Greater fool theory

“Mr Draghi announced this week that the ECB would not buy bonds yielding less than minus 0.2 percent..”

–       Ralph Atkins for the Financial Times, 7th March 2015.


TRADER: “Joe, let’s give this guy a little test ! When interest rates go up, which way do bond prices go ?”

ME: “Down.”

TRADER: “Terrific. You get an ‘A’..”

ME: “Can I help in any way ?”

TRADER: “Get me a burger. With ketchup.”

–       Michael Lewis, ‘Liar’s Poker’.


Danish sex therapist Eva Christiansen stands a good chance of becoming the definitive example for future historians of our current interest rate insanity. The New York Times reports that the 36-year-old businesswoman has just been approved for a small business loan at a rate of minus 0.0172 percent. The bank is actually paying her interest on the loan – albeit just over $1 a month. Representing the flip side of this nonsense is the 27-year-old Danish student Ida Mottelson. Her bank just wrote to her advising that it would be charging her 50 basis points (0.5%) to hold her money on deposit. What’s wrong with this picture ?

The French economist Frederic Bastiat created what may be the most powerful – and perhaps most overlooked – metaphor in finance, in his 1850 piece ‘That which is seen, and that which is not seen’. It goes as follows:

A young boy happens to break a shopkeeper’s window. Pretty soon a crowd gathers, which quickly becomes philosophical:

“It is an ill wind,” says the crowd,

“that blows nobody good. Everybody must live, and what would become of the glaziers if panes of glass were never broken ?”

Bastiat nicely catches the intellectual mood of the mob. Let’s say it costs six francs to repair the window. That is six francs given to the glazier, who can spend it as he will. The six francs will circulate in the wider economy. Perhaps we should break more windows and watch the economic stimulus take hold. The six francs given to the glazier are what is seen.

What is not seen is what the shopkeeper might have done with those six francs had he not been obliged to pay them to the glazier. He would, perhaps, have replaced some old shoes, or bought  a book for his library. If he were markedly stupid and easily led, he could perhaps have bought ‘End this depression now !’ by Paul Krugman, or ‘Capital in the twenty-first century’ by Thomas Piketty. But what’s important is that he doesn’t have those six francs any more. Whatever he might have done with the money is now not seen:

“To break, to spoil, to waste, is not to encourage national labour; or, more briefly,

“Destruction is not profit.”

The Austrian economic school has a term for those things that are undertaken foolishly in the economy, perhaps because the pricing mechanism has become hopelessly distorted. It terms them ‘malinvestments’. Do we think malinvestments are more or less likely to happen when people are actually paid to borrow money ? Do we think malinvestments are more or less likely to happen when people are actively penalized for saving ? When there is a punitive cost for holding money on deposit at a bank, are malinvestments more or less likely ? What about money hoarding ? Or ultimately, following the introduction of negative interest rates, a run on banks altogether ? Money destruction is not profit either.

One dreads to think what problems are being stored up for the future by the current monetary policy of our central banks. We have made this point before on innumerable occasions. But an argument is not wrong simply for its being frequently repeated. In this week’s Spectator, Ros Altmann draws attention to the damage being wrought on pension funds by Quantitative Easing:

“During last year, company scheme deficits rose by more than £200 billion, as pension assets increased by around 10 percent but liabilities (which increase when bond yields fall) rose by over 25 percent..

“It is not just company pensions that have been hit. Private pension funds have been damaged too. Annuity rates depend on bond yields – and the lower yields fall, the lower retirees’ annuity pensions will be for the rest of their lives..

“ gilt prices have driven pension deficits up, pension advisers have increasingly recommended that trustees reduce the risks of their pension schemes. The traditional way to do this has been to buy more bonds and sell shares, so trustees have felt forced into buying bonds, whatever their long-term value.”

Buying assets irrespective of their long-term value is in some contexts referred to as ‘greater fool theory’. That would seem to be the case in the euro zone, where Mario Draghi at the ECB is just about to begin a €1.1 trillion Quantitative Easing programme. Banks and other institutions have already driven down the yields of many sovereign bonds into negative territory (according to ABN Amro, more than a quarter of government bonds in the euro zone now have negative yields), in anticipation that some ‘greater fool’ will take them off their hands. Enter Mario Draghi.

Awkwardly, the ECB’s bond buying programme may prove to be the most ill-timed securities purchase programme in history. That was already the case given that interest rates are now at 5,000-year lows. It looks even more like the case given how bond markets behaved on Friday. “Treasuries in biggest rout since 2009 as job gains spur Fed bets,” reported Bloomberg. Last week the long bond, the 30 year US Treasury, saw its yield rise by 25 basis points to 2.84%. Mr Draghi may be bringing a knife to a gunfight.

Meanwhile, investment consultants will continue to give pension funds the benefit of their advice. That advice, both at a macro and a micro level, may be worth less than nothing; an academic paper has just won the 2015 Commonfund prize for concluding

“we find no evidence that [consultants’] recommendations add value, suggesting that the search for winners, encouraged and guided by investment consultants, is fruitless.”

So other than being unable to offer any practical advice whatsoever other than to recommend buying government debt at its most expensive levels in world history, perhaps ahead of a grave turning point in the market, and being unable to add any value either in specific fund manager recommendations, pension consultants are clearly well worth the fees they charge to their gullible pension fund clients.

Lest this seem a counsel of despair, for any investor unconstrained by benchmark or regulatory fiat, there is an answer. It lies in the sad passing, just reported, of the lateIrving Kahn, at the age of 109. Kahn was a teaching assistant to Benjamin Graham, the dean of value investing and a man whose influence on and development of the principles of successful investing was second to none.

