[Editor’s Note: this piece, by Ivo Mosley, first appeared at http://defendinghistory.com/antisemitism-banking/69351]
A good deal of today’s nationalist and right-wing antisemitism rests upon the fantasy that “the Jews” control the world through finance and banking. Nor is the same fantasy entirely absent from left-wing antisemitism, which currently tends to concentrate itself on criticism of Israel.
The fact that some Jews are very good at banking is, apparently, enough to justify race-hate in the antisemite’s mind. Of course, a number of Jews are also prominent as scientists, civil rights activists, generals, hairdressers, actors, musicians, historians, etcetera, without anyone blaming science, civil rights, theatre, hairdressing, war, music, history, etcetera on “the Jews.” This highlights one of the traditional functions of antisemitism: if something is obviously bad, “the Jews” can be reached for as a scapegoat.
The object of this article is twofold: first, to analyze what is rotten in the world of capitalism and finance; second, to show that while it has nothing to do with “the Jews” as a people or as a tradition, it has everything to do with a tradition that for centuries excluded “the Jews.”
Capitalism and Predatory Capitalism
There are two stories about how capitalism is financed. One is commonly believed and accepted, but not true. The other is true, but hidden under veils of obscurity.
The familiar story is that citizens save up bits of money: banks gather up those bits of money and lend them to capitalists, who put them to good use for the benefit of all. This, however, is not what banks do – nor is it necessarily what capitalists do.
The unfamiliar, but true, story is that banks create money out of nothing when they lend to capitalists, who use the new money to purchase assets and/or labor, from which they expect to make a profit.
The first story needs no elaboration: as well as being untrue, it is simple and widely understood. The second needs to be explained, however, because though it is not so very complicated, it is unfamiliar to most people.
Economists generally avoid mentioning the fact that banks create money, but central bankers are happy to state it and even on occasion to try to explain it. The Bank of England website states simply: “Most money in the modern economy is in the form of bank deposits, which are created by commercial banks themselves.” And again: “The majority of money in the modern economy is created by commercial banks making loans.” The same article explains that this fact is not recognized by most economists: “rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.” (Quotes from the Bank of England Quarterly Bulletin, 2014/1.)
The way bankers create money today requires two things: a “magic trick” by which a small quantity of money held by the banker becomes a great deal of money in circulation; and laws which make the “’magic trick” not just legal, but binding on all citizens.
The “Magic Trick” of Banking
“A banker may accommodate his friends without the payment of money merely by writing a brief entry of credit; and can satisfy his own desires for fine furniture and jewels by merely writing two lines in his books,” wrote Tommaso Contarini, Venetian Banker and Senator in 1584.
The Encyclopedia Britannica of 1950 states firmly and definitively, “A bank does not lend money.” So just what does it do, when we think it is lending money? The answer is: it writes two numbers into a ledger, just as Tommaso Contarini did in 1584. Those numbers represent two equal-and-opposite claims, with a time lapse in between. The borrower gets a claim on cash belonging to the bank, which it can exercise immediately. The bank gets a delayed claim against the borrower, which it may exercise when the loan is due for repayment. In the meantime, the bank charges the borrower interest. When both claims have been exercised, the bank’s creation – the loan – disappears.
The claim which the bank creates for the borrower is called “credit.” “Credit” means “believes,” meaning whoever owns the claim believes they can get cash from the bank when they want it. This is where the “magic trick of banking”’ begins. If people believe they can get cash from a claim, they are happy to receive a claim in payment, so long as they too can use the claim to get cash from the bank. Joseph Schumpeter observes: “There is no other case in which a claim to a thing can, within limits to be sure, serve the same purpose as the thing itself: you cannot ride a claim to a horse, but you can pay with a claim to money.”
The second bit of the magic trick is for the banker to create many claims on the same bit of money – or, to put it another way, to create claims on money that isn’t there. Banks, naturally enough, want to maximize their profits, so they create as many claims as they think they can get away with, bearing in mind the regulators and people’s demand for cash. By creating fictitious claims a bank turns a billion, say, of cash into sixty billion, say, of credit.
The magic trick may seem somewhat technical in nature, but it has enabled bankers, with the active connivance of governments and capitalists, to replace money we can own with money we must rent off governments and banks. The effects of this substitution are immense, incalculable, far-reaching, all-pervasive (more on this later).
The Legal Underpinnings and Authority for Bank-Money
For a claim to pass from hand to hand as money, completing the “magic trick of banking,” one more thing is needed: the law must recognize it as a valid claim.
Normally, people are not allowed to create claims on property they don’t have. You can’t, for instance, create a claim on Buckingham Palace – unless you happen to own it. Nor can you mortgage your house sixty times over, and spend the money. Banks alone may do this kind of thing. Only banks (and “other depository institutions”) are authorized in law to create claims on property they do not have.
For centuries, banks operated in a legal grey area. Their activities were restricted to merchants, who understood the risks involved, and to what might be called the “higher criminal class” of rulers and potentates. Lending to princes often carried an interest rate of 100% — but still, most bank-crashes occurred when monarchs defaulted on their debts.
The watershed in banking history came during the decades on either side of 1700, when the English House of Commons, newly-all-powerful and consisting of rich men voted in by other rich men, wanted to exploit the fruits of bank-credit for their own devices of war and profit.
The Lord Chief Justice of the time, Sir John Holt, was supporting the traditional legal position that a claim on property was valid only if the claim was on a specific piece of property. Parliament passed an Act of Parliament (the Promissory Notes Act of 1704) to overrule him. Over the next three centuries, other countries followed the English example and “credit-creation” — creating claims on assets that don’t exist — is now authorized for bankers all across the world.
The Two Traditions: Money-Lending and Banking
Within the European tradition, Jews were long known as money-lenders. The relatively straightforward nature of money-lending, as a freely-negotiated contract between lender and borrower, was complicated by moral and social issues.
Usury (lending money at interest) was deplored in the Judeo-Christian tradition, but Jews were allowed (by their own religious laws and by self-interested Christian monarchs) to lend to non-Jews. A pattern was established: monarchs licensed Jewish money-lenders to lend to their subjects; agents of the monarch helped them collect their debts, then the monarch would rob the money-lenders of much of their profits. Throughout much of Europe, discriminatory laws forbade Jews to earn a living any other way. Although money-lending was a despised and hated occupation, it could make people very rich.
Meanwhile, banking — the creation of credit — was developing in an entirely separate tradition via the activities of merchants, exchange-dealers and civic banks. The tradition was Christian, protective of its own, and often openly antisemitic. When these early bankers “lent” money they were not lending hard cash, they were lending claims written into ledgers.
Failure to distinguish between banking and money-lending, and the superior social status of bankers (who being in close collusion with the State are liable to pick up honors as well as great wealth) have led many writers to claim that Jewish money-lenders were bankers, i.e. creators of credit. This in turn has fed the delusions of antisemitic pseudo-historians. In reaction to this false history, most serious historians of banking have found themselves making statements similar to this from Raymond de Roover: “Unlike the Christian moralists, the rabbis paid little attention to exchange dealings or cambium, because, as Yehiel da Pisa explains, this business was not practiced by Jews. This is further evidence that the latter confined their activities to money-lending on a small scale and that the leading international bankers, such as the Medici or the Fuggers, were all Christians. There is, therefore, nothing to support Sombart’s thesis according to which the Jews were the originators of international finance and the founders of modern capitalism.”
All this, of course, was a long time ago, and nowadays bankers are Anglo-Saxon, Chinese, African, Indian, Jewish, Christian, Islamic or whatever: assorted individuals who have no more consuming interest than to make lots of money.
What is Wrong With Creating Money as Fictitious Credit?
