich, which was the investment centre for physical bullion. The establishment of the LBMA was the formalization of an existing gold market based on the 400-ounce “good delivery” standard and the operation of both allocated and unallocated accounts.
During the twenty-year bear market, attitudes to gold diverged, with capital markets increasingly taking the view that the inflation dragon had been slain and gold’s bull market with it. At the same time, Asian demand – initially from the Arab oil exporters but increasingly from other nations led by Turkey, India, and Iran – ensured that there were buyers for all the physical gold available. Mine supply, which benefited from the introduction of heap-leaching techniques, had increased from 1,314 tonnes in 1980 to 2,137 tonnes in 1990 and 2,625 tonnes by 2000. Together with scrap supply, London was in a strong position to intermediate between a substantial increase in gold flows to Asian buyers, and it was from this that central bank leasing naturally developed.
Gold backed by these physical flows was the ideal asset for the carry trade. A bullion bank would lease gold from a central bank, sell the gold, and invest the proceeds in short-term government debt. It was profitable for the bullion bank, governments were happy to have the finance, and the lessor was happy to see an idle asset work up some extra income. However, leasing only works so long as the bullion bank can hedge by accessing future supply so that the lease can eventually be terminated.
Before 2000, this was a growing activity, fuelled further by Swiss portfolio disinvestment in the late 1990s. As is usual in markets with a long-term behavioral trend, competition for this business extended the risks beyond being dangerous. This culminated in a crisis in September 1999, when a 30% jump in the price threatened to bankrupt some of the bullion banks who were in the habit of running short positions.
Bull markets always start with very little mainstream and public involvement, and so it has proved with gold since the start of this century. So let us recap where all the gold was at that time:
- Total above-ground gold stocks were about 129,000 tonnes, of which 31,800 tonnes were officially monetary gold. Of the balance, approximately 85-90% was turned into jewellery or other wrought forms, leaving only 10-15,000 tonnes invested in bar and coins and allocated for industrial use.
- Out of a maximum of 15,000 tonnes, coins (mostly Krugerrands) accounted for about 1,500 tonnes and other uses (non-recovered industrial and dental), say, 1,000 tonnes. This leaves a maximum of 12,500 tonnes and possibly as little as 7,500 tonnes of investment gold worldwide at that time.
- After Swiss fund managers disposed of most of the bullion held in portfolios for their clients in the late 1990s, there was very little investment gold left in European and American ownership.
- Frank Veneroso in 2002 concluded, after diligent research, that central banks had by then supplied between 10-15,000 tonnes of monetary gold into the market. Much of this would have gone into jewellery, particularly in Asia, but some would have gone to the Middle East. This explains how extra investment gold may have been supplied to satisfy Middle Eastern demand.
- Middle Eastern countries must have been the largest holders of non-monetary gold in bar form at this time. We can see that 10% of petrodollars invested in gold would have totalled over 50,000 tonnes, yet there can only have been between 7,500-12,500 tonnes available in bar form for all investor categories world-wide. This may have been increased somewhat by the addition of monetary gold leased by central banks and acquired through the market.
It was at this point that the second gold bull market commenced against a background of very little liquidity. Investment bullion was tightly held, the central banks were badly short of their declared holdings of monetary gold, and from about 2004 onwards, ETFs were to grow to over 1,500 tonnes. Asian demand continued to grow (led by India), and China began actively promoting private ownership of gold at about the same time.
Other than through physically-backed ETFs, Western investors were encouraged to satisfy their demand for bullion through derivatives and unallocated accounts at the bullion banks. There are no publicly available records detailing the extent of these unallocated accounts, but the point is that Western demand has not resulted in increased holdings of bullion except through securitised ETFs. Instead, the liabilities faced by the bullion banks on uncovered accounts will have increased to accommodate growth in demand. Therefore, the vested interests of the bullion banks and the central banks overseeing the gold market call for continued suppression of the gold price, so as to avoid a repeat of the crisis faced in September 1999 when the price increased by 30% in only two weeks.
Where are the sellers?
Price suppression can only be a temporary stop-gap, and there has never been sufficient supply to allow the central banks to retrieve their leased gold from the bullion banks. Therefore, Frank Veneroso’s conclusion in 2002 that there had to be existing leases totalling 10-15,000 tonnes is a starting point from which leases and loans have increased. There are two events which will almost certainly have increased this figure dramatically:
- When the price rose to $1900 in September 2011, there was a concerted attempt to suppress the price from further rises. The lesson from the 1999 crisis is that the bullion banks’ geared exposure to unallocated accounts was forcing a crisis upon them; if they had been forced to cash-settle these accounts, the gold price would almost certainly have risen further, risking a widespread monetary crisis.
- Through 2012, Asian demand, particularly from China, coinciding with continued investor demand for ETFs, was already proving impossible to contain. In February this year, the Cyprus bail-in banking crisis warned depositors in the Eurozone that all bank deposits over the insured limit risked being confiscated in the event of a wider Eurozone banking crisis. This drove many unallocated account holders to seek delivery of physical gold from their banks, forcing ABN-AMRO and Rabobank to suspend all gold deliveries from their unallocated accounts. This was followed by a concerted central- and bullion-bank bear raid on the market in early April, driving the price down to trigger stop-loss sales in derivative markets and subsequent liquidation of ETF holdings.
It is widely assumed that the unexpected rise in demand for bullion that resulted from the April take-down was satisfied through ETF sales, but an examination of the quantities involved shows they were insufficient. The table below includes officially reported demand for China and India alone, not taking into account escalating demand from the Chinese diaspora in the Far East and from elsewhere in Asia:
These figures do not include Chinese and Indian purchases of gold in foreign markets and stored abroad, typically carried out by the rich and very rich. Nor do they include foreign purchases by the Chinese Government and its agencies. Despite these omissions, in 2012, recorded demand from these two countries left the world in a supply deficit of 131 tonnes. Furthermore, ahead of the April smash-down in the first quarter of this year, the deficit had jumped to 88 tons, or an annualised rate of 352 tonnes.
Demands for delivery by panicking Europeans in the wake of the Cyprus fiasco could only provoke one reaction. On Friday 12th April, 400 tonnes of paper gold were dumped on the market in two orders, triggering stop-loss sales and turning market sentiment bearish in the extreme. Western investors started to think about cutting their losses, and they sold down ETF holdings to the tune of 325 tonnes in 2013 by the end of May. However, this triggered record demand among those who looked on gold as insurance against currency and systemic risks.