Now, more than ever, is a time to insist that our investments carry a “margin of safety” – the cushion represented by buying assets (today, most likely to be equity assets, and almost certainly not most sovereign bonds) at a meaningful discount to their inherent value. At a time when few financial prices can really be trusted, courtesy of a tidal wave of QE that is lifting most boats, stocks possessing a “margin of safety” ensure that we run the least risk of consciously overpaying for our investments. Irving Kahn long ago “stopped wasting time on what people claimed a stock was worth and started looking at the numbers”.

Value investing – attempting to buy dollar bills for forty or fifty cents – always makes sense, but it makes a whole lot more sense when risk-taking and asset market reflation are off the charts. The alternative, which has become bizarrely popular among those retail investors flocking into index-tracking ETFs, is simply to gain broad market exposure. That is surely a grisly accident waiting to happen. John Hussman points out that

“the present moment likely represents the best opportunity to reduce exposure to stock market risk that investors are likely to encounter in the coming 8 years.. An environment of compressed risk premiums coupled with increasing risk-aversion is without question the most hostile set of features one can identify in the historical record.”

So the choices seem pretty clear. Track absurdly expensive stock markets higher. Buy government bonds at their most expensive levels in history – even as there are early signs that the interest rate cycle may finally be about to turn. Or take shelter in the sort of value stocks that made Irving Kahn, Ben Graham and Warren Buffett mightily successful long-term investors. Doesn’t seem like a particularly difficult choice to us.



The new London gold fix and China

This month the physical gold market will undergo radical change when the four London fixing banks hand over the twice-daily fix to the International Commodity Exchange’s trading platform on 20th March.

From 1st April the Financial Conduct Authority will extend its powers from regulating the participants to regulating the fix as well. This will transfer price control away from the bullion banks allowing direct access to the fixing process for all direct participants and sponsored clients.

From this flow two important consequences. Firstly, the London market is changing from an unregulated to a partially regulated market, reducing room for price manipulation. And secondly, the major Chinese state-owned banks, assuming they register as direct participants, have the opportunity to dominate the London physical market without having to deal through one of the current fixing banks. No announcement has been made yet as to who the direct participants will be, but it is a racing certainty China will be represented.

Implications of becoming a regulated market

Under the current regime a buyer or seller on the fix has to deal through one of the four fixing bullion banks. The information gained by them from seeing this business is crucial, giving them a quasi-monopolistic trading advantage over all the other dealers. Instead, buyers and sellers will be anonymous during the auction process.

The new platform should, therefore, ensure equal opportunity, eliminating the advantage enjoyed by the fixing banks. Crucially, it will change market domination from the privileged fixing members in favour of the deepest pockets. These are almost certain to be China’s through the state-owned banks which already control the largest physical market in Asia, the Shanghai Gold Exchange (SGE).

China’s gold strategy

China actually took its first deliberate step towards eventual domination of the gold market as long ago as June 1983, when regulations on the control of gold and silver were passed by the State Council. The following Articles extracted from the English translation set out the objectives very clearly:

  • Article 1. These Regulations are formulated to strengthen control over gold and silver, to guarantee the State’s gold and silver requirements for its economic development and to outlaw gold and silver smuggling and speculation and profiteering activities.
  • Article 3. The State shall pursue a policy of unified control, monopoly purchase and distribution of gold and silver. The total income and expenditure of gold and silver of State organs, the armed forces, organizations, schools, State enterprises, institutions and collective urban and rural economic organizations (hereinafter referred to as domestic units) shall be incorporated into the State plan for the receipt and expenditure of gold and silver.
  • Article 4. The People’s Bank of China shall be the State organ responsible for the control of gold and silver in the People’s Republic of China.
  • Article 5. All gold and silver held by domestic units, with the exception of raw materials, equipment, household utensils and mementos which the People’s Bank of China has permitted to be kept, must be sold to the People’s Bank of China. No gold and silver may be personally disposed of or kept without authorisation.
  • Article 6. All gold and silver legally gained by individuals shall come under the protection of the State.
  • Article 8. All gold and silver purchases shall be transacted through the People’s Bank of China. No unit or individual shall purchase gold and silver unless authorised or entrusted to do so by the People’s Bank of China.
  • Article 12. All gold and silver sold by individuals must be sold to the People’s Bank of China.
  • Article 25. No restriction shall be imposed on the amount of gold and silver brought into the People’s Republic of China, but declaration and registration must be made to the Customs authorities of the People’s Republic of China upon entry.
  • Article 26. Inspection and clearance by the People’s Republic of China Customs of gold and silver taken or retaken abroad shall be made in accordance with the amount shown on the certificate issued by the People’s Bank of China or the original declaration and registration form made on entry. All gold and silver without a covering certificate or in excess of the amount declared and registered upon entry shall not be allowed to be taken out of the country.

Additionally, China has deliberately developed her gold production regardless of cost so that she is now the largest producer by far in the world today. State-owned refineries process this gold along with doré imported from elsewhere. None of this gold leaves China.

The regulations quoted above formalise the State’s monopoly over all gold and silver which is exercised through the People’s Bank, and they allow the free importation of gold and silver but keep exports under very tight control. On the basis of these regulations and as subsequently amended the People’s Bank established the SGE, which remains under its total control. The intent behind the regulations is not to establish or permit the free trade of gold and silver, but to control these commodities in the interest of the state.

This being the case, the growth of Chinese gold imports recorded as deliveries to the public since 2002 is only the most recent evidence of a deliberate act of policy embarked upon thirty-two years ago. China had been accumulating gold for nineteen years before she allowed her own nationals to buy any when private ownership was finally permitted. Furthermore, the bullion was freely available, because in seventeen of those years gold was in a severe bear market fuelled by a combination of supply from central bank disposals, leasing, scrap, rapidly-increasing mine production and investor selling, all of which I estimate totalled about 76,000 tonnes in all. The two largest buyers for all this gold for much of the time were the Middle East and China. The breakdown from these sources and the likely demand are identified in the table below taken from my article for GoldMoney on the subject published last October, where a more detailed discussion of global bullion distribution during those years can be found.