Bank-credit — money created as credit on assets that don’t exist — has many features that may be viewed as negative. It replaces money owned outright with money rented out, and is therefore (in the words of John Taylor of Virginia, 1753-1824) a “machine for transferring property from the people to capitalists.” Along the same lines, it allocates new money to borrowers on the mere promise of profit: as a result, much of it goes to inflating asset prices, again increasing inequality. It enables governments to borrow with little accountability, and to charge interest and repayment to “the people”: these charges make domestic labor more expensive, and therefore less competitive. It is created in large quantities during booms, and disappears during busts as loans are retired or “go bad,” thereby exacerbating business cycles. It encourages the production of arms and war by providing unaccountable finance to both governments and arms manufacturers, at the expense of their peoples. It encourages large concentrations of power in government, corporations, and individual “oligarchs,” reducing independence among citizens. It has an endogenous (inbuilt) insatiability: money drifts to the ownership of capitalists and only economic growth, state hand-outs and war (when governments create new money for working people rather than for banks) can supply consumer-money to the poor. The effects of this insatiability on the environment are literally devastating. It gives vast wealth to an elite who care only for making more money: the tastes of this elite have corrupted human culture. Lastly, because the process is not widely understood and is conducted largely in secret, it makes Western claims to political “democracy” dubious at best.
Given all this, it might be a good idea to contemplate reform, which would have to include (i) the replacement of credit money with digital money owned outright and (ii) withdrawal of the license allowed banks, to create claims on assets they don’t have.
Most people familiar with the reality of bank-credit also profit from it. Reason gives way to self-interest in human affairs, so enlightenment and reform are hardly to be expected from among the powers-that-be. As for antisemitism, mental disease is also resistant to reason, so the targets of criticism in this essay are unlikely to be affected by the contents of this article. However, the majority of humanity have strong reasons to desire both financial reform and less racial hate and I hope this essay has made a small contribution to those ends by shedding light on a topic that is not at present widely understood.
Later today, I will be speaking at this year’s Cato Annual Monetary Conference in Washington, DC. The theme of this year’s conference is positively eye-watering for proponents of private money: “Alternatives to Central Banking: Toward Free-Market Money.” I will be speaking on the first session, “The Bitcoin Revolution”. So will I be expanding on how bitcoin will revolutionise money and change the world as we know it? Well, not exactly. My topic is: Bitcoin will bite the dust. Bitcoin will collapse, and probably soon.
The core of the argument is simple. To work as intended, the Bitcoin system requires atomistic competition on the part of the ‘miners’ who validate transactions blocks in their search for newly minted bitcoins. However, the mining industry is characterized by large economies of scale. In fact, these economies of scale are so large that the industry is a natural monopoly. The problem is that atomistic competition and a natural monopoly are inconsistent: the inbuilt centralization tendencies of the natural monopoly mean that mining firms will become bigger and bigger – and eventually produce an actual monopoly unless the system collapses before then. The implication is that the Bitcoin system is not sustainable. Since what cannot go on will stop, one must conclude that the Bitcoin system will inevitably collapse. The only question is when.
I could go on at length about how this centralizing tendency will eventually destroy every single component of the Bitcoin value proposition, knocking them down like a row of dominos: the first domino to fall will be distributed trust, Bitcoin’s most notable attraction; instead, the system will come to depend on trust in the dominant player not to abuse its power. This player will become a point of failure for the system as whole, so the ‘no single point of failure’ feature of the system will also disappear. Then anonymity will go, as the dominant player will be forced to impose the usual anti-anonymity regulations justified as means to stop money laundering and such like, but in reality intended to destroy financial privacy. Even the Bitcoin protocol, the constitution of the system, will eventually be subverted. Every component of the Bitcoin value proposition will be destroyed. For bitcoin users and investors, there will be no reason to stay with the system. Plus the large mining pools, or at least one of them, are already a major threat to the system and the system has no effective way of dealing with this threat.
The whole thing is a house of cards: there will be nothing left within the system to maintain confidence in the system. If you have money invested in Bitcoin, best get out now before it collapses, because collapse it will.
Before going further, let me stress that I have not changed my support for private money one jot: researching and promoting private money has been my life’s work. Am I against Bitcoin? No. I just don’t think it is unsustainable. Am I against the alt currencies, the blockchain etc? Not at all. For the record: I support all experimentation in the private money space. My point is that some experiments will fail, and Bitcoin will be one of them.
Informal feedback on my and Martin Hutchinson’s paper on which the presentation is based leaves me in no doubt that our message will provoke outrage amongst the more extreme Bitcoiners: indeed, it already has. We have no axe to grind against Bitcoin and no desire to offend the Bitcoin lunatic fringe. However, one has to follow the logic of one’s argument as one sees it: Hier stehe ich, ich kann nicht anders. If others disagree, well, that’s just the way it is.
I would ask everyone involved in this controversy to note that Martin and I are making a prediction, made before the event: Bitcoin will bite the dust. The more extreme Bitcoiners say it won’t: they say that Bitcoin will reach the moon. They are welcome to their views, but only one side of this argument is going to be proven right. So let’s wait and see who is right and who gets egg on their face. If we have to eat humble pie afterwards, then so be it, but we don’t think so.
Our best guess is that we are facing a mass extinction in the cryptocurrency ecosystem. However, the competition for market share will continue and we expect that that ecosystem will soon repopulate. If the experience of life on earth offers any guide, we could expect to see such cycles of proliferation and extinction occurring again and again. For all we know, cryptocurrencies might still be in their Ediacaran Period, when a wonderful diversity of multicellular life had first colonized the seas, but many of these organisms are about to become extinct. No, correction: many of the alts have already bitten the dust – the mass extinction is well under way.
The undeniable achievement of Bitcoin is that it demonstrates the practical possibility of fully decentralized monetary systems based on the principle of distributed trust rather than central authority: it shows that they can fly, but the problem is that it does not demonstrate that they can stay in the air for too long. Where Bitcoin falls short is that its model is not sustainable thanks to the contradiction between the decentralization on which it depends to work properly and its inbuilt tendencies toward centralization. I therefore regard Bitcoin as an instructive creative failure, but I am hopeful that the lessons to be drawn from its impending demise will lead to superior cryptocurrencies that are free of its major design flaws. Designing such systems would be a challenge worthy of a new Satoshi Nakamoto – or possibly the old one if he is still out there somewhere and looking to complete the project that he didn’t quite get right the first time.
Pity about the conference date though. Had the conference been yesterday, I could have gone dressed as Guy Fawkes or a Catherine wheel.
“Sir, Your headline “Fed’s grand experiment draws to a close” (FT.com, October 29) combines ignorance of what quantitative easing is with insouciance as to its potential effects – both of these mistakes being perennial features of FT coverage of QE. The “experiment”, as you call it, is not at an end; it is, with the purchases now ending, at its height. Only when the Fed starts selling the securities it has purchased back into the market will the US’s QE begin its withdrawal from that height; only when the last purchased security has been sold back into the market, or allowed to expire with consequent permanent expansion of the money supply, will the “grand experiment” (I would prefer that you called it “reckless gamble”) be at its end.
“Only at that point will we even start to see the results – on interest rates, on securities prices, on the economy. The outcome, as has so often been the case with such Keynesian experiments, is unlikely to be pretty.”
The other potential cause of a sell-off in markets is through a central bank mistake. Some think the liquidity created by QE will eventually leak into higher inflation, but there is no sign of this as yet. More likely is a decline into deflation which would lead to financial distress as debts become more difficult to repay.
“If that does show signs of happening, then we may indeed get to see QE4 rolled out. Daddy might have let go of the market’s hand for the moment but he’s still close by.”
Strange things are happening in the bond market. Few of them are stranger than the reports that a French fund management colleague of Bill Gross (formerly of Pimco) took such exception to public excoriation from his stamp-collecting associate that he quit the business to sell croques monsieur from a food truck. According to the Wall Street Journal, Gross told Jeremie Banet in front of Pimco’s entire investment committee that, “I never understand what you’re saying. Ever.” With those credentials, M. Banet is clearly supremely qualified to become the next chairman of the Federal Reserve. As it is, he elected to return to his job managing an inflation-linked bond portfolio.
He has his work cut out. Consider the sort of volatility that the 10 year US Treasury bond – the closest thing the financial world has to a “risk-free rate” – experienced on 15th October (below).