Later that year, in July, Ben Bernanke told the Senate Banking Committee he didn’t understand gold. That was probably a reference to the April gold price smash orchestrated by the central banks and how it unleashed record levels of demand. It was an admission that he thought everyone would follow the new trend by acting like portfolio investors, forgetting that if you lower the price of a commodity, you merely unleash demand. It was also an important admission of policy failure.
Since those events in April, someone has been supplying the market with significant quantities of gold to keep the price down. We know it is not Arab gold, because I have discovered through interviewing a director of a major Swiss refiner that Arab gold is being recast from LBMA specification bars into one-kilo .9999 bars, which has become the new Asian standard. Arab gold does not appear to be being sold, only recast, and anyway, it is only a small part of their overall wealth. We also know from our long-term analysis that any European gold bullion is relatively small in quantity and tightly held. There can only be one source for this gold, and that is the central banks.
I discovered that there was a discrepancy in the Bank of England’s custodial gold of up to 1,300 tonnes between the date of its last Annual Report (28th February) and mid-June, when a lower figure was given out to the public on the Bank’s website. This fits in well with the additional amount of gold needed to manage the price between those months. Furthermore, the Finnish Central Bank recently admitted that all its gold held at the Bank of England was “invested” – i.e., sold – and further added that the practice “was common for central banks.”
Bearing in mind Veneroso’s conclusion in 2002 that there must be 10,000-15,000 tonnes out on lease and loan from the central banks at that time, one could imagine that this figure has increased significantly. Officially, the signatories of the Central Bank Gold Agreement, plus the U.S. and U.K. own 20,393 tonnes. A number of other central banks are likely to have been persuaded to “invest” their gold, but this is bound to exclude Russia, China, the Central Asian states, Iran, and Venezuela. Taking these holders out (amounting to about 3,000 tonnes) leaves a balance of 8,401 tonnes for all the rest. If we further assume that half of that has been deposited in London, New York, or Zurich and leased out, that means the total gold leased and available for leasing since 2002 is about 12,000 tonnes. And once that has gone, there is no monetary gold left for the purpose of price suppression.
Could this have disappeared since 2002 at an average rate of 1,000 tonnes per annum? Quite possibly, in which case, the central banks are very close to losing all control over the gold price.
This article was previously published at PeakProsperity.com.
Steve Baker has written an article for today’s City A.M. calling for an end to the ‘cruel delusion of cheap money and reckless spending‘:
George Osborne will present his Autumn Statement to a country in the grip of a cruel economic delusion, perpetrated against the poor and the aspirational.
Welfare states everywhere are spending chronically beyond their means while papering over the cracks with easy money. Budget 2013 forecast spending in excess of receipts of about £9bn a month. Defence, criminal justice, local government and the Foreign Office have been squeezed. Two thirds of spending was expected on health, education and welfare, mostly pensions.
The sick and disabled, families, children and pensioners are reliant on these crucial services. With taxes already too high, government is critically funded by the bond markets. Those bond markets are in a dangerous bubble, deliberately inflated by central banks.
Keynesian economists prescribe even more stimulus to dreadfully-mistaken applause, as if it were in the general interest to expand the state yet further and borrow to do it. They should be more honest about their politics. It’s true the Budget isn’t like that of a household or business, because the government can tax, intervene and create money. That’s just the problem: state power is a great force for destruction …
Read the whole article.
The FT blog entry dealing with the Pope’s recent apostolic exhortation is, as we might expect, a somewhat tendentious selection, archly culled from the proclamation. But, in the spirit in which it is there presented, let us deal with a few of the passages excerpted.
While the earnings of a minority are growing exponentially, so too is the gap separating the majority from the prosperity enjoyed by those happy few. This imbalance is the result of ideologies which defend the absolute autonomy of the marketplace and financial speculation…
No, such gross inequalities arise only due to state intervention (not least in the imposition of flawed systems of state money), from state-granted legal privilege, and through the state-exercised, post hoc largesse which is routinely showered upon its favoured lackeys whenever they make one of their frequent gross errors of judgement or succumb to their all too typical and wholly execrable violations of ethics.
Let us here be clear, whatever the pope may think, tax minimisation is not one of the latter. A man’s honestly come-by income is his, not his petty overlord’s, to dispose of and all non-violent efforts he makes to reduce the depredations being visited upon that income are just. The problem with this contention is that the ability to do so not extend equally to all. Thus, the larger fish – flaunting their state-granted immunities – swim free while the smaller fry – who might one day grow to be their competitors were they not so viciously oppressed – are caught in the net and squeezed all the more mercilessly in order to make up a budgetary shortfall (which itself only seems so pressing because of the insatiable lust for power of their rulers).
Jesus may have made a point of cultivating the company of publicans – i.e., of tax farmers – as a way of showing up the self-righteousness of the Pharisees, but He was surely not suggesting that it was their office that was the highest of all callings in that it assisted the voracious state in its attempt at ensuring ‘a better distribution of income’ – better distributed to its functionaries and supporters for the most part, that is.
…they reject the right of states, charged with vigilance for the common good, to exercise any form of control. A new tyranny is thus born, invisible and often virtual, which unilaterally and relentlessly imposes its own laws and rules
Does anyone in their right mind really think the market makes the rules? If so, then why are we plagued with a cradle-to-grave, self-perpetuating, largely self-selecting claque of political parasites and bureaucratic busybodies whose path up the greasy pole to view ‘all the kingdoms of the world, and the glory of them’ consists of a never-ending striving to think up new rules, regulations, prescriptions and prohibitions to impose upon the rest of us, the better to prove the political ‘vision’ – and hence fitness for high office – of their promulgators?
Furthermore, it strikes one as the bitterest of ironies that in this flight of rhetoric the Holy Father has seemingly chosen to confound the utterly notional ‘tyranny’ of fair dealing and contractual fulfilment with the innumerable, very real horrors inflicted upon his flock by that most bestial of institutions, the state, throughout its long, bloody history.
In a true free market – however much of an abstraction that concept may, alas, remain – self enrichment can only come about as the reward for a meritorious success in best satisfying the material needs of others. This is hardly a ‘tyranny’. Indeed, if anyone is subject to such a binding constraint, it is the profit-seeking entrepreneur since, in such a world, he is a man who earns his daily bread by making sure others receive theirs at the lowest cost, in the highest abundance, on the most regular basis, according to the shortest delay, and comprised of the greatest quality. If he does not do so as a matter of basic business principle, he risks soon going hungry himself.