Put in another context the cost of China’s 25,000 tonnes of gold equates to roughly 10% of her exports over the period, and the eighties and early nineties in particular, also saw huge capital inflows when multinational corporations were building factories in China. However, the figure for China’s gold accumulation is at best informed speculation, but given the determination expressed in the 1983 regulations and subsequent events it is clear she had deliberately accumulated a significant undeclared stockpile by 2002.

So far China’s long-term plans for the acquisition of gold appear to have achieved some important objectives. Deliveries to the public through the SGE since only 2008 totalled 8,459 tonnes, gross of returned scrap, probably more than 9,500 tonnes since 2002 given estimated domestic mine production of 1,352 tonnes between2002-2007.

With such a large commitment to this market, we must now anticipate the next stage for China’s gold policy, which is why the changes in London may be important.

China now has the opportunity to take a dominant role in London, without having to direct its order flows through the fixing banks. Therefore, it is no exaggeration to say that from 20th March, China will be able to control the global physical gold market, which will permit her to manage the price. She has the deepest pockets, backed by the largest single stockpile.

China’s motives

China’s motives for taking control of the gold bullion market have almost certainly evolved. The regulations of 1983 make sense as part of a forward-looking plan to ensure that some of the benefits of industrialisation would be accumulated as a counterparty risk free national asset. This reasoning is similar to that of the Arab nations capitalising on the oil-price bonanza only ten years earlier, which led them to accumulate their hoard for the benefit of future generations. However, as time passed the world has changed both economically and politically.

2002 was a significant year for China, when geopolitical considerations entered the picture. Not only did the People’s Bank establish the SGE to facilitate deliveries to private investors, but this was the year the Shanghai Cooperation Organisation (SCO) formally adopted its charter. This merger of security and economic interests with Russia has bound Russia and China together with a number of resource-rich Asian states into an economic bloc. When India, Iran, Mongolia, Afghanistan and Pakistan join (as they are committed to do), the SCO will cover more than half the world’s population. And inevitably the SCO’s members are looking for an alternative trade settlement system to using the US dollar.

At some stage China with her SCO partner, Russia, will force the price of gold higher as part of their currency strategy. You can argue this from an economic point of view on the basis that possession of properly priced gold will give her a financial dominance over global trade at a time when we are trashing our fiat currencies, or more simply that there’s no point in owning an asset and suppressing its value for ever. From 2002 there evolved a geopolitical argument: both China and Russia having initially wanted to embrace American and Western European capitalism no longer sought to do so, seeing us as soft enemies instead. The Chinese public were then encouraged even by public service advertising to buy gold, helping to denude the west of her remaining bullion stocks and to provide market liquidity in China.

What is truly amazing is the western economic and political establishment have dismissed the importance of gold and ignored all the warning signals. They do not seem to realise the power they have given China and Russia to create financial chaos by simply hiking the gold price. If they do, which seems to be only a matter of time, then London’s fractional reserve system of unallocated gold accounts would simply collapse, leaving Shanghai as the only major physical market.

Therefore the failure of the London bullion market to see strategically beyond its short-term interests has opened the door to China’s powerful state-owned banking monopoly to control the gold bullion market. This is probably the final link in China’s long-standing gold strategy, and through it a planned domination of the global economy in partnership with Russia and the other SCO nations.


Money, Money, Money

[For the original article, please see here:]

As the title of the blog suggests, we pay close attention to developments in money and credit since the twin precepts of our outlook are that ‘the credit cycle IS the business cycle’ and that ‘silver [i.e., money] is the true sinews of the circulation’.

It is all very well for both macro-economists and stock-pickers to look at flows, but unless a weather eye is kept on how they are being financed and what that implies for the future vulnerabilities of the contracting parties, a very important element is being overlooked.

Indeed, when, in the immediate wake of the collapse, Her Britannic Majesty somewhat querulously asked the foregathered luminaries of the DSGE crowd with whom she was mingling at the LSE, ‘why did nobody see it coming?‘, the one-line answer she might have been given is because none of them have ever cared much to look at the balance sheet, since they are trained to view finance as nothing more than a conduit to be safely neglected in their thickets of unrealistic matrix algebra.

In recent posts, we have dealt with some aspects of the debt issue – that ‘web of contracts’, as Axel Leijonhufvud calls it – which is the deadweight partly responsible for shackling our material aspirations to the ground (the other being the ghastly, taloned hand of the grasping and capricious, interventionist state). So, now, on the eve of the upcoming ECB meeting, let us take a quick look at a few of the monetary developments instead.

As a prelude to this, we should like to point out that, on our twitter account – where the compressed nature of the communications means that a certain sloganeering is not only permissible but almost de rigeur – we have adopted one or two mottos in the attempt to try to bind our monetary text-bites into a more coherent narrative.

One is simply, ‘Abenomics fail’ – shorthand for our disdain for a programme of pretending that an ageing nation of import-reliant savers can get rich by devaluing their currency and by promoting a speculative hunger for equities. Another leitmotif is the‘Ghost of ’37’ – a reference to the widely shared folk mythology that a combination of monetary and fiscal tightening in 1937 prematurely put paid to America’s burgeoning recovery from the earlier slump when in fact the proximate cause was that a new front was opened that year in the New Deal’s regulatory and ideological war on ‘Capital’ – i.e., on entrepreneurship itself.