Intra-day yield, 10 year US Treasury bond, 15th October 2014
Source: Bloomberg LLP
Having begun the day sporting a 2.2% yield, the 10 year note during the trading session experienced an extraordinary surge in price that took its yield down briefly towards 1.85%. Later in the same session the buying abated, and the bond closed with a yield of roughly 2.14%. During the same trading session, equity markets sold off aggressively (the UK’s FTSE 100 index, for example, closed down almost 3% on the day). What accounts for such melodrama ?
Analyst Russell Napier takes up the story:
“There it was — a real market come and gone in half an hour, like a pregnant panda at Edinburgh zoo. What did it mean and what should you do? You should pay attention to what happens to the direction of prices when volumes surge and markets work. When the veil is lifted, pay attention to what you see beneath. Last Wednesday, in the space of half an hour of active trading, the Treasury market had one of its most rapid rises ever recorded and equities fell sharply.
“There is a very simple lesson that when the markets finally break through the manipulation they move to price in deflation and not inflation. This is key because it means financial repression has failed. Such repression requires the artificial depression of interest rates but, crucially, it must be paired with boosting inflation above such rates. On October 15th 2014, if only for a few short minutes, market forces broke out and the failure of central bankers was briefly evident.”
These days, you don’t tend to hear the words ‘failure’ and ‘central bankers’ in the same sentence (unless the topic happens to be Zimbabwe). But perhaps the omniscience and omnipotence of central bankers is somewhat overstated. On October 29th, the US Federal Reserve followed a long-rehearsed script and announced that it had “decided to conclude its asset purchase program [also known as QE] this month.”
So now stock and bond markets will have to look after themselves, so to speak. The Economist’s Buttonwood columnist described it as “Letting go of Daddy’s hand”. That coinage nicely speaks to the juvenilisation to which markets have been reduced during six long years of financial repression, unprecedented central bank asset purchases, and the official manipulation of interest rates. Only the asset purchases have abated (for now): the financial repression, one way or another, will go on.
Whether the asset purchases have really disappeared, or merely been suspended, will be a function of how risk markets behave over the coming months and years. We would not be in the least surprised to see petulant markets rewarded with yet more infusions of sweets.
Yet some still associate QE with success. The Telegraph’s Ambrose Evans-Pritchard, or his sub-editor, reckon that central bankers deserve a medal for saving society. He dismisses any scepticism as “hard money bluster”. Economist David Howden, on the other hand, can see somewhat further than the end of his own nose:
“One of the true marks of a great economist is an ability to see past the obvious outcomes and into the veiled results of policies. Friedrich Bastiat’s great essay on “that which is seen, and that which is not seen” provides a cautionary parable that disastrous analyses result when people don’t bother looking further than the immediate results of an action.
“Nowhere is this lesson more instructive than with the Fed’s QE policies of the past 6 years.
“Consider the Austrian business cycle theory. The nub of the theory is that changes in the money market have broader results on the greater economy. In its most succinct form, when a central bank pushes interest rates lower than they should be (by buying assets, for example), the greater economy gets distorted. Some of these distortions are immediately apparent, as consumers buy more goods and everyone takes on more debt as a result of lower interest rates. Some of the distortions are not immediately apparent. The investment decision of firms gets skewed as interest rates no longer reflect savings preferences, and the whole economy becomes fragile over time as erroneous investments add up (what Mises coined “malinvestments”).
“When a financial crisis or economic recession hits, it’s almost never because of some event that apparently happened at the same time. The crisis of 2008 did not occur because of the collapse of Lehman Brothers. It happened because the whole financial system and greater economy were fragile following years of cheap credit at the hands of the Greenspan Fed. If anything, Lehman was a result of this and a great (if unfortunate) example of the type of bad business decisions firms are lured into by loose money. It wasn’t the cause of the troubles but a result of them. And if Lehman didn’t go under to spark the credit crunch, some other fragile financial institution would have.
“The Great Depression is a similar case in point. It wasn’t the stock market crash in 1929 that “created” the Great Depression. It was a decade of loose money policies by the Fed that created a shaky economy. Again, if anything the stock market crash was the result of stock prices being too buoyant and in need of a repricing to reflect economic fundamentals. Just like today, stocks rose to such storied heights as a result of cheap credit, not because of the seemingly “great” investments funded by it.
“The Fed has lowered interest rates since July 2006. We have just come off the period with the most rapid and extreme increase in the money supply ever recorded in American history. The seeds of the next Austrian business cycle have been sown. In fact, they are probably especially fertile seeds when one considers that the monetary policy has been so loose by historical standards. Just as cheap credit of the 1920s beget the Great Depression, that of the 1990s beget the dot-com bust and that of the mid-2000s beget the crisis of 2008, this most recent period will also give birth to a financial crisis.”
Although our crystal ball is no more polished than anyone else’s, our fundamental views are clear. Bonds are already grotesquely expensive, yet may get more so (we’re not investing in “the usual suspects” so we don’t much care). Most stock markets are pricey – but in a world beset by QE (and prospects for more, in Europe and Asia) which prices can we really trust ? By a process of logic, elimination and deduction, out of the major asset classes, only quality listed businesses trading at or ideally well below a fair assessment of their intrinsic worth offer any semblance of value or attractiveness. Pretty much everything else amounts to nothing more than paper, prone to arbitrary gusts from some very powerful, and very windy, bureaucrats. We note also that former Fed chairman Alan Greenspan, no doubt looking to polish his legacy, managed to front-run the Fed’s QE announcement by pointing to the merits of gold within a government-controlled, fiat currency system. Strange days indeed.
It is generally held that for an economist to be able to assess the state of the economy he requires macro-economic indicators which will tell him what is going on. The question that arises is why is it necessary to know about the state of the overall economy? What purpose can such types of information serve?
Careful examination of these issues shows that in a free market environment it doesn’t make much sense to measure and publish various macro-economic indicators. This type of information is of little use to entrepreneurs. The only indicator that any entrepreneur pays attention to is whether he makes profit. The higher the profit, the more benefits a particular business activity bestows upon consumers.
Paying attention to consumers wishes means that entrepreneurs have to organise the most suitable production structure for that purpose. Following various macro-economic indicators will be of little assistance in this endeavour.
What possible use can an entrepreneur make out of information about the rate of growth in gross domestic product (GDP)? How can the information that GDP rose by 4% help an entrepreneur make a profit? Or what possible use can be made out of data showing that the national balance of payments has moved into a deficit? Or what use can an entrepreneur make out of information about the level of employment or the general price level?
What an entrepreneur requires is not general macro-information but rather specific information about consumers demands for a product or a range of products. Government lumped macro-indicators will not be of much help to entrepreneurs. The entrepreneur himself will have to establish his own network of information concerning a particular venture. Only an entrepreneur will know what type of information he requires in order to succeed in the venture. In this regard no one can replace the entrepreneur.
Thus if a businessman assessment of consumers demand is correct then he will make profits. Wrong assessment will result in a loss. The profit and loss framework penalizes, so to speak, those businesses that have misjudged consumer priorities and rewards those who have exercised a correct appraisal. The profit and loss framework makes sure that resources are withdrawn from those entrepreneurs who do not pay attention to consumer priorities to those who do.
In a free market environment free of government interference the “economy” doesn’t exist as such. A free market environment is populated by individuals, who are engaged in the production of goods and services required to sustain their life and well being i.e. the production of real wealth. Also, in a free market economy every producer is also a consumer. For convenience sake we can label the interaction between producers and consumers (to be more precise between producers) as the economy. However, it must be realised that at no stage does the so called “economy” have a life of its own or have independence from individuals.
While in a free market environment the “economy” is just a metaphor and doesn’t exist as such, all of a sudden the government gives birth to a creature called the “economy” via its constant statistical reference to it, for example using language such as the “economy” grew by such and such percentage, or the widening in the trade deficit threatens the “economy”. The “economy” is presented as a living entity apart from individuals.
According to the mainstream way of thinking one must differentiate between the activities of individuals and the economy as a whole, i.e. between micro and macro-economics. It is also held that what is good for individuals might not be good for the economy and vice-versa. Within this framework of thinking the “economy” is assigned a paramount importance while individuals are barely mentioned.