Moreover, the ‘worship of the ancient golden calf’ which is held up as so abhorrent a practice has always been something most pitilessly enforced by the state, not the market. Leviathan – in order to shore up the pillars of its earthly dominion – has typically either perverted true faith into a religion of diabolical service to own glorification, or else has set itself up as the secular deity, one to be defied only at the price of life, liberty, and property. It is therefore not the ‘idolatry of money’ wherein we meet the most awful, crushing, ‘inhuman dictatorships’, but in societies which pretend to despise honest trade and which prey upon fruitful commerce.
We can no longer trust in the unseen forces and the invisible hand of the market… [and when, pray tell us, did we ever get a chance fully to do that?]
Growth in justice requires more than economic growth, while presupposing such growth: it requires decisions, programmes, mechanisms and processes… [etc., etc.]
Perhaps we might encourage His Holiness to find time among his regular schedule of devotions to read a little Hayek and perhaps some Buchanan, for here he has succumbed to the fallacy of the pretence of knowledge and he is also gathering up tares, not wheat, by failing to take note of the teachings of ‘public choice’ theory. Planning – for that is what this passage is advocating - is the scourge which drove us into this mess in the first place. The very ‘decisions, programmes, mechanisms and processes’ being implemented by the idiot savants and the hubristic meddlers who populate the ranks of the influential are what keep us mired within that mess and so prolong the suffering of one and all, far beyond their due measure and far in advance of their allotted span.
Our new Pope is doubtless a man of unimpeachable piety and great personal humility, but what the chosen paragraphs appear to demonstrate is that the concept of his infallibility is rightly reserved for his considered pronouncements on matters of doctrine, not economics or even politics. Otherwise, instead of echoing the sentiments of such a leading light of humanitarianism as Che Guevara – whose Stalinist ramblings also dwelt on the ‘alienation’ suffered by the masses and who likened the market economy uncomprehendingly as a ‘contest among wolves’ – he would surely acknowledge that, for all the inevitable human failings of the individuals who make up the class, entrepreneurs routinely do, have always done, and always will do more good for more people in more instances than ever have or ever will the commissars, crony plutocrats, and corrupted vote-mongers from whom the Alphaville redactor (if not necessarily the Pope himself) finds them drearily indistinguishable or else beside whom she deems them decidedly less commendable.
The FT post itself concluded with fashionably cheap jibe en passant at the Tea Party – which it no doubt sees as a howling mob of ape-knuckled reactionaries stubbornly resisting all that uplifting soixante-huitard progressiveness which some of its authors and the rest of the more enlightened so joyously embrace. This itself reveals much about the ideological intent behind the careful culling of the Pope’s words, as does the breathless worship of Keynes and Krugman which has become FT Alphaville’s default setting.
Yet there are one or two phrases in the Apostolic which could be cited to support a completely opposite view of the world, as for example, when the Pope says:
…Today’s economic mechanisms promote inordinate consumption, yet it is evident that unbridled consumerism combined with inequality proves doubly damaging to the social fabric…
Agreed. But on the FT blog the talk is usually a wearisome rehearsal of ‘paradoxes of thrift’, ‘liquidity traps’, and of the need for programmes of economic ‘stimulus’ which are all aimed at fostering that two-masses-for-the dead, pyramid-building Uber-consumption of the kind which can only spawn what are ultimately unsustainable levels of ‘…Debt and the accumulation of interest [which] also make it difficult for countries to realize the potential of their own economies and keep citizens from enjoying their real purchasing power…’ – that latter a cry not to resort to any further inflationism, perhaps; not to mention a suggestion that we might do well to reduce, not inexorably increase, indebtedness, pace the Bloomsbury Sage and his brutish New York Times enforcer?
And as for the inherent collectivism of much of the commentary here, well, there is always this to consider:
…all this becomes even more exasperating for the marginalized in the light of the widespread and deeply rooted corruption found in many countries – in their governments, businesses and institutions – whatever the political ideology of their leaders.
Here, Pope Francis – if with perhaps not the greatest degree of consistency, given what he has argued earlier in his address – is categorically expressing his deep disapproval of those same enlightened, disinterested, Platonic philosopher-kings to whose tender judgement we are often told in the FT we should commit our care, lest the evils of the market come upon us as a wolf upon the fold.
Adding to this, in a different section, the pontiff argues that,
…the principal author, the historic subject of this process [of building a fair society], is the people as a whole and their culture, and not a single class, minority, group or elite. We do not need plans drawn up by a few for the few, or an enlightened or outspoken minority which claims to speak for everyone. It is about agreeing to live together, a social and cultural pact…
Not much room there for that sordid Republic of Men, not Laws for which we are enjoined to abandon that fructifying “social and cultural pact” which is the market.
Francis goes on:
…it is the responsibility of the State to safeguard and promote the common good of society. Based on the principles of subsidiarity and solidarity, and fully committed to political dialogue and consensus building, it plays a fundamental role, one which cannot be delegated, in working for the integral development of all. This role, at present, calls for profound social humility…
Here, ultimately, is the root of all our woes. Not the “absolute autonomy of the marketplace and financial speculation”, but the fact that none of those who hold sway over us – neither the unelected technocrats like Mario Draghi and Janet Yellen, the heads of our increasingly arbitrary governments – whether elective, theocratic, single-party socialistic, or monarchic in flavour – the sinister spymasters they have empowered to snoop and pry and curtain-twitch at our every thought and deed, nor the pettifogging officials they have let loose to harry us about our daily round – not one of them display much in the way of ‘social humility’, profound or otherwise.
Perhaps that’s because most of these worthies have never had to operate within the one institution most likely to inculcate such a virtue; the one in which the consumer – and not the producer – is sovereign; the one where the customer – not the merchant – is always right.
I refer, of course, to the free, unhampered market – the bringer of bounty and promoter of peace, the forum of fraternity and congress of co-operation where man meets with man in order to trade, mine for yours, to the mutual benefit of both.
Still unnoticed by a large part of the population is that we have been living through a period of relative impoverishment. Money has been squandered in welfare spending, bailing out banks or even — as in Europe — of fellow governments. But many people still do not feel the pain.
However, malinvestments have destroyed an immense amount of real wealth. Government spending for welfare programs and military ventures has caused increasing public debts and deficits in the Western world. These debts will never be paid back in real terms.
The welfare-warfare state is the biggest malinvestment today. It does not satisfy the preferences of freely interacting individuals and would be liquidated immediately if it were not continuously propped up by taxpayer money collected under the threat of violence.