The fiction persists however that it was an instance of what we might now call ‘austerity’ that did it. As if it alone did not suffice to stay the policy-maker’s hand, this stultifying belief mingles with the perverse incentive that while central bankers might have to endure a mild and momentary criticism of their approach if the ‘controlled’ inflation they so desire ever threatens to go critical, they know that they will be burnt in effigy and their memory forever accursed if they ever have the temerity to try to allow markets to function once again and any noticeable relapse in hot-house growth eventuates as a consequence.

Our most commonly used meme, however, is ‘QEuro = 2 much, 2 late’ – a blunt reference to the fact that Draghi’s long-awaited Whatever initiative has arrived well after any conceivable need for it has passed; indeed, that it has come at a point where the consequences may rapidly be revealed to be almost exclusively counter-productive.

Just look at the GfK readings of Germans’ desire to spend – now at the highest since Dec 2006. Or at the harder confirmation contained in the just-released retail sales numbers  – up 5.3% in real terms yoy – or at the fact that IG Metall managed a 3.4%-plus-benefits wage rise with barely a wave of a red, ‘Wir Streiken’ banner needed. We shall forebear to make overmuch of the fact that the Deauville sale of yearling race-horses also set new records last month.

Yes, French industry may be contracting more sharply again, if we take the latest Markit survey at face value; yes, the Greeks are still trying unsuccessfully to roll that infernal rock up their Hadean hill; yes, Austrian embarrassment is intense as that captive funding arm of local political corruption – Hypo Alpe – is again making the wrong sort of headlines. But money – ever more copiously provisioned money – is beginning to burn a hole in the pockets of more than just stock market plungers and would-be real estate moguls.

A look at the graph of European monetary trends shows us why.15-03-03 EZ M1

Not exactly a dearth of the folding stuff, is there, neither among the T2 creditors, the middle ranking countries, nor the sinful PIIS (Greece, for obvious reasons we exclude from the roll of shame, just now)?

Moreover, if we focus on changes in the balance sheets of the residents of the latter four problem children – specifically with regard to their deposits at and loans from the region’s banks – we arrive at the remarkable observation that, for the whole of the last 2 1/2 years, the non-financial private sector has improved its net position by just over €1 billion per working day for a €750 billion total – with two-fifths of that betterment coming from a household sector biased toward deposit acquisition and the remaining three-fifths resulting from corporates’ efforts at reducing debt levels.15-03-04 PIIS PVT

Indeed, corporate liquidity has not been this favourable since early 2006 while households are enjoying the biggest surplus to be found in our sample. As a pairing, the private sector is back where it was eleven years ago, having worked off the entire €1 trillion cumulative deficit it disastrously ran up between the end of 2003 and the latter part of 2007.

15-03-04 PIIS PVT net

As we said,  ‘QEuro = 2 much, 2 late’

Malign consequences elsewhere are already becoming evident. For example, S&P has calculated that the actuarial shortfall in defined benefit pension plans worsened by anything up to €90 billion last year (widening an already substantial gap by a quarter in one bound). The agency went on to point out – rather superfluously, one might think – that things will only deteriorate again this year.

Insurers also face a squeeze between their long-term liabilities – many of which carry minimum pay-out clauses well above today’s nugatory bond yields – and the medium-duration assets they hold and roll in order to meet these. Despite the plaintive acknowledgement of their likely future difficulty – and who better to compute long-term probabilities than members of an actuarial industry? – they are all presently hiking dividends and raising pay-out ratios in order to disburse some of last year’s one-shot gains on equities and on the MTM value of their bonds in a crass attempt at trying to massage their share prices upwards!

It is supposed to be rapid rises in the price of goods which promotes such economic short-termism and which encouragesunwitting capital consumption, but here we see asset-price inflation inducing those who really should know better into aconscious dissipation of their substance.

Other harmful side effects are that despite what Nick Nelson of UBS told Reuters were “47 months uninterrupted of earnings downgrades,” and with nary a care that Q-IV revenues were down 6% yoy, record amounts of money are flowing into European equities. Presumably most of the foreign component is arriving with the currency exposure well-hedged in that same Gutenberg Trade manner by which the world and his wife went long Nikkei/short yen when the BOJ got the printing press humming back in 2013/14.

A glance at the following two charts (courtesy of Nikko Asset Management) might give some pause for thought, however, even as the markets ratchet ever upward. The first shows the eternal over-optimism with which the all-important earnings estimates for Europe are routinely framed at the beginning of every season and how they are doomed to dwindle inexorably as each successive year rolls on:

Courtesy: Nikko AM
Courtesy: Nikko AM

The second shows whence investor returns to date have been derived as a consequence of this (Answer: not through the agency of anything tangible):-

Courtesy: Nikko AM
Courtesy: Nikko AM

As the team at Nikko dryly conclude their examination of this trend:-

‘…there are several credible reasons to expect that QE will boost corporate earnings in Europe, though by not as much as in the US. However, the risk of disappointment relative to inflated expectations remains high.

And finally, of course, there is property – always the first and last outlet for the Middling Sort but, as ever, too, an unproductive, Ponzi-prone use of funds which is fraught with long term danger on that same account. Even in Hollande’s benighted France, SCPIs – a kind of local REIT – saw a 10% rise in inflows to set a new record last year, while BNP Paribas reported that foreign buying ‘drove European hotel investment’ to the extent that France, Germany, Italy, Spain and the UK attracted two-thirds more cash than the year before and so topped 2007’s pre-crash record.

Would you like some more? Well, German ratings agency FERI reported that institutions it surveyed there were intending ‘strong’ increases in allocations to residential and retail RE together with a widely expressed appetite for higher-risk and indirect investment vehicles. Property giants CBRE, for their part, noted that 2014 saw €218 bln ploughed into Europe with the final quarter’s €78 billion just failing to top 2006’s bubble highs. Sweden, Spain, and Ireland did, indeed, set new records, we are told, while Portugal and Holland were also notaly strong. Any prizes for guessing what might happen this year with bond yields negligible or even negative in most of these countries?