In fact one gets the impression that it is the “economy” that produces goods and services. Once the output is produced by the “economy” what is then required is its distribution among individuals in the fairest way. Also, the “economy” is expected to follow the growth path outlined by government planners. Thus whenever the rate of growth slips below the outlined growth path, the government is expected to give the “economy” a suitable push.
In order to validate the success or failure of government interference various statistical indicators have been devised. A strong indicator is interpreted as a success while a weak indicator a failure. Periodically though, government officials also warn people that the “economy” has become overheated i.e. it is “growing” too fast.
At other times officials warn that the “economy” has weakened. Thus whenever the “economy” is growing too fast government officials declare that it is the role of the government and the central bank to prevent inflation. Alternatively, when the “economy” appears to be weak the same officials declare that it is the duty of the government and central bank to maintain a high level of employment.
By lumping into one statistic many activities, government statisticians create a non-existent entity called the “economy” to which government and central bank officials react. (In reality however, goods and services are not produced in totality and supervised by one supremo. Every individual is pre-occupied with his own production of goods and services).
We can thus conclude that so called macro-economic indicators are fictitious devices that are used by governments to justify intervention with businesses. These indicators can tell us very little about wealth formation in the economy and thus individuals’ well-being.
China first delegated the management of gold policy to the People’s Bank by regulations in 1983.
This development was central to China’s emergence as a free-market economy following the post-Mao reforms in 1979/82. At that time the west was doing its best to suppress gold to enhance confidence in paper currencies, releasing large quantities of bullion for others to buy. This is why the timing is important: it was an opportunity for China, a one-billion population country in the throes of rapid economic modernisation, to diversify growing trade surpluses from the dollar.
To my knowledge this subject has not been properly addressed by any private-sector analysts, which might explain why it is commonly thought that China’s gold policy is a more recent development, and why even industry specialists show so little understanding of the true position. But in the thirty-one years since China’s gold regulations were enacted, global mine production has increased above-ground stocks from an estimated 92,000 tonnes to 163,000 tonnes today, or 71,000 tonnes* ; and while the west was also reducing its stocks in a prolonged bear market all that gold was hoarded somewhere.
The period I shall focus on is between 1983 and 2002, when gold ownership in China was finally liberated and the Shanghai Gold Exchange was formed. The fact that the Chinese authorities permitted private ownership of gold suggests that they had by then acquired sufficient gold for monetary and strategic purposes, and were content to add to them from domestic mine production and Chinese scrap thereafter rather than through market purchases. This raises the question as to how much gold China might have secretly accumulated by the end of 2002 for this to be the case.
China’s 1983 gold regulations coincided with the start of a western bear market in gold, when Swiss private bankers managing the largest western depositories reduced their clients’ holdings over the following fifteen years ultimately to very low levels. In the mid-eighties the London bullion market developed to enable future mine and scrap supplies to be secured and sold for immediate delivery. The bullion delivered was leased or swapped from central banks to be replaced at later dates. A respected American analyst, Frank Veneroso, in a 2002 speech in Lima estimated total central bank leases and swaps to be between 10,000 and 16,000 tonnes at that time. This amount has to be subtracted from official reserves and added to the enormous increase in mine supply, along with western portfolio liquidation. No one actually knows how much gold was supplied through the markets, but this must not stop us making reasonable estimates.
Between 1983 and 2002, mine production, scrap supplies, portfolio sales and central bank leasing absorbed by new Asian and Middle Eastern buyers probably exceeded 75,000 tonnes. It is easy to be blasé about such large amounts, but at today’s prices this is the equivalent of $3 trillion. The Arabs had surplus dollars and Asia was rapidly industrialising. Both camps were not much influenced by western central bank propaganda aimed at side-lining gold in the new era of floating exchange rates, though Arab enthusiasm will have been diminished somewhat by the severe bear market as the 1980s progressed. The table below summarises the likely distribution of this gold.
Today, many believe that India is the largest private sector market, but in the 12 years following the repeal of the Gold Control Act in 1990, an estimated 5,426 tonnes only were imported (Source: Indian Gold Book 2002), and between 1983 and 1990 perhaps a further 1,500 tonnes were smuggled into India, giving total Indian purchases of about 7,000 tonnes between 1983 and 2002. That leaves the rest of Asia including the Middle East, China, Turkey and South-East Asia. Of the latter two, Turkey probably took in about 4,000 tonnes, and we can pencil in 5,000 tonnes for South-East Asia, bearing in mind the tiger economies’ boom-and-bust in the 1990s. This leaves approximately 55,000 tonnes split between the Middle East and China, assuming 4,850 tonnes satisfied other unclassified demand.
The Middle East began to accumulate gold in the mid-1970s, storing much of it in the vaults of the Swiss private banks. Income from oil continued to rise, so despite the severe bear market in gold from 1980 onwards, Middle-Eastern investors continued to buy. In the 1990s, a new generation of Swiss portfolio managers less committed to gold was advising clients, including those in the Middle East, to sell. At the same time, discouraged by gold’s bear market, a western-educated generation of Arabs started to diversify into equities, infrastructure spending and other investment media. Gold stocks owned by Arab investors remain a well-kept secret to this day, but probably still represents the largest quantity of vaulted gold, given the scale of petro-dollar surpluses in the 1980s. However, because of the change in the Arabs’ financial culture, from the 1990s onwards the pace of their acquisition waned.
By elimination this leaves China as the only other significant buyer during that era. Given that Arab enthusiasm for gold diminished for over half the 1983-2002 period, the Chinese government being price-insensitive to a western-generated bear market could have easily accumulated in excess of 20,000 tonnes by the end of 2002.
China’s reasons for accumulating gold
We now know that China had the resources from its trade surpluses as well as the opportunity to buy bullion. Heap-leaching techniques boosted mine output and western investors sold down their bullion, so there was ample supply available; but what was China’s motive?
Initially China probably sought to diversify from US dollars, which was the only trade currency it received in the days before the euro. Furthermore, it would have seemed nonsensical to export goods in return for someone else’s paper specifically inflated to pay them, which is how it must have appeared to China at the time. It became obvious from European and American attitudes to China’s emergence as an economic power that these export markets could not be wholly relied upon in the long term. So following Russia’s recovery from its 1998 financial crisis, China set about developing an Asian trading bloc in partnership with Russia as an eventual replacement for western export markets, and in 2001 the Shanghai Cooperation Organisation was born. In the following year, her gold policy also changed radically, when Chinese citizens were allowed for the first time to buy gold and the Shanghai Gold Exchange was set up to satisfy anticipated demand.
The fact that China permitted its citizens to buy physical gold suggests that it had already acquired a satisfactory holding. Since 2002, it will have continued to add to gold through mine and scrap supplies, which is confirmed by the apparent absence of Chinese-refined 1 kilo bars in the global vaulting system. Furthermore China takes in gold doré from Asian and African mines, which it also refines and probably adds to government stockpiles.
Since 2002, the Chinese state has almost certainly acquired by these means a further 5,000 tonnes or more. Allowing the public to buy gold, as well as satisfying the public’s desire for owning it, also reduces the need for currency intervention to stop the renminbi rising. Therefore the Chinese state has probably accumulated between 20,000 and 30,000 tonnes since 1983, and has no need to acquire any more through market purchases given her own refineries are supplying over 500 tonnes per annum.
All other members of the Shanghai Cooperation Organisation** are gold-friendly or have increased their gold reserves. So the west having ditched gold for its own paper will now find that gold has a new role as Asia’s ultimate money for over 3 billion people, or over 4 billion if you include the South-East Asian and Pacific Rim countries for which the SCO will be the dominant trading partner.
*See GoldMoney’s estimates of the aboveground gold stock by James Turk and Juan Castaneda.
**Tajikistan, Kazakhstan, Kyrgyzstan, Uzbekistan, India, Iran, Pakistan, and Mongolia. Turkey and Afghanistan are to join in due course.