Another source of malinvestment has been the business cycle triggered by the credit expansion of the semi-public fractional reserve banking system. After the financial crisis of 2008, malinvestments were only partially liquidated. The investors that had financed the malinvestments such as overextended car producers and mortgage lenders were bailed out by governments; be it directly through capital infusions or indirectly through subsidies and public works. The bursting of the housing bubble caused losses for the banking system, but the banking system did not assume these losses in full because it was bailed out by governments worldwide. Consequently, bad debts were shifted from the private to the public sector, but they did not disappear. In time, new bad debts were created through an increase in public welfare spending such as unemployment benefits and a myriad of “stimulus” programs. Government debt exploded.
In other words, the losses resulting from the malinvestments of the past cycle have been shifted to an important degree onto the balance sheets of governments and their central banks. Neither the original investors, nor bank shareholders, nor bank creditors, nor holders of public debt have assumed these losses. Shifting bad debts around cannot recreate the lost wealth, however, and the debt remains.
To illustrate, let us consider Robinson Crusoe and the younger Friday on their island. Robinson works hard for decades and saves for retirement. He invests in bonds issued by Friday. Friday invests in a project. He starts constructing a fishing boat that will produce enough fish to feed both of them when Robinson retires and stops working.
At retirement Robinson wants to start consuming his capital. He wants to sell his bonds and buy goods (the fish) that Friday produces. But the plan will not work if the capital has been squandered in malinvestments. Friday may be unable to pay back the bonds in real terms, because he simply has consumed Robinson’s savings without working or because the investment project financed with Robinson’s savings has failed.
For instance, imagine that the boat is constructed badly and sinks; or that Friday never builds the boat because he prefers partying. The wealth that Robinson thought to own is simply not there. Of course, for some time Robinson may maintain the illusion that he is wealthy. In fact, he still owns the bonds.
Let us imagine that there is a government with its central bank on the island. To “fix” the situation, the island’s government buys and nationalizes Friday’s failed company (and the sunken boat). Or the government could bail Friday out by transferring money to him through the issuance of new government debt that is bought by the central bank. Friday may then pay back Robinson with newly printed money. Alternatively the central banks may also just print paper money to buy the bonds directly from Robinson. The bad assets (represented by the bonds) are shifted onto the balance sheet of the central bank or the government.
As a consequence, Robinson Crusoe may have the illusion that he is still rich because he owns government bonds, paper money, or the bonds issued by a nationalized or subsidized company. In a similar way, people feel rich today because they own savings accounts, government bonds, mutual funds, or a life insurance policy (with the banks, the funds, and the life insurance companies being heavily invested in government bonds). However, the wealth destruction (the sinking of the boat) cannot be undone. At the end of the day, Robinson cannot eat the bonds, paper, or other entitlements he owns. There is simply no real wealth backing them. No one is actually catching fish, so there will simply not be enough fishes to feed both Robinson and Friday.
Something similar is true today. Many people believe they own real wealth that does not exist. Their capital has been squandered by government malinvestments directly and indirectly. Governments have spent resources in welfare programs and have issued promises for public pension schemes; they have bailed out companies by creating artificial markets, through subsidies or capital injections. Government debt has exploded.
Many people believe the paper wealth they own in the form of government bonds, investment funds, insurance policies, bank deposits, and entitlements will provide them with nice sunset years. However, at retirement they will only be able to consume what is produced by the real economy. But the economy’s real production capacity has been severely distorted and reduced by government intervention. The paper wealth is backed to a great extent by hot air. The ongoing transfer of bad debts onto the balance sheets of governments and central banks cannot undo the destruction of wealth. Savers and pensioners will at some point find out that the real value of their wealth is much less than they expected. In which way, exactly, the illusion will be destroyed remains to be seen.
This article was previously published at Mises.org.
“We have the best government that money can buy.” – Mark Twain.
It says a lot about the financial establishment that the most revelatory coverage of the worst financial crisis in living memory has appeared, not in the pages of ‘The Financial Times’ or ‘The Wall Street Journal’, but in those of ‘Vanity Fair’ and ‘Rolling Stone’. In the first example, former bond salesman Michael Lewis displayed the finest characteristics of investigative journalism whilst exploring the more ridiculous examples of modern greed and credit-based insanity in forensic detail. In the second, Matt Taibbi broke new ground in gonzo journalism as he tilted against the previously impregnable windmills of Wall Street, giving us in the process the immortal description of the taxpayer-rescued brokerage firm Goldman Sachs as “a giant vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”. In the latest iteration of serious economic and cultural analysis arising from a non-mainstream source, we now have ‘Life After The State’ – a critique of government written by a stand-up comedian.
In Dominic Frisby’s defence, he wears multiple hats. As his Twitter profile puts it, he is an “Accidental financial bod, MoneyWeek writer, comedian, actor of unrecognized genius, voice of many things, & presenter.” And now an author. Published by the crowd-funding website Unbound, ‘Life After The State’ follows hot on the heels of Douglas Carswell’s ‘The End Of Politics’ and Guy Fraser-Sampson’s ‘The Mess We’re In’, and each attempts to address a nagging feeling from a slightly different perspective. That feeling was well expressed recently by the outspoken investor Paul Singer of Elliott Management when he remarked, almost in passing, that
America is deeply insolvent, and for that matter, so are most of continental Europe, the UK and Japan.
Or to put it another way, what the hell just happened, and why ?
The answer, and the beast that has to be slaughtered for any hope of progress and recovery, is Big Government. Many readers will doubtless respond that any retrenchment by an over-mighty State is simply wishful thinking. Some of us might respond in turn that it is actually a mathematical certainty. But Dominic, early on, spikes the guns of scepticism by citing the anonymous internet poster known as ‘Injin’:
Find the right answer, realise you’ll never see it in your lifetime, and then advocate it anyway, because it’s the right answer.
Frédéric Bastiat’s broken window fallacy also gets an early airing, which is entirely justifiable – it’s one of the most powerful ideas in the history of economics. We can ‘see’ what in the economy gets spent (by Big Government, having raided our wallets first, or worse, the wallets of those as yet unborn), but we cannot ‘see’ how that money might have been spent in the absence of Big Government. And there are only four ways of spending money. We can spend our money on ourselves. Which is nice. Or we can spend it on other people. Which is quite nice. We can spend other people’s money on ourselves (generally illegal). Or we can spend other people’s money on other people, which is what government actually does, and which tends to lead to malinvestment, waste, zombie banking, and so on. Happily, although there’s no shortage of economics in ‘Life After The State’, it’s all painlessly incorporated into the general argument, which makes for a highly readable and engaging book.
Another powerful idea arises in Chapter 8, and it’s a killer – quite literally. If governments had been separated from their monopoly control to print money, World War I would have been over by Christmas 1914.