Given all the foregoing, one final Twitter tagline of ours is of relevance, viz., ‘CBs, 2 save the Few, ruin the Many’

Sadly, this is not likely to turn out to be much of an exaggeration. Sadly, too, Snr Draghi is unlikely to pay the slightest attention to our worries when he convenes his cabal for the scheduled away-day meeting in Cyprus this week.


Bank Robbery: Banks and the Money Supply

[Editor’s Note: The following is from Ivo’s forthcoming book ‘Bank Robbery’.]

Chapter 1

‘If it ain’t broke, don’t fix it.’ Sensible advice, especially when it comes to tinkering with the money supply: with laws about how money is made, how we get it, how we spend it. What would happen if the financial system was dismantled or thrown out of joint? Would we be able to pay the bills, eat, have shelter and live?

Most people don’t even want to think about the system, let alone how it should be reformed. Fear and ignorance reinforce each other. But reasons for reform grow stronger and stronger every day. Besides the massive criminality and corruption that go unpunished even in the complacent West, there are troubles which may not originate in the way we create money, but which are mightily fed by it: war, inequality, unemployment, mental health, drug abuse, environmental destruction, climate change; unaccountable power in governments, corporations and wealthy individuals; loss of moral freedom; misuse of assets and human resources; booms and busts of the ‘business cycle’: the list could go on and on.

To understand the connections between the way we create money and the troubles listed above is the subject of this book. Explaining how money is created is no problem: just one sentence will do (see the next paragraph for that). But unravelling the implications is a bit like a detective story. The blunt instrument that did the murder has been discovered, but the human story behind it is what’s interesting. Who did the murder? Why did it happen? What will the consequences be? And finally, the all-important question that lurks in the background of all good detective stories: Will justice eventually be done?

Instead of just one villain, however, the story of how our money is created is a whole history, with good intentions travelling alongside the usual motives of greed and deception. In the past, money was lots of different things in different places: cowry shells, tobacco, precious stones, any number of things. For many hundreds of years, money in the West was gold, silver and other cheaper metals. Today, money is almost all ‘credit’ – numbers in bank balances, representing claims (which we own) on digital money belonging to the bank. Here is a one-sentence description of how credit is created today: ‘Central banks, in obedience to their governments, create digital ‘reserve money’ which they sell to commercial banks; commercial banks are then allowed, by special legal privilege, to create multiple claims on their ‘reserve money’ and to lend those claims to whomsoever they please.’ It is these claims that we call ‘credit’, and which pass from person to person as the money we use every day.

Such simple facts are only seeds when it comes to understanding how this way of creating money affects the workings of our world. But three things stand out right from the start about the system, which uses law and privilege to establish ‘credit’ as a form of money.

  • First, it is a source of great profit to governments, who create and sell ‘reserve money’ to banks, and can borrow almost unlimited amounts in the name of their citizens.
  • Secondly, it is a source of great profit to banks, who collect interest on the credit that they in turn create.
  • Thirdly, money – credit – can be allocated in vast amounts, by mere decision of those who profit from it.

It is pretty obvious that this way of creating money advantages some and disadvantages others.

That money should be created in such a way may seem bizarre, but it makes complete sense when it is looked at in historical context – in other words, when it is read as a human story. What follows is the human story of how banks came to create our money supply.

A banking historian named Loyd Mints – a deeply respectable and learned man – wrote the following:

It would seem that an evil designer of human affairs had the remarkable prevision to arrange matters so that funds repayable on demand could be made the basis of profitable operations by the depository institutions.

Loyd Mints is referring to the fact that once a bank gets hold of people’s money, a host of devilish opportunities open up to it. The situation today, which can only be described as madness, is the culmination of a series of developments in banking over the last three thousand years. A number of clear stages followed on quite naturally from each other, and noticing these stages makes it easy to understand how banks create money today.

Banking can be said to be as ancient as writing itself. Some of the earliest surviving bits of writing are not literature or law or religious stories, but records on clay tablets of how much is owed by someone to someone else. This record is from several thousand years ago: ‘Mannu-ki-Ahi and Babu-Asherad acknowledge that they have 10 minas of silver belonging to Remanni-Adad, chariot-driver, at their disposal.’  This is banking in its simplest form: a person (or institution) accepts money from someone, and issues a credit note (or clay tablet) in return. Temples in ancient Sumer, Babylon, Egypt, Greece and Rome did this: they were religious institutions doubling up as banks.

Once money is in the hands of a banker – ‘at his disposal’ – he can put some of it to use. He can lend it, or invest it, or simply spend it. If he wants to stay in business, he will have to keep enough on hand to pay customers who come asking for ‘their’ cash. So, part of a banker’s skill is to judge how much he should keep handy, to meet his obligations.

The more a banker has on deposit, and the more skilfully he uses it, the richer he may become. He may even pay depositors to leave money with him, so that he can have more to play with. Naturally, his favourite customers will be those who leave money with him for a long time. When he lends (or invests or spends) money that he is ‘storing’ for his customers, the money re-enters circulation. The important point to notice at this stage is that the banker is not creatingmoney; he is just putting some of it back into circulation.

The next development in banking is when bankers start to actually create money. This happens quite naturally, when customers begin using their credit notes as a way of paying other people. A credit note is, effectively, a claim on a bank’s money: so if a bank is generally trusted, a seller might be happy to take a credit note in payment, provided he’s confident he can use it to get cash from the bank. Being paid with a note was popular among rich customers: when cash was silver and gold, a credit note was easier to manage than chests of heavy metal. Credit notes begin to circulate alongside gold and silver: they became a form of money.