As inflation rates continue to fall across the Eurozone one might expect Austrian economists to rejoice. After all, inflation reduces our purchasing power and acts as a hidden form of taxation. Failure to control inflation caused some of the greatest social and political disturbances of the twentieth century, and attempts to centrally plan the monetary system are destined to failure. George Selgin’s “Less than Zero” is the seminal account of how deflation can be beneficial, and why central banks should be willing to tolerate it. However it also provides a useful, and highly relevant distinction between “good” and “bad” deflation. The underlying point that needs to be expressed is that not all deflation is ghastly. Indeed the readily available examples of falling prices – such as the Great Depression – are not representative. Allowing a fear of deflation to prevent deflation in any circumstance will commit monetary policy to steady and suboptimally high inflation. The Great Moderation is perhaps the best example of the harm that can be done when we fail to allow increases in productivity to manifest themselves in falling prices. But the relevant point is whether this is the situation we find ourselves in right now.
Austrians tended to be ahead of the expectations revolution therefore to some extent it isn’t inflation or deflation per se that matters, but how it ties into expectations. If the inflation rate is falling, and especially if it’s falling more than expected, we have problems. If inflation is 2% a year, but this is anticipated, then the costs of inflation are reasonably low. If it’s -2% a year, and anticipated, ditto. The problems occur if we transition from one to the other.
Inflation in the Eurozone is currently 0.3%, and the rate has been steadily falling since early 2012. There’s two main reasons why we may expect falling pressure on prices. One is that the underlying capacity of the economy has increased. Positive productivity shocks will increase the potential growth rate, make it easier to produce output for a given amount of inputs, and make things cheaper. In terms of Dynamic AD-AS analysis
, it constitutes an increase in the Solow curve. This is good deflation. But it also implies that real GDP will be rising.
Alternatively, prices might be falling because of a reduction in what Keynesians call “aggregate demand”, Monetarists call “nominal income”, or what Austrians call “the total income stream”. These are all various ways to refer to total spending. This could fall as a result of a monetary contraction, or an increase in the demand for money. It’s important to realise that whilst central banks are the prime culprits of the former, they are also a key instigator of the latter. Keynesians might blame it on “animal spirits”, but we can also think of this as “regime uncertainty”. These are two ways to treat confidence as a meaningful concept, and something that can be negatively affected by central bank policy.
Many commentators attribute low inflation to low oil prices. On the surface this seems like a positive supply shock and hence the reason for low prices is a good one. However the reason oil prices are low is because of increases in supply and decreases in demand. The former is a result of IS getting the keys to the pumps. The latter is due to a slowdown in China. Neither of these bode well for the global economy. Both of them have reduced confidence.
We can see this negative AD shock in the data. With GDP growth of just 0.7% this means that total spending is just 1%. This is significantly lower than where we would like it to be in a world with a greater rate of achievable growth and a 2% inflation target.
So what needs to be done? Austrians are loathe to advocate monetary activism and for good reason. But the goal of monetary policy is not inactivism, but neutrality. The issue comes down to the costs of adjustment. If aggregate demand remains at 1% then people will adjust their expectations, prices will adjust, and output will return to normal. During the Great Depression Hayek advocated this path, even though he recognised that prices take time to adjust, and whilst they do so unemployment would rise. His reasoning was that increasing the load on price adjustments will increase their flexibility. In a time of chronic wage and price inflexibility it was a moment to bust the unions. However he later came round to the idea that those costs were too high. The collateral damage of using a downturn to put more emphasis on nominal wage adjustments was unfair. For the mass unemployed, nominal wage rigidities isn’t their fault. So instead of placing the burden on wage adjustments, central banks have the option of maintaining a certain level of total income. This avoids the necessity of a nominal wage adjustment, in part because inflation allows real wages to adjust.
The fact that we are starting to see inflation expectations fall
implies that this is only the beginning of an economic adjustment. If the total income stream continues to grow at a less than expected (and possibly even a negative) rate then we will have plenty new problems to worry about. This isn’t just the economy responding to the pre 2007 boom. This is the economy responding to fresh problems being introduced by central bank incompetence.
The difficulty for the ECB – and possibly the explanation for why things are so much worse in the Eurozone than in the US or UK – is that they don’t have the same tools available. But let’s leave a debate over tools for another time. The bottom line is that the ECB should be striving to give clear guidance and generate credibility for pursuing a steady increase in a target nominal variable. Monetary policy cannot generate wealth – all it can do is buy time for governments to sort out their competitiveness and improve their public finances. The fact that they aren’t making use of the breathing room provided by central banks is their fault. But monetary policy can destroy wealth, and a failure to maintain a steady total income stream is contributing to those competitiveness and public finance problems. I would love to believe that this impending deflation is the good sort, or that Eurozone labour markets were flexible enough to allow prices to do all the heavy lifting. But I fear that we’re seeing an impending catastrophe, and the ECB needs to take bolder action to prevent making things even worse.
Janet Yellen gave a widely noted speech, Perspectives on Inequality and Opportunity from the Survey of Consumer Finances, at the Conference on Economic Opportunity and Inequality held by the Federal Reserve Bank of Boston on October 17th.
The speech presented as a if ghostwritten for her by Quincy Magoo, that beloved cartoon character described by Wikipedia as “a wealthy, short-statured retiree who gets into a series of comical situations as a result of his nearsightedness compounded by his stubborn refusal to admit the problem.” What was most interesting was how political was the speech… and what Madame Yellen didn’t say.
Her omission even raised an eyebrow of one of the commentariat’s most astute Fed sympathizers, The Washington Post‘s Ylan Q. Mui. Mui: “Yellen did not address in her prepared text whether the Fed has contributed to inequality. Nor did she weigh in on whether it may actually be slowing down economic growth, an idea that is gaining traction among economists but which remains controversial.”
Yellen’s speech drew a public comment from the Hon. Steve Lonegan, director of monetary policy for American Principles Project and project director of its sister organization’s grass roots FixTheDollar.com campaign (which I professionally advise):
There is a strong correlation between the post-war equitable prosperity to which Madam Yellen alluded and the post-war Bretton Woods gold-exchange standard. And there is a strong correlation between the increase in inequality under the Federal Reserve Note standard put into effect by President Richard Nixon to supplant Bretton Woods.
The monetary policy of the United States has a profound impact on wage growth and prices, both domestically and internationally. Hence the importance of a thorough, objective, and empirical look at its policies — from Bretton Woods through the era of stagflation, the Great Moderation, and the “Little Dark Age” of the past decade.
That is why the Brady-Cornyn Centennial Monetary Commission, and the Federal Reserve Transparency Act which recently passed the House with a massive bipartisan majority, are critical steps forward to ending wage stagnation and helping workers and median income families begin to rise again. As President Kennedy once said, “Rising tide lifts all boats.”
Madam Yellen addresses four factors in what she calls “income and wealth inequality.” Madame Yellen stipulates that “Some degree of inequality in income and wealth, of course, would occur even with completely equal opportunity because variations in effort, skill, and luck will produce variations in outcomes. Indeed, some variation in outcomes arguably contributes to economic growth because it creates incentives to work hard, get an education, save, invest, and undertake risk.”
Even with that ostentatious stipulation, the Fed Chair’s speech is amplifying one of the Democratic Party’s foremost election themes, “income inequality.” The New York Times‘s Neil Irwin observed of this speech: “Nothing about those statements would seem unusual coming from a left-leaning politician or any number of professional commentators. What makes them unusual is hearing them from the nation’s economist-in-chief, who generally tries to steer as far away from contentious political debates as possible.”
Her speech could be read as an Amen Corner to Elizabeth Warren’s stump speech, on behalf of Sen. Al Franken’s reelection effort, that “The game is rigged, and the Republicans rigged it.” Her speech could be read as a little election-season kiss blown to Sen. Franken (D-Mn), who voted for her confirmation and then glowed on Madame Yellen very publicly.
One cringes at the thought that the Fed even might be giving the appearance of playing politics. To align the Fed, even subtly, with either party’s election themes during an election season would seem a deeply impolitic, and unwise, violation of the Fed’s existential principle of political independence. House Financial Services Committee chair Jeb Hensarling and Sen. Mike Crapo (R-Id), should he accede to the chairmanship of the Senate Banking Committee, might just wish to call up Madam Yellen for a public conversation about avoiding even the appearance of impropriety.
The Fed’s independence is as critical as it is delicate. To preserve it demands as much delicacy by the officials of the Federal Reserve System as by the Congress. As Barack Obama might say, here is a “teachable moment” for our new Fed chair.