Neither the British nor the German governments had the money, or gold, to pay for it. Both came off the gold standard and printed the money they needed. Had either government not had the power to print money or create debt – i.e. if they did not have control of money – the war would have had to stop.. Think about the implications.. German reparations.. Weimar hyperinflation.. the rise of Hitler..
And the same holds for almost all wars.
No war has ever been fought on a cash basis. Costs are concealed by deficit spending. If taxes had to rise concomitantly in the same year that wars were being fought, people would not pay. Instead, the cost is added to the national debt. People don’t have to pay £10 billion this year; instead they pay an extra £500 million every single year for eternity in interest on the national debt. Take away this power to create money and run deficits, and you suddenly limit the scope of the war to the amount of money the government has. In other words you limit government power – and you limit the damage that they can do. That alone is reason enough to separate money and state.
‘Life After The State’ is particularly good as a primer on gold, sound money and inflation. The anecdotal always helps, for context.
But the price of oil in US dollars has gone from $3.50 a barrel in 1972 to around $100 now. That’s something like a.. 96% loss in purchasing power. The same goes for all modern government currencies, which buy you less and less each year: less house, less chocolate bar, less anything. In 1971 I could have taken my son to the FA Cup Final for £2 (now over £100). The Mars bar I bought him at half-time would have been 2p (now 60p). The beer I bought myself would have been 11p (now £5 a pint at Wembley). The gallon of petrol I needed to get me there and back would have been 33p (now £7). And the house we went home to would have been something like 40 times cheaper.
The State is so entrenched in our lives it is sometimes difficult to imagine life without it. It “looks after the birth of the baby, educates the child, employs the man, cares for the aged, and buries the dead.” But in doing so it also spends £700 insuring each birth against negligence claims; while it educates the child, there can be no guarantee that it does so well – no matter, the examination pass rates, like the currency, can easily be inflated; the man may be employed, but not gainfully so..
On Thursday last week, the newspaper of the neo-Keynesian financial establishment, ‘The Financial Times’ had room for three stories on its front page. One of them covered the resignation of Barclays’ head of compliance, Sir Hector Sants, on the grounds of stress and exhaustion (cue mass playing by an orchestra of the world’s smallest violins). Sir Hector was previously chief executive of the Financial Services Authority, an arm of Big Government – in other words, not a particularly successful one, if current financial scandals and the health of the banking system are any guide. Another detailed how a Prime Minister evidently deeply committed to free markets was pressing mobile phone companies to cut their bills to customers. If David Cameron were really serious about inflation, though, he would be advised to pay closer attention to what Mark Carney has been up to at the Bank of England. The FT’s main story, ‘Rate rise signalled for 2014 as UK recovery takes hold’, was accompanied by a photograph of Mr. Carney looking for all the world like an evil little elf (for all we know, perhaps he is one).
Apparently the Bank of England is now considering a UK rate hike as soon as next year, and 18 months sooner than previously expected by the market. One wonders what all those first-time buyers lured into buying property by the government, the Bank of England and their easy money policies, might make of that.
This article was previously published at The price of everything.
In 2008 as The Great Moderation came to an end, Queen Elizabeth II asked Mervyn King “Why did no-one see this coming?” Her Majesty had clearly not read either Irrational Exuberance by recent Nobel laureate Robert Shiller, or Crash Proof by Peter Schiff (probably not a Nobel candidate). If she had she would have realised that, in fact, at least two economists, albeit with very different approaches, did see this coming. There were warnings, but many chose to ignore them. But Her Majesty was on to something, the belief that the crash had caught economists napping became quite widespread.
This dissatisfaction with the orthodox macroeconomics practiced by policymakers and taught in universities on both sides of the Atlantic has sparked an increased interest in heterodox economics, such as inspired Manchester University’s Post-Crash Economics Society which declares “The world has changed, the syllabus hasn’t”. There is much to commend this trend – much orthodox macroeconomics is mathematically overelaborate bunk. But what exactly is the orthodox we should be shunning and the heterodox we should be embracing?
According to the Guardian, one of the economists backing the efforts of students like those in Manchester is Cambridge University’s Ha-Joon Chang who says “Students are not even prepared for the commercial world. Few [students] know what is going on in China and how it influences the global economic situation. Even worse, I’ve met American students who have never heard of Keynes.”
Really? I did my economics degree at Birkbeck College between 2007-2011. One of my modules was Macroeconomic Theory and Policy and the course text was 2007’s Macroeconomics by N. Gregory Mankiw and Mark P. Taylor. It contains eleven index entries under ‘Keynes, John Maynard’ (‘consumption function’, ‘economic theory’, ‘gold standard’, ‘inflation’, ‘inflation as taxation’, ‘interest rate determination’, ‘investments’, ‘IS curve’, ‘IS-LM model’, ‘real wages, cyclical behaviour of’, and ‘stock market speculation’) and a further nine under ‘Keynesian Cross’ (‘adjustments’, ‘decrease in taxes’, ‘dwindling in popularity of’, ‘economy in equilibrium’, ‘government purchases’, ‘planned expenditure’, ‘policy shifts and’, and ‘taxes’). In another module, Intermediate Macroeconomics, the course text was 2007’s Macroeconomics by Stephen Williamson. Solidly in the Real Business Cycle tradition even this book contains index references to ‘Keynesian business cycle theory’ (‘labor market in a sticky wage model’), eleven references under ‘Keynesian coordination failure model’, and one each for ‘Keynesian transmission mechanism for monetary policy’, and ‘Keynesian unemployment’.
Besides, the point of university is that you do much of the study off your own bat. At the end of my first year I had got so fed up reading textbooks telling you what was in The General Theory that I went and read it myself. Quite honestly, it is difficult to believe that Chang actually has met “American students who have never heard of Keynes” and if he did they would seem to be uninquisitive, unrepresentative idiots who a change of syllabus is unlikely to help.
In another Guardian article Mahim Husnain and Rikin Parekh of the Manchester society write that “in the education we receive as economics students, there is little stress on how a market could fail”. If this is true then the curriculum at Manchester University is very different to mine. In a module on Intermediate Microeconomics one of the textbooks we used was 2003’s Microeconomics by Robert S. Pindyck and Daniel L. Rubinfeld, the fourth and final part of which was called ‘Information, Market Failure, and the role of the Government’. We also used Hal R. Varian’s 2006 text Intermediate Microeconomics which included entire chapters on supposed sources of market failure such as ‘Monopoly’ and ‘Oligopoly’, ‘Public Goods’, ‘Externalities’, and ‘Asymmetric Information’.
Much of the microeconomics taught at universities is, in fact, based on notions of market failure and what the government can apparently do to remedy them, so much so in fact, that Joseph Stiglitz, George Akerlof, and Michael Spence won the Nobel prize in 2001 for their work on the subject. If you haven’t come across it either your university is letting you down or you’re not paying attention in class.