It was good for bankers’ business when their credit notes began to circulate because they stayed out longer and fewer were presented for cash. Bankers could use their cash more freely. Credit notes were circulating alongside cash, so there was a clear increase in the money supply. Bankers were not just putting money into circulation; they were actually creating it.

The next development in banking occurred again quite naturally. Bankers realised they could write out new credit, even when no new cash had been deposited. If the credit was in the form of notes, they could sell the notes, or lend them, or buy things with them and become instantly a great deal richer. If the credit was just a couple of lines in a banker’s ledger books, the result was the same; payment could be made by transferring credit from one customer to another, either within the same bank or between banks. The Venetian banker and Senator Tommaso Contarini wrote in 1584:

“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.”

In 17th century England, the practice of credit creation came under intense and public scrutiny. Banking developed fairly late in England, and when it arrived it expanded quickly. ‘New-fangled’ bankers began writing notes in large amounts and getting very rich off the proceeds. The old landed class felt threatened, and the practice was highly disapproved of by many contemporary lawyers and economists. Such notes ‘represented nothing’; they were ‘fictitious credit’; in the words of Bolingbroke (English political writer, and major influence on the ‘founding fathers’ of the United States): a ‘new sort of property, which was not known twenty years ago, is now increased to be almost equal to the terra firmaof our island’.

Battle lines were drawn. The Lord Chief Justice, Sir John Holt, ruled that the credit notes of bankers, passing from person to person as currency, were not to be enforced at law. Many in Parliament, however, which at that time consisted of rich men voted in by other rich men, liked the new money. As individuals, it offered them opportunities to get richer; as a body, it made it easier for them to finance war. Parliament passed a law (the Promissory Notes Act of 1704) stating that bankers’ credit notes should be enforced regardless of who presented them. Notes could pass from hand to hand as currency, and the law would enforce their payment. Centuries of legal attempts to prevent fraudulent contract were overturned in favour of capitalists, bankers, and the government’s need to finance war.

Bit by bit, this bankers’ privilege was incorporated into legal systems across the world. In 1845, the American judge Joseph Story wrote: ‘Most, if not all, commercial nations have annexed certain privileges, benefits, and advantages to Promissory Notes, as they have to Bills of Exchange, in order to promote public confidence in them, and thus to insure their circulation as a medium of pecuniary commercial transactions.’

This last development is normally considered to constitute the foundation of modern banking: credit-money manufactured by banks for first use by capitalists and governments. However, there were two significant stages still to go before the madness of today could be arrived at.

At this point in banking history, the difference between the two forms of money – cash and credit – was obvious: ‘cash’ was valuable metal and ‘credit’ was just written words and numbers. But an owner of credit could legally demand something valuable in exchange – gold. Paper could be easily created, words and numbers are easily written, but gold was hard to come by. Nations and their bankers had to amass gold if they wanted to be trusted. The ‘gold standard’ lasted pretty intact until the First World War, when the need for money to finance war could not be met by taxes or loans. Nor could it be met by claims on gold, for the fighting nations (and their banks) were running out of gold. So governments adopted a recipe which had been tried a few times before: they issued paper promises to substitute for the gold, with the assurance that after the crisis passed, gold would be accumulated and once again supplied.

Production of this government paper was so prolific that after the war, the ‘gold standard’ was ‘smashed to smithereens’, as one commentator put it. Subsequent attempts to restore it were sporadic, half-hearted and hedged around by conditions. Meanwhile, it had become apparent that an economy could function well on money that was just paper and numbers in bank accounts, so long as the amounts were restricted.

Once money became just paper and numbers, we can, with hindsight, see a choice: should ‘money’ be restored to its old character, as property to be owned outright; or should it continue along the path it had travelled for so long – towards being a commodity rented out by governments and banks? In reality, the question was barely posed. Credit-creation was the fountainhead of power: it operated in shadows of obscurity, far from public scrutiny, not quite understood even by those it advantaged and even less understood by those it disadvantaged.

Now that credit and cash are mostly digits in computer systems (with a few notes and coins thrown in – roughly 3% of the money supply – as if just to confuse us) the difference between them is less than obvious. But the system is structurally the same as when it was based on gold. In retrospect, it may seem an act of genius that a group of people (governments, bankers, capitalists) have established a money supply manufactured by themselves and lent to the public at interest. Had it been a conspiracy, it would have been the most diabolical conspiracy ever made. But it was not a conspiracy: it was merely the continuation of a system which had worked well for the rich and powerful, and would now work for them even better.

Before banking reached its modern status, however, it had still one stage further to go. This was deregulation. At the beginning of 1971, one last vestige of the gold standard still survived: payments between nations could still be demanded in gold. This last vestige was put to rest in August 1971, when U.S. President ‘Tricky Dick’ Nixon refused to honour a demand from France for payment in gold. He gave them dollars instead.

At this point, some extra regulation might have been a good idea, to give some protection to those of us who ‘merely wish for a normal existence’. What actually happened was deregulation – as if to remind us of Adam Smith’s words: ‘All for ourselves, and nothing for other people, seems, in every age of the world, to have been the vile maxim of the masters of mankind.’ The fundamental privilege of banks, allowing them to create multiple claims on the same asset, was allowed to other ‘depository institutions’. Accounting practices went one step further, allowing two different persons to actually ‘own’ the same asset. Madness had struck – or, in Hollywood-speak, greed had become good, even God: a new Commandment replacing all the older Ten.

Multiple claims on multiply-owned assets now enable ‘shadow banking’ to create financial assets equal in nominal worth to fifty (or more) times annual global production. The relationship between these ‘financial assets’ or ‘near-moneys’ to the lives and freedoms of those who ‘merely wish for a normal existence’ will, I hope, be addressed in a later chapter. For now, enough!