Also troubling is the decision by the Chair to focus her mental energy, and remarks, on four areas entirely outside the Fed’s jurisdiction: resources available for children; higher education that families can afford; opportunities to build wealth through business ownership; and inheritances. These might be splendid areas for a president’s Council of Economic Advisors (which Madame Yellen chaired, commendably, under President Clinton). Good topics for a professor emerita at the University of California, Berkeley, Haas School of Business, as is Madam Yellen.
They are, however, at best mere homilies from the leader of the world’s most powerful central bank. We would like to hear Madam Yellen talk about monetary policy and its possible role in the diminishing of economic mobility. It does not seem like too much to ask.
Since Madame Yellen, rightly, is considered an eminent Keynesian (or Neo-Keynesian), why not begin with Keynes? In The Economic Consequences of the Peace, Chapter VI, Keynes addressed this very point. The brilliant young Keynes was addressing the insidious power of inflation, not now in evidence and not portended by the data. Yet let it be noted that there is more than one way to debauch a currency:
Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. … By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. …
Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.
America and the world needs, and rightly expects, the chair of the Federal Reserve to be that one in a million able to diagnose. Madame Yellen is called upon to step up her game and pivot from pious homilies to the heart of the matter. If Keynes could call out how bad monetary policy can strike “at confidence in the equity of the existing distribution of wealth,” perhaps so too ought his followers.
What is to be done? Wikipedia also observes of Mr. Magoo that “through uncanny streaks of luck, the situation always seems to work itself out for him, leaving him no worse than before.” We devoutly hope that Madame Yellen — and, thus, the economy — will be the beneficiary of “uncanny streaks of luck.” Hope is not a strategy. Relying on luck tautologically is a dicey way of bringing America, and the world, to a renewed state of equitable prosperity.
Rely on luck? It really is time to shift gears. An obvious place for Madame Yellen to begin would be to register active support for the Brady-Cornyn Centennial Monetary Commission designed to conduct a thorough, empirical, bipartisan study of what Fed policies have worked. What policies of the Federal Reserve have proven, in practice, or credibly portend to be, conducive to equitable prosperity and healthy economic mobility?
Should the correlation between the (infelicitously stated if technically accurate) “40 years of narrowing inequality following the Great Depression” and the Bretton Woods gold-exchange standard be ignored? Why ignore this? Should the tight correlation of “the most sustained rise in inequality since the 19th century” with the extended experiment in fiduciary dollar management be ignored? Why ignore that?
What might be learned from the successes of the Great Moderation inaugurated by Paul Volcker? Is Volcker’s recent call for a “rules-based” system, a position from which Madam Yellen staunchly dissents, pertinent? Discuss.
Madame Yellen? Let’s have a national conversation about monetary policy and its effects on economic mobility. It really is time to bring to a decisive end many decades of Magooonomics and the disorders that derive therefrom. Fire Magoo. Show the world that you are Keynes’s one in a million.
Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/10/20/janet-yellen-the-new-magoo-2/
“Sir, Your editorial “A Nobel award for work of true economic value” (October 15) cites the witty and memorable line of J M Keynes about wishing that economists could be “humble, competent people, on a level with dentists”, which concludes his provocative 1930 essay on the economic future. You fail to convey, however, the irony and condescension of the original text of the arrogant, intellectual elitist Keynes, who, while superlatively competent, was assuredly not humble. With the passage of 84 years, the irony has changed directions, for modern dentistry is based on real science, and has made huge advances in scientific knowledge, applied technology and practice, to the great benefit of mankind. It is obviously far ahead of economics in these respects, and it is indeed unlikely that economics will ever be able to rise to the level of dentistry.”
Changing people’s minds, apparently, has very little to do with winning the argument. Since people tend to make decisions emotionally, ‘evidence’ is a secondary issue. We are attempting to argue that the policy of QE, quantitative easing, is not just pointless but expensively pointless. Apparently, instead of using cold logic, we will have to reframe our argument as follows:
Agree with our argumentative opponents;
Reframe the problem;
Introduce a new solution;
Provide a way to “save face”.
In terms of argumentative opponents, they don’t come much bigger than the former Fed chairman himself, Ben Bernanke. And it was Bernanke himself who rather pompously declared, shortly before leaving the Fed this year, that
“The problem with QE is it works in practice, but it doesn’t work in theory.”
There is, of course, no counter-factual. We will never know what might have happened if, say, the world’s central banks had elected not to throw trillions of dollars at the world’s largest banks and instead let the free market work its magic on an overleveraged financial system. But to suggest credibly that QE has worked, we first have to agree on a definition of what “work” means, and on what problem QE was meant to solve. If the objective of QE was to drive down longer term interest rates, given that short term rates were already at zero, then we would have to concede that in this somewhat narrow context, QE has “worked”. But we doubt whether that objective was front and centre for those people – we could variously call them “savers”, “investors”, “the unemployed” or “honest workers” – who are doubtless wondering when the economy will emerge from its current state of depression. As James Grant recently observed in the FT (“Low rates are jamming the economy’s vital signals”), it’s quite remarkable how, thus far, savers in particular have largely suffered in silence.
So yes, QE has “succeeded” in driving down interest rates. But we should probably reframe the problem. The problem isn’t that interest rates were or are too high. Quite the reverse: interest rates are clearly already too low – at least for savers, and for that matter investors in the euro zone and elsewhere. All the way out to 3 year maturities, investors in German government bonds, for example, are now faced with negative interest rates, and still they’re buying. This isn’t monetary policy success; this is madness. We think the QE debate should be reframed: has QE done anything to reform an economic and monetary system urgently in need of restructuring ? We think the answer, self-evidently, is “No”. The answer is also “No” to the question: “Can you solve a crisis of too much indebtedness by a) adding more debt to the pile and simultaneously b) suppressing interest rates ?” The toxic combination of more credit creation and global financial repression will merely make the ultimate Minsky moment that much more spectacular.
What accentuates the problem is market noise. @Robustcap fairly points out that there are (at least) four groups at play in the markets – and that at least three of them aren’t adding to the sum of human wisdom:
Group 1 comprises newsletter writers, and other dogmatic “End of the world newsletter salesmen” using every outlet to say “I told you so…” (even though some of them have been saying so for the last 1000 S&P handles..).
Group 2 comprises Perma-Bulls and other Wall Street product salesmen, offering “This is a buying opportunity” and other standard from-the-hip statements whenever the Vix index reaches 30 and the market trades 10% off from its high, at any time.
Group 3 includes “any moron with a $1500 E-trade account, twitter, Facebook etc…”, summing to roughly 99% nonsense and noise.
Group 4, however, comprises “True investors and traders” asking questions such as, “Is this a good price ?”; “Is this a good level ?”; “What is my risk stepping in here, on either side ?”; “Am I getting better value than I am paying for ?”; “What is the downside / upside ?” etc.
“With the “magnification” of noise by social media and the internet in general, one must shut off the first three groups and try to engage, find, follow, communicate with the fourth group only, those looking at FACTS, none dogmatic, understand value, risk, technicals and fundamentals and most importantly those who have no agenda and nothing to sell.”
To Jim Rickards, simply printing money and gifting it to the banks through the somewhat magical money creation process of QE is like treating cancer with aspirin: the supposed “solution” does nothing to address the root cause of the problem. The West is trapped in a secular depression and “normal” cyclical solutions, such as monetary policy measures, are not just inappropriate, but damnably expensive for the rest of us. Only widespread economic restructuring will do. And that involves hard decisions on the part of politicians. Thus far, politicians have shown themselves predictably not up to the task. Or in the words of Jean-Claude Juncker,
“We all know what to do; we just don’t know how to get re-elected after we’ve done it.”
And let’s not forget that other notable Junckerism,
“When it becomes serious, you have to lie.”
No cheers for democracy, then.
So, back to the debate:
Yes, QE has driven down long term interest rates.
But the problem wasn’t the cost of capital. The problem was, and remains, an oversupply of debt, insufficient economic growth, and the risk, now fast becoming realised, of widespread debt deflation. To put it another way, the world appears to be turning Japanese after all, despite the best efforts of central bankers and despite the non-efforts of politicians.