Michael Joffe, professor of economics at Imperial College, London, says “many reformers (have) called for economics courses to embrace the teachings of Marx and Keynes”. But heterodox economics should not simply mean any old rubbish. Some of it, like Marx with the ludicrous Labour Theory of Value as the keystone of his system, is heterodox for a very good reason. And the idea that Keynes is or was particularly neglected and that universities are teaching that markets can never fail is simply untrue; he is an integral part of the orthodox mainstream.
Economists should always be testing their theories against new ideas and to that extent the recent interest in different approaches is to be welcomed. But we should be wary of people trying to pass off the useless (Marx) or the thoroughly familiar (Keynes) as something fresh and challenging.
Zerohedge recently drew attention to the growing level of foreign bank cash deposits, tucked away at the bottom of the Fed’s H.8 statement.
Foreign banks’ cash balances have increased by $518.7bn since September 2012, accounting for almost all of the increase in these banks’ total assets in the H.8 table. The implication is that these cash balances are held as reserves on the Fed’s balance sheet, the counterpart of quantitative easing.
This naturally raises the reasonable question posed by Zerohedge’s article as to why the Fed appears to be benefiting foreign banks with QE. The answer is either these deposits have been transferred to them from US banks in the normal course of business or the Fed is prepared to provide liquidity to foreign banks: after all the US dollar is the reserve currency. And this liquidity is most needed by the weakest banks in the international banking system, many of which are in the eurozone.
The ECB’s room for manoeuvre with respect to money-printing is more limited, and it is the only central bank of the big four not to have overtly quantitatively eased. Furthermore, the eurozone is still in trouble even though it has disappeared from the headlines. The chart below of bank lending figures supplied by the ECB illustrates the problem.
Bank lending peaked in mid-2012, and by mid-2013 it had contracted over €1 trillion. By now, the ECB should have advance knowledge of the yet-to-be-released Q3 bank lending total, which if it has continued the downward trend explains why the ECB unexpectedly reduced interest rates recently.
Meanwhile, the Bank of England has finally admitted that the UK’s economy is growing. Conventional wisdom suggests the BoE should permit interest rates to return to more normal levels, but it refuses to do so for at least another year. The fact that the UK continues with current interest rate polices is due in part to policy coordination with the Fed, the ECB and to a lesser extent perhaps the Bank of Japan.
The logical implication from the Fed’s and the BoE’s actions is that interest rate policies are being managed with the weakest in mind. Therefore the course of prices and bank lending in the eurozone could be regarded as the current determinant of when tapering will be introduced by the Fed.
However there is still an overriding problem: if the stimulant of monetary inflation is reduced, rates along the yield curve will rise rapidly from today’s wholly artificially suppressed levels. The two cannot be divorced. The Fed knows this, and it is central to its internal debate.
The fact of the matter is that just as zero interest rates flatter bank balance sheets and government borrowing costs, the reverse is also true. Add into the mix the deflationary implications of more normal interest rates and it is obvious that the Fed and the BoE are trapped. They will not be looking forward to the day when they run out of excuses for this dilemma. But for now at least there is a rescue mission in place for the eurozone, and the Fed will continue to lend its support to foreign banks.
This article was previously published at GoldMoney.com.
“No warning can save people determined to grow suddenly rich.” – Lord Overstone.
We have seen a confluence of events that suggests we may be reaching the terminal point of the financial markets merry-go-round – that point just before the ride stops suddenly and unexpectedly and the passengers are thrown from their seats. Having waited with increasing concern to see what might transpire from the gridlocked US political system, the market was rewarded with a few more months’ grace before the next agonising debate about raising the US debt ceiling. There was widespread relief, if not outright jubilation. Stock markets rose, in some cases to all-time highs. But let there be no misunderstanding on this point: the US administration is hopelessly bankrupt. (As are those of the UK, most of western Europe, and Japan.)
The market preferred to sit tight on the ride, for the time being. Three professors were awarded what was widely misreported as ‘the Nobel prize in economics’ for mutually contradictory research. What they actually received was the ‘Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel’, which is not quite the same thing. But then economics is not a science, and Eugene Fama’s ‘efficient market hypothesis’ is not just empirically wrong, but dangerously so. History, it would seem, is clearing the decks. Perhaps the most intriguing development of the week was the news that Neil Woodford would soon be retiring from his role managing £33 billion of other people’s money at Invesco Perpetual to start up his own business. It was widely reported that Mr. Woodford nursed growing frustration at the short-termism of the financial services industry. We will return to this theme.
One of the sadder stories in the history of investment management is that of Mr. Tony Dye. The following extract is taken from his obituary in The Independent:
Tony Dye was one of Britain’s best known fund managers, becoming a household name in the late 1990s due to his controversial opinions about the outlook for global stock markets. At a time when markets were soaring, Dye insisted they were overvalued and on the verge of a crash – a view which put him at odds with most other investors at the time and earned him the nickname “Dr Doom”.
As early as 1995, as the FTSE 100 was approaching 4,000 points, Dye began to make the case that markets were too expensive. At the time, he was the chief investment officer for Phillips & Drew, one of Britain’s biggest asset management firms, and by 1996 he had begun to move large sums of clients’ money out of equities and into cash.
In the years that followed, however, stock markets continued to soar, driven by the technology boom. But Dye stuck to his guns, avoiding the high-growth, high-risk internet stocks, maintaining large positions in cash, and consequently ensuring that Phillips & Drew’s funds significantly underperformed their rivals. By 1999, the firm was ranked 66th out of 67 for performance amongst Britain’s institutional fund managers, and was haemorrhaging clients – and in February the following year, just weeks after the FTSE had broken through 7,000 points for the first time, Dye was sacked.
Days later, his prophesy finally came true. Markets collapsed, and settled into a three year slump, which saw more than 50 per cent wiped off the value of global stock markets.
Neil Woodford’s apparent concerns are well placed. There is a grotesque mismatch between the set-up of institutional asset managers and what is in the best interests of their end clients, the individual members of the public who pay their fees. The investment fund marketplace is grotesquely oversupplied. There is far too much, to use the dismal phrase, product. The problem is exacerbated by perhaps inevitable weaknesses in psychology – both on the part of the manager, and on the part of the investor. Stress points abound throughout the chain. The investment fund world is hopelessly balkanised, and brimming over with a degree of product specialisation utterly unwarranted by investors’ real needs. The fund management industry is a perpetual production line of novelty, or rather an endless rehash of the same old ideas. The point of absurdity was reached and surpassed when there were more mutual funds listed on the New York Stock Exchange than there were common stocks with which to populate them. The industry is a monstrous hydra, busily consuming its own, and its investors’, capital. New funds are launched daily. Failing older funds are quietly tidied away, merged, or destroyed. They are ‘uninvented’.