What’s in a Word?

[You can find the original here]

After yet another masterly performance before Congress – one which was immediately confounded by the usual cacophony of cross-talk from the Pigeons and Doves (no Hawks!) among her colleagues – Madame Yellen has left no-one really the wiser as to what the all-things-to-all-men Federal Reserve thinks it is actually doing with regard to monetary policy.

Is she ‘patient’ or not? And is ‘patient’ a nudge-nudge, wink-wink code for a period stretching beyond the next few FOMC meetings or is it just a tacit admission that the Fed will start checking its parachute harness only after the plane’s engines have at last caught fire?

Given all this prevarication, have you lost patience with the whole weary rigmarole, as have we, Dear Reader? If so, can we suggest you join us in setting aside your frustrations by concentrating on the one abiding truth of current policy: that even if theredoes exist a door marked ‘EXIT’ in the haunted house in which the world’s central bankers have long confined themselves, it would be one guarded by that most fearsome of all the ghastly bogeymen of economic myth – the Ghost of ’37.

But why not, you ask? Is the Fed not right to hold fire in this world of ‘secular stagnation’ Is it not only prudent to avoid tipping the country headlong into ‘deflation’ by spooking the financial markets and so risking a full-scale reprise of the Lehman moment of six years ago?

Perhaps not. For even as has been belatedly recognised by the ‘professional second-hand dealers in ideas’ who write, for example, for the FT – when not flitting to Davos or popping up to sing for their supper at self-flattering symposia sponsored by billionaire financial St. Augustins (‘O Lord, help me eradicate all inequality, but just not by setting a personal example’) – what the world urgently needs is not any further incentive to take on debt. but a means of expunging some of its gross, existing burden of the stuff.

Yes, without any acknowledgement of the error of their ways and lacking any display of contrition at the long misery to which their pontifications have greatly contributed, the Clerisy are starting to realise that they may as well help Atlas to shrug off his crushing load and that the world must thereafter be ordered to allow the newly liberated Titan to enjoy as much freedom as possible (‘structural’ reforms must be enacted, as they put it) if he is to help rebuild both his and our prosperity.

It is almost mischievous to say so but, in the circumstances, a genuine bout of deflation could actually represent a useful Plan B. After all, few can argue that the authorities’ Plan A has so far been a rather dismal failure; that the Powers-that-Be have not managed to alleviate the real impact of all that debt as they had planned, in an inflation of anything other than the price of prestige property, race-horse yearlings, modernist daubings, and all manner of financial assets. To their mounting frustration, their efforts so far have achieved little more than to ignite a version of inflation which has served only to aggravate the divide between the rest of us poor saps and the same plutocratic 1% which is so vilified by the very bleeding heart Progressives who are to be found at the forefront of the mob noisily advocating the current policy mix.

Without wishing to call the glib ‘liquidationist’ slur down upon our heads, one might point out that the one guaranteed way to cancel debt is to allow a sufficiently rapid deflation that creditors can no longer hold out for the soothing money-illusion balm of a repayment in debased coin but must instead face up to the reality that their debtors are unable to comply with the terms of their mutual contract as originally drawn up.

If you agree with a man that you will feed him and his co-workers for a month in exchange for them delivering a tonne of coal to you at the end of the period and he later finds he and his team cannot possibly comply with his undertaking, it serves no very great purpose to redefine the mass which makes up a tonne to half its former value in place of either accepting the reduced physical repayment your debtor can make for what it is, or of otherwise working out some alternative scheme of mutually-agreed recompense which will at least allow him and his mates the chance to continue to make a living – an activity from which you might yet hope to derive some ancillary benefits.

Inflation is not, therefore, a panacea, especially when the principal means of injecting the posion into the economic circulation is by encouraging people to continue to borrow more than they should.

Deflation in this sense is, of course, unmitigatedly ugly but it is at least a purgative. The soothing inflationary alternative nurtures a more chronic disease in place of that febrile crisis, but this is an illness whose mortality rate may well turn out to be higher, not lower, than its more acute cousin. Arguably, too, it is one which introduces even more inequity into the system for while neither the struggling debtor, nor the prudent, middling sort see any benefit from the asset-heavy, differentiated increase in prices, the members of  the speculative class make out like the state-sponsored bandits they are.

QE may thus prove to be little more in form than an issue of letters of marque to our era’s financial privateers on a truly unimaginable scale. Every new higher close on the stock market and every notch lower in bond yields and credit spreads should therefore be added to the charge sheet of financial larceny, even if the move does not end up inducing a panicky rush for the wheelbarrows.

But, in any case, what do we mean by ‘deflation’? In truth this should imply an increased perception that money has become more scarce, whether because the quantity available has actually shrunk or because money – final-settlement, trust-no-man money – is being demanded in place of the Good-time Charlie credit which was formerly allowed to assume some of its functions.

15-02-27 Bank Credit

On that score, we can hardly talk of the United States being at risk of ‘deflation’. To consult but two of the more timely gauges of the financial temper of the times, commerical bank balance sheets – minus the hoard of excess reserves they have been forced to pile up at the Fed – are again growing smartly, rising by 7.8% YOY, close to the best in five years and not too far removed from the 8.4% median of the two decades preceding the collapse of Lehman. Money proper is also not in short supply, rising 10.4% nominal, 8.1% real in the past twelve months and so moving far, far above the long-term trend.

15-02-27 USM1+

Even if we do succumb to the dubious practice of defining deflation by means of a simple fall in what we imagine to be the general price level, it is not at all clear that any ‘threat’ to any but the most confirmed sufferer of katatimophobia exists either at present.