The solution is fundamental economic restructuring along with measures that can sustainedly boost economic growth rather than just enriching the already rich through artificial financial asset price boosterism. Government spending cuts will not be optional, although tax cuts might be. The expansion of credit must end – or it will end in an entirely involuntary market-driven process that will be extraordinarily messy.
How to “save face” ?
This is where we start to view the world, once again, through the prism of investments – not least since we’re not policy makers. For those wondering why a) markets have become that much more volatile recently (and not just stocks – see the recent wild trading in the US 10 year government bond) and b) inflation (other than in financial asset prices) seems weirdly quiescent – the answer has been best expressed by both Jim Rickards and by the good folk at Incrementum. The pertinent metaphor is that of the tug of war. The image below (source: Incrementum) states the case.
The blue team represents the markets. The markets want deflation, and they want the world’s unsustainable debt pile to be reduced. There are three ways to reduce the debt pile. One is to engineer sufficient economic growth (no longer feasible, in our view) to service the debt. The second is to default (which, in a debt-based monetary system, amounts to Armageddon). The third brings us over to the red team: explicit, state-sanctioned inflationism, and financial repression. The reason why markets have become so volatile is that from day to day, the blue and red teams of deflationary and inflationary forces are duking it out, and neither side has yet been convincingly victorious. Who ultimately wins ? We think we know the answer, but the outcome will likely be a function of politics as much as investment forces (“markets”). While we wait for the outcome, we believe the most prudent and pragmatic course of action is to seek shelter in the least overpriced corners of the market. For us, that means explicit, compelling value and deep value equity. Nothing else, and certainly nothing by way of traditional government or corporate debt investments, or any form of equity or bond market index-tracking, makes any sense at all.
In the Wealth of Nations Adam Smith outlines a commercial society:
When the division of labour has been once thoroughly established, it is but a very small part of a man’s wants which the produce of his own labour can supply. He supplies the far greater part of them by exchanging… the produce of his own labour… for such parts of the produce of other men’s labour as he has occasion for. Every man thus lives by exchanging, or becomes in some measure a merchant, and the society itself grows to be what is properly a commercial society.
The last sentence of the just quoted passage forms the leitmotif of this immensely accomplished and insightful book by Christopher Berry, Professor Emeritus in Political Theory at Glasgow University. The book’s cover is graced by a drawing of the inner court of that university where Smith, in a letter of thanks upon his installation as its rector in 1787, reports he had spent “by far the most useful and therefore as by far the happiest and most honourable period” of his life, both as student and subsequently successor to his one-time teacher there, Francis Hutcheson, in the Chair of Moral Philosophy.
Hutcheson, an Ulster-born Presbyterian Scot, had, in turn, also been educated there before moving to Dublin to open and run an academy. It was there Hutcheson acquired international fame that led to his appointment at Glasgow by writing and publishing in 1725 a celebrated tract on the origin of our moral ideas. This tract had been heavily influenced by works in ethics with which he first became acquainted in Dublin written by John Locke’s former tutee, the third Earl of Shaftesbury to whom Hutcheson dedicated the first edition of his own tract. Shaftesbury, in a letter to the Swiss theologian Jean Le Clerc in March 1705, made the following highly prescient observation about that great efflorescence of ideas in Europe in the eighteenth century, subsequently known as the Enlightenment, in which Adam Smith’s Scotland was to play such a prominent part:
There is a mighty light which spreads itself over the world especially in those two free nations of England and Holland… and if Heaven sends us soon a peace… it is impossible but letters and knowledge must advance in greater proportion than ever.
Shaftesbury made this remark early on during the so-called War of Spanish Succession which raged in Europe for more than a decade until 1714. It was during it that, to forestall its becoming allied with and used as springboard for invasion by its traditional enemy, France, England was to engineer political union with Scotland, in return for which it provided its economically backward northern neighbour with an enormous economic stimulus. Within a few decades, this previous economic and cultural backwater became the epitome of a commercial society whose idea was to fascinate and absorb the intellectual energies of that small country’s band of literati whose most illustrious member was Adam Smith.
Berry’s book is about how these Scottish literati conceptualised and reacted to this novel form of society their country was fast turning into during the half century between publication of David Hume’s Treatise of Human Nature in 1739-40 and the sixth edition of Adam Smith’s Theory of Moral Sentiments in 1790. It would be hard to exaggerate the importance of their achievement. As was noted by Arthur Herman in his 2001 book How the Scots Invented the Modern World:
The Scots created the basic ideals of modernity… When we gaze out on the contemporary world shaped by technology, capitalism, and modern democracy… we are in effect viewing the world through the same lens as the Scots did… In 1700 Scotland was Europe’s poorest independent country… [By 1800] this small, underpopulated, and culturally backward nation had] rose to become the driving wheel of modern progress… [I]f you want a monument to the Scots, look around you.
As Berry observes, the Enlightenment was not just a collection of forward-looking intellectuals and their ideas. It was also a set of formal and informal institutions through which the intellectuals propagated these ideas and drew mutual support and encouragement.
In his opening chapter, Berry explains just how tight-knit this set of institutions was in Scotland’s case. At their core were its universities whose curricula became modernised more than a century before England’s did. Closely connected with them was a large network of clubs and debating societies which brought together academics, merchants, lawyers and clergymen in a highly fruitful symbiosis. As Berry remarks ‘these various societies were an important part of the institutional fabric and played a leading role within Scotland… By forming a point of convergence for universities, the law, the church and the ‘improving’ gentry… the idea of a commercial society took on an institutional form… thinking about “commercial society” was woven into the fabric; it was not some detached academic exercise.’
What, then, did Scotland’s eighteenth century thinkers observe about the new form of society that they were witnessing springing up around them?
In the second chapter of his book, Berry offers a highly useful account of their understanding of this idea from which the following vignettes are taken:
One of the ideas for which the Scots are best known is their notion of the four stages (hunting, herding, farming, commerce)… To understand their own commercial era meant for the Scots placing it in a narrative that began with the destruction of the Roman Empire, but in which the pivotal ‘event’ is the collapse of feudalism… [T]he history… portrayed in the four stages rests on a particular model of ‘natural’ development… from concrete to abstract, from simple to complex, from rude to cultivated or civilised…. A commercial society does indeed have a distinctive property regime but that is only one aspect of the complex inter-related whole which defines that type of society.
The remaining chapters of Berry’s book explore various aspects that comprised a commercial society in the eyes of Scotland’s literati. Of them, the much greater opulence and freedom it confers on all its members, relative to other social formations, constitute its two chief distinguishing features as well as its most salient advantages over them. As Berry puts it:
Although in the Scots’ writings there is no explicit definition or even delineation of what constitutes ‘civilisation’ (a new term), nevertheless there was a definitive difference between Athens and Edinburgh (the so-called ‘Athens of the North’). The latter was civilised and free. The Scots are clear that their own (and similar) society is civilised… Contrary to Stoic and republican ‘frugality’ or Christian asceticism… Smith [along with his fellow Scottish literati] is firmly repudiating any notion that poverty is ennobling or redemptive… Smith’s and others’ repudiation of the nobility of poverty is a key factor in the vindication of a commercial society.
Underpinning commercial societies, in the eyes of the Scottish literati, is the rule of law as the one institution on which depends the mutual trust between strangers involved in regular trade, contract, credit, and paper money. As Berry explains with characteristic cogency:
The argument relies on a series of [posited] causal connections: stability from a framework of law causes security and security is a causal precondition for the development of a market and extension of contracts and exchange. This goes to the heart of the idea of a commercial society… What the authority of law provides is security of property for all… Perhaps the most decisive development [in the establishment of the rule of law] was the separation and independency of the judiciary for it is that which ensures the impartiality of administration [of justice] that imparts security to all.
Yet, a problem remains as to how such rule becomes established and what maintains it. There is a problem here, of which the Scottish literati were acutely aware and did their best to address. Berry explains the problem so: ‘In a commercial society we live predominantly among “an assembly of strangers”… Since the bulk of our dealings are impersonal then they must be conducted on the basis of adhering to the complementary impersonal (abstract) rules of justice… [Yet] the Scots are aware that this society can be construed to appear to rely to a reprehensible extent on “self” or “private”, rather than, “social” or “public”, interest.’