Alison Smith and Stephen Foley covered the news of Neil Woodford’s resignation for the Financial Times. They cited the FT’s own John Kay, who carried out a review of UK equity markets last year, and who said,
The short-term horizon is basically introduced by the intermediary sector.. Pension trustees [for example] are told they should keep reviewing managers, while retail investors get constant invitations to trade from independent financial advisers [for example] and the platforms set up to enable them to do so.
As they suggest, Neil Woodford’s past success means that raising money for his new business is unlikely to be much of a struggle. “But imagine the hurdles in the way of a manager who would like to purse long-term strategies but is just starting out.” In the words of Professor Kay,
How easy would Warren Buffett find it to set up now?
We have not been immune to the demands of clients frustrated at the performance of diversified portfolios lagging the broader equity markets (although this explicit benchmarking against stocks was never a mandate to which we subscribed). We struggle, in some cases, to make sufficiently clear our concerns about broader market valuation, or just as importantly the gravity of the global financial situation (including a potential QE-driven currency crisis), which makes a wholehearted commitment to the stock market in late 2013 seem to us a risky strategy. So where, if anywhere, does the fault lie? Sometimes it is not just asset managers who should be accused of being short-termist, or of missing the big picture.
Our thesis has been consistent for five years now. We believe we are at the tail end of a 40-years’ and counting experiment in money and the constant expansion of credit. This experiment is not ending well. Because government money, unbacked and unchecked as it now is by anything of tangible value, can be created at will, it has been. What is extraordinary is that despite trillions of dollars / pounds / yen of stimulus, there are few visible signs of what we would call inflation, in anything other than the prices of financial assets themselves.
We are living through a historic period of global currency debasement. The neo-Keynesian money-printers who dominate the world’s central banks have ‘won’ the debate, but are now scratching their heads, looking in vain for the economic recovery that they were expecting all those trillions to have bought. They will continue to look in vain, because money creation and true wealth creation are polar opposites. As portfolio manager Tony Deden has asked,
If cheaper currency is the source of wealth, where has Bangladesh gone wrong? If cheaper money means economic prosperity, why not just print as much as we can and give it out to everyone? We have become fools. The customers know nothing and the advisers know even less. And then we have the idiot economists – the neo-classical Keynesian variety with solutions to problems they did not even anticipate; solutions that have, in fact, been long discredited. And so we lurch from crisis to crisis, eating our meagre capital in the hopes of becoming rich in money. It is a pity.
Those words were written four years ago. The printing presses have been run to exhaustion ever since. So far they have bought us an inflationary rally in the prices of financial assets, and not much else. It has been a lousy time for anyone focused on the disciplined and genuinely diversified pursuit of capital preservation in real terms (more recently, for anyone seeking to escape the inflationary insanity via the honest money that is gold). We have not, to any significant extent, participated in the ‘phony rally’. But then we are playing a longer game than most of our peers. Round and round and round she goes; where she stops, nobody knows. Fund manager Sebastian Lyon recently quoted another celebrated fund manager, Jean-Marie Eveillard:
I would rather lose half of my shareholders than half of my shareholders’ money.
This article was previously published at The price of everything.
What shape is the Short Run Aggregate Supply (SRAS) curve? The question might sound tediously esoteric but it is, in fact, central to current economic policy debate.
In the long run almost all economists agree that the supply curve is vertical. The quantities of factors of production (land, labour, capital) available at a given time are fixed and even combined in the most efficient way can yield only a given amount of output. In this long run analysis the only way to increase the supply of goods and services available, the essence of economic growth, is to shift the vertical supply curve to the right by either increasing the amount of productive factors, or increasing the efficiency of their combination (their Total Factor Productivity).
Some economists think this also applies in the short run. As a result they argue that any attempted expansion of demand via monetary or fiscal policy, shifting the demand curve to the right, will simply result in rising prices. Output and employment will be unaffected.
But does it actually apply in the short run? After all, we see many factors of production lying idle. Unemployment, at 7.7%, is higher than at any time between January 1997 and May 2009. 14.1% of shops were empty in September according to the Local Data Company, barely down from 14.2% in February. Here we are in the ‘output gap’, the difference between current output and what output would be if all those unemployed workers were put to work in all those empty shops.
Couldn’t monetary stimulus bring these unemployed workers and empty shops together to increase employment and output without causing inflation? Monetary expansion will not cause higher prices, on this thinking, because rather than bidding up the wages of workers already employed or rents of commercial premises already occupied, the idle ones will be employed instead. That is what Bank of England governor Mark Carney sees when saying that monetary stimulus will continue at least until unemployment falls to 7%. Isn’t this the economist’s hitherto mythical ‘free lunch’?
A problem with this approach is that it views the factors of production as largely homogenous. Every square foot of empty commercial property, whether boarded up corner shop or out-of-town retail unit, is lumped in with every JCB as ‘capital’. All unemployed workers, whether builders or estate agents, are aggregated as undifferentiated slack in the labour market. What this approach misses, as does much clumsy, aggregative, ‘modern’ macroeconomics, is heterogeneity.
As economist Benjamin Powell points out, “A tractor is not a hammer”. An economy experiencing a tractor boom may find itself with a glut of unemployed tractors when that boom busts. Hammers, on the other hand, would be relatively scarce. As a result the returns on employing each capital good, tractors or hammers, will differ.
Any monetary stimulus attempting to bring these tractors back into employment will not be confined to spending on tractors. Some, probably most, will be spent on hammers which are not currently idle and whose supply will not expand to accommodate this new ‘demand’ immediately. It will simply bid up hammer prices. And if hammer supply does expand, that expansion will be revealed as an unsustainable malinvestment when the monetary stimulus is withdrawn.
And, a tractor not being a hammer (capital goods being heterogeneous in other words), they are not substitutes. An increased demand for one from monetary stimulus need not result in a proportionate increase in demand for the other. Those idle tractors will remain idle as the hammer boom takes off.
Just as a tractor is not a hammer, Mesut Özil is not Miley Cyrus; labour is also heterogeneous. If the economy had overinvested in midfielders during a singing bubble and there were now too many to gain employment as such in a sustainable pattern of demand, any monetary stimulus designed to get these guys back to work would begin driving up the wages of relatively scarce twerking pop stars before a substantial number of those midfielders had found employment.