Self-love is the animating force behind commerce, yet the viability of commerce presupposes a degree of self-restraint on the part of those who engage in it, out of consideration for others. From whence arises the motivation needed to energise such self-restraint? Their answer was that such consideration arose from individual moral conscience variously understood, with Smith having characteristically described its restraining power the most graphically as well as illuminatingly. He writes of it in one of the most memorable passages in his Theory of Moral Sentiments:
When our passive feelings are almost always so sordid and so selfish, how comes it that our active principles should often be so generous and so noble?… It is not the soft power of humanity, it is not that feeble spark of benevolence… that is thus capable of counteracting the strongest impulses of self-love. It is a stronger power, a more forcible motive which exerts itself upon such occasions. It is reason, principle, conscience, the inhabitant of the breast, the man within, the great judge and arbiter of our conduct…
While the rule of law could thus be supposed capable of prevailing within commercial society through the moral probity induced in members by the strictures of their consciences, the Scottish literati remained exercised by the notion that commerce had a morally deleterious effect on those whose livelihoods were gained by means of it, which increasingly meant everyone in a commercial society. The source of such concern lay in the ancient republican notion that true freedom and virtue demanded a form of active citizenship governed by a concern for the public good for which a narrow preoccupation with mercenary self-interest characteristic of commerce simply had no place. Berry terms this concern ‘the luxury critique’ of commercial society and characterises it so:
A free state depended on virtuous (free) men devoted to the public good for which they were willing to fight (and die)… A society where wealth is valued will produce a generation… [that]will devote itself to private ends and… be unwilling to act foe the public good, where crucially central to such action is a willingness to fight… Once poisoned by luxury they invest life itself with value and become afraid of death, with the consequence that the society will be militarily weak – a nation of cowards… will easily succumb.
Among the Scots literati, Adam Ferguson and Lord Kames who were the most exercised by this issue. Hume and Smith by contrast tended to consider such concern about the morally corrupting effects of luxury misplaced, being redolent of nostalgia for a bygone era irretrievably passed whose claim in any case to greater valour than modernity was in their view highly exaggerated. Berry is particularly instructive in detailing the argumentative stratagems through which Hume and Smith sought to defuse and repudiate the luxury critique of commerce.
Thus, in the case of Hume, Berry notes: ‘The Spartan regime, where everyone has a “passion for the public good”, is contrary to “the natural bent of the mind”, and ‘to govern men along Spartan lines would require a “miraculous transformation of mankind”.’ Similarly, for Hume: ‘The supposed causal link between luxury and military weakness fails the test of constant conjunction, as manifest by the cases of France and England, that is, the two most powerfulbecause the two most polished and commercial societies’. Likewise: ‘For Smith, militias are outmoded… in an “opulent and civilised nation” a professional army is the means to preserve civilisation against invasion from a “poor and barbarous nation”… In explicit repudiation of the position of “men of republican principles”.., he claims [a professional] army’ can… ‘be favourable to liberty’… in those circumstances where the chief officers… are drawn from the “principal nobility and gentry”.’
Berry is rightly not oblivious to the morally detrimental effects that Smith identified commercial society having on its members. He notes that: ‘In Book 5 of the Wealth of Nations he [Smith] observes… that the dexterity of the specialised operative (read pin-maker) is bought at the cost of his “intellectual, social and martial virtues”.’ Yet, for all that, contrary to many recent expositors of Smith such as Denis Rasmussen and Ryan Hanley, Berry contends that:
Smith is… not to be saddled with the possession of some profound disquiet about the soul of modern man… Smith’s purpose in identifying these threats to these virtues, these deficiencies or ailments of commercial society, is programmatic…. [T]he point is to identify where government action, and the public purse, is called for in order to remedy the deficiencies…
The remedy for torpid intellectual virtues is… [publicly-funded] education… [T]he shortfall in the “pin-maker’s” social virtues… [can be remedied by] use of the tax system to reduce the number of alehouses… [plus state support of] “public diversions”, such as drama, music, dancing and the like… to lift the “melancholy and gloomy humour” that Smith associates with the “disagreeably rigorous and unsocial character “of [austere religious] sects [to which he considers are especially prone migrants to large cities from rural backgrounds]… When it comes to addressing the erosion of the martial virtues… [Smith] refers to the military exercises that the Greeks and Romans made the citizens perform… He does not say the exercises should be compulsory but… recurrence of the phrase ‘premiums and badges of distinction’ with respect both to parish schools and the Greek and Roman republics suggests… [Smith favored] a government-backed incentive structure to encourage participation in activities that would help the decline of the martial spirit.
What is being suggested here is that whatever morally subversive effects commerce might have upon populaces whose ways of life had become deeply informed by it can all be adequately addressed by judicious forms of state intervention be they public subsidy of schooling, of the arts, or of sport. Berry ably sums up the resultant idea of a commercial society when he observes that:
What the Scots’ idea seems to resemble is the outlines of a “liberal” picture of society… The complex interlocking whole is not some perfect functioning system… [T]he Scots are well-aware of commercial society’s imperfections just as they remain cautiously optimistic that these will be eroded by progress.
Whether we can share their optimism remains an open question. Even should we not be able to, we can nonetheless still share their common confidence that this form of societal organisation is superior to all others. Berry is to be commended for having explained so clearly and carefully why members of the Scottish Enlightenment shared such confidence and why we might do so too.
The behaviour of financial markets these days is frankly divorced from reality, with value-investing banished.
Markets have become distorted by Rumsfeld-knowns such as interest rate policy and “market guidance”, and Rumsfeld-unknowns such as undeclared market intervention by the authorities. On top of these distortions there is remote investing by computers programmed with algorithms and high-frequency traders, unable to make human value-assessments.
Take just one instance of possible “market guidance” that occurred this week. On Thursday 16th October, James Dullard of the St Louis Fed hinted that QE might be extended. In the ensuing four trading sessions the Dow rallied over 5%. Was this comment sparked by signs of slowing economic growth, or by a desire to buoy up sliding equity markets? Then there is the vested interest of keeping government funding costs low, which raises the question whether or not exceptionally low bond yields, particularly in the Eurozone, are by design or accidental.
Those who support the theory that it is all an evil plot will also note that governments and their central banks through exchange stability funds (set up with the explicit purpose of market intervention), wealth funds and state pension funds have some $30 trillion to direct as they see fit. The reality is that there is intervention across a range of markets; but most of the mispricing is in the hands of private, not government investors. For evidence look no further than the record level of brokers’ loans to buyers of equities, who with greed worthy of a latter-day South-Sea Bubble seek to gear up their speculative profits.
These are not markets with widespread public participation, buying dot-coms and the like. Instead ordinary people have given their savings and pension funds to professionals who speculate on their behalf. It is the professionals who talk about the Yellen put, meaning the Fed simply won’t let prices fall significantly. We can fret about who is actually responsible for market distortions, instead we should ask who benefits.
Governments: in the past they have covered their debts through a process dubbed financial repression, when artificially low interest rates and bond yields were the principal mechanism whereby wealth is transferred from savers to the government. This process still goes on today. Forget government inflation figures: when did a bank deposit net of taxes last give a positive return after your cost of living increases?
Zero interest rate policy lays the process bare, and turns savers into borrowers. Mr Average has replaced savings with mortgages and car loans. And while the elderly and other passive savers are still defenceless against financial repression, the process has taken on a new twist. The transfer of wealth to governments now targets investment managers.
Investment and hedge funds we invest with together with the banks which take our deposits speculate on our behalf. They think that with a Yellen or Draghi put underwriting markets a ten-year government bond with a two per cent yield is an attractive investment. In doing so they are transferring financial resources to governments in a variation on old-fashioned financial repression.
Our dysfunctional markets have become little more than the essential prerequisite, as Louis XIV’s finance minister Colbert might have said, to plucking the goose for the largest amount of feathers with the minimum of hissing.