Those footballers, like the tractors, do not represent ‘slack’ waiting to be picked up by a few more dollars. They are just dead capital and unsuitable labour, the product of malinvestments.
The lesson is that there is no single Short Run Aggregate Supply curve for the ‘the economy’. In each example above, at a given point the SRAS curve for tractors and running backs was horizontal while those for hammers and pop stars were vertical. Attempts to drive the economy along one aggregated economy-wide curve towards full employment will hit choppy waters sooner than monetary policy makers, with their crude view of a few macro variables, think. They might find they have less room for manoeuvre than their models tell them.
According to the popular way of thinking, bubbles are an important cause of economic recessions. The main question posed by experts is how one knows when a bubble is forming. It is held that if the central bankers knew the answer to this question they might be able to prevent bubble formations and thus prevent recessions.
On this, at the World Economic Forum in Davos Switzerland on January 27, 2010, Nobel Laureate in Economics Robert Shiller argued that bubbles could be diagnosed using the same methodology psychologists use to diagnose mental illness. Shiller is of the view that a bubble is a form of psychological malfunction. Hence the solution could be to prepare a checklist similar to what psychologists do to determine if someone is suffering from, say, depression. The key identifying points of a typical bubble according to Shiller, are,
- Sharp increase in the price of an asset.
- Great public excitement about these price increases.
- An accompanying media frenzy.
- Stories of people earning a lot of money, causing envy among people who aren’t.
- Growing interest in the asset class among the general public.
- New era “theories” to justify unprecedented price increases.
- A decline in lending standards.
What Shiller outlines here are various factors that he holds are observed during the formation of bubbles. To describe a thing is, however, not always sufficient to understand the key factors that caused its emergence. In order to understand the causes one needs to establish a proper definition of the object in question. The purpose of a definition is to present the essence, the distinguishing characteristic of the object we are trying to identify. A definition is meant to tell us what the fundamentals or the origins of a particular entity are. On this, the seven points outlined by Shiller tell us nothing about the origins of a typical bubble. They tell us nothing as to why bubbles are bad for economic growth. All that these points do is to provide a possible description of a bubble. To describe an event, however, is not the same thing as to explain it. Without an understanding of the causes of an event it is not possible to counter its emergence.
Now if a price of an asset is the amount of money paid for the asset it follows that for a given amount of a given asset an increase in the price can only come about as a result of an increase in the flow of money to this asset.
The greater the expansion of money is, the higher the increase in the price of an asset is going to be, all other things being equal. We can also say that the greater the expansion of the monetary balloon is, the higher the prices of assets are going to be, all other things being equal. The emergence of a bubble or a monetary balloon need not be always associated with rising prices – for instance if the rate of growth of goods corresponds to the rate of growth of money supply no change in prices will take place.
We suggest that what matters is not whether the emergence of a bubble is associated with price rises but rather with the fact that the emergence of a bubble gives rise to non-productive activities that divert real wealth from wealth generators. The expansion of the money supply, or the monetary balloon, in similarity to a counterfeiter, enables the diversion of real wealth from wealth generating activities to non productive activities.
As the monetary pumping strengthens, the pace of the diversion follows suit. We label various non-productive activities that emerge on the back of the expanding monetary balloon as bubble activities – they were formed by the monetary bubble. Also note that these activities cannot exist without the expansion of money supply that diverts to them real wealth from wealth generating activities.
From this we can infer that the subject matter of bubbles is the expansion of money supply. The key outcome of this expansion is the emergence of non wealth generating activities.
It follows that a bubble is not about strong asset price increases but about the expansion of money supply. In fact, as we have seen, bubbles – i.e. an increase in money supply – can take place without a corresponding increase in prices. Once we have established that an expansion in money supply is what bubbles are all about, we can further infer that the key damage that bubbles generate is by setting non-productive activities, which we have labelled as bubble activities. Furthermore, once it is established that formation of bubbles is about the expansion in money supply, obviously it is the central bank and the fractional reserve banking that are responsible for the formation of bubbles. As a rule, it is the central bank’s monetary pumping that sets in motion an expansion in the monetary balloon.
Hence to prevent the emergence of bubbles one needs to arrest the monetary pumping by the central bank and to curtail the commercial banks’ ability to engage in fractional reserve banking – i.e. in lending out of “thin air”. Once the pace of monetary expansion slows down in response to a tighter central bank stance or in response to commercial banks slowing down on the expansion of lending out of “thin air” this sets in motion the bursting of the bubbles. Remember that a bubble activity cannot fund itself independently of the monetary expansion that diverts to them real wealth from wealth generating activities. (Again bubble activities are non-wealth generating activities).
The so-called economic recession associated with the burst of bubble activities is in fact good news for wealth generators since now more wealth is left at their disposal. (An economic bust, which weakens bubble activities, lays the foundation for a genuine economic growth). Note again that it is the expansion in the monetary balloon that gives rise to bubble activities and not a psychological disposition of individuals in the market place.
Psychology and economics
Psychology was smuggled into economics on the grounds that economics and psychology are inter-related disciplines. However, there is a distinct difference between economics and psychology. Psychology deals with the content of ends. Economics, however, starts with the premise that people are pursuing purposeful conduct. It doesn’t deal with the particular content of various ends.
According to Rothbard,
A man’s ends may be “egoistic” or “altruistic”, “refined” or “vulgar”. They may emphasize the enjoyment of “material goods” and comforts, or they may stress the ascetic life. Economics is not concerned with their content, and its laws apply regardless of the nature of these ends.
Psychology and ethics deal with the content of human ends; they ask, why does the man choose such and such ends, or what ends should men value?
Therefore, economics deals with any given end and with the formal implications of the fact that men have ends and utilize means to attain these ends. Consequently, economics is a separate discipline from psychology. By introducing psychology into economics one obliterates the generality of the theory, and renders it useless. The use of psychology is counterproductive as far as economic analyses are concerned.
Summary and conclusions
Contrary to Shiller, in order to establish that a bubble is forming we don’t need to apply the same methodology employed by psychologists. What we require is the establishment of a correct definition of what bubbles are all about. Once it is done, one discovers that bubbles have nothing to do with some kind psychological malfunction of individuals – they are the result of loose monetary policies of the central bank.
Furthermore, once we observe an increase in the rate of growth of money supply we can confidently say that this sets the platform for bubble activities – for an economic boom.
Conversely, once we observe a decline in the rate of growth of money supply we can confidently say that this lays the foundations for the burst of bubble activities – an economic bust.
 Murray N. Rothbard, Man, Economy and State, (Los Angeles: Nash Publishing) p63.