Take the Cleveland Fed’ s Median CPI index, for example, an index whose primary virtue is that it throws out the outliers, high and low, and so is less affected by either positive or negative ‘shocks’ to small numbers of its constituents.

As it has for some little while now, this is giving a thoroughly, unexceptional, if not impressively stable reading: one which, moreover, manages to meet that cabbalistic ideal of modern central bankerhood of a rise of close to 2% per annum – at which sacred pace, we are constantly assured, the doors to earthly paradise will instantly be thrown open.

15-02-27 MCPI

And lest this observation give rise to the opposite argument that if the maintenance of this Babylonianly perfect rate requires no countermeasures on the downside, it need call forth no monetary tightening either, just be aware that, as for much of the past four years, this leaves the real Fed Funds rate at highly unsettling 2%-negative. For comparison, the seventeen years of the so-called ‘Great Moderation’ between 1992 and 2008 saw a typical CPI rate not much more elevated than at present – at 2.7% – but also experienced a nominal funds rate of around 4% and an ex-post real one of plus-1.2%.

Given that, with the benefit of hindsight, this supposed golden era was the one in which were actively sowing the seeds of our own ruin, it might give pause for thought about quite how much harm our masters ‘ stubbornly accommodative stance is causing us again today.




At a recent conference hosted by a major global bank in London I sat on a panel alongside a macro investment strategist who referred to the euro as a ‘Trojan horse’ intended to force fiscal austerity on traditionally profligate countries such as Greece. While that is true, I believe there is also a second euro Trojan horse, this one intended to force through greater fiscal, banking and political integration, enabling the creation of a European ‘superstate’ to rival the US and China in economic and political power. What we are witnessing now is the inevitable battle between the two horses to win over German public opinion, on which the euro’s future most depends. In my opinion the battle will have several national casualties, resulting in a smaller but more competitive euro-area. While this could be negative for European government bonds, it could be supportive of stocks, eventually.


Although my career in international finance began in New York, in 1995 I moved to Germany. By that time it was generally assumed that European Monetary Union (EMU) would begin, more or less as planned, in 1999. In my role as a macro investment strategist it thus became necessary to develop a methodology for asset valuation and investment strategy in the presumed future single-currency area.

This required first an aggregate economic statistical dataset for the future euro-area taking many months to develop, with the greatest challenge finding ways to harmonise differing national calculation methodologies for key aggregates. But by focusing as we did primarily on the larger prospective members: Germany, France, Italy, Spain and the Netherlands, the goal was nevertheless achievable and in early 1998 we presented our harmonisation methodology, initial dataset, model suite and key investment recommendations on a ‘roadshow’ to major investors in Europe and around the world. (Subsequently I presented regular updates on these data and associated thoughts on European macro investment strategy on a financial television show jointly hosted by the Wall Street Journal and CNBC Europe, The Eurozone Barometer.)

Now it wasn’t exactly easy to get investors’ full attention in early 1998 due to the Asian currency crises unfolding at the time. Nor did it become any easier as the year went on. In August, Russia defaulted. In the fall, the massive hedge-fund Long-Term Capital Management blew up, with the Fed brokering a deal to contain the substantial potential fallout. But there was sufficient interest in EMU as a historic international monetary development that we nevertheless managed to get meetings with senior officials at many major central banks and other financial institutions who would be the amongst the largest future holders of euro-area sovereign debt. They wanted to know how to value and estimate the risks of such debt, issued by sovereign borrowers with the power to tax but lacking a national central bank to set interest rates and serve as a potential ‘lender of last resort’ in a crisis.

This unusual situation required a novel approach to asset valuation and risk estimation. How to determine debt valuations not only for the presumed benchmark issuer, Germany, but also the borrowing spreads to Germany for the other member countries? While it was easy to assume that those economies highly integrated with Germany and with a similar sovereign debt structure, such as the Netherlands, would trade at a minimal liquidity spread to Germany, what about highly-indebted Italy or Greece? At the time, Greece’s debt rating was barely above junk.

And so the process began to find some example or precedent to ground euro-area debt strategy and I found it in Canada, of all places. While in the US much debt is raised at the state and local level, the amount is nevertheless much smaller than the federal debt. Moreover, in the US there are large fiscal transfers to and from the federal to state and local authorities. Canada, however, was structured much more like the euro-area, in that provincial borrowing was large in proportion of the total public debt. Quebec in particular was a useful example as a province with both a large debt and also one at risk of seeking independence from Canada in future. Thus there was both an element of credit and possibly devaluation risk associated with the prospect of Quebecois independence—just what was needed for thinking about the future risks associated with the financially weaker euro-area sovereign borrowers.

As part of my research I travelled to Canada and met with both investors and issuers of central government and provincial bonds. I also had discussions with the ratings agencies to understand their methodology for determining Canadian provincial ratings. What I learned was that there were large perceived variations in provincial credit quality and it was thought unlikely that the federal government would come to the rescue of an overindebted province. This helped to explain the relatively wide spread divergence. My initial conclusions were thus that, following the launch of EMU in 1999, euro-area sovereign spreads for relatively weaker credits would remain wide enough to compensate investors for the risk of a future funding crisis or possible withdrawal and devaluation. For high-quality sovereign credits however, spreads were likely to converge on German Bunds, although the latter would retain a liquidity premium as the benchmark securities providing the basis for euro interest rate risk management.

When asked by a Wall Street Journal reporter to place some numbers on these predictions, I suggested that Dutch government bonds would trade at low double- or even single-digit basis-point (bp) spreads to German Bunds. Italy, however, I suggested would need to pay from 50-100bp above Bunds in 10y borrowing costs. As it happened, while Italy did trade in this range in the first 1-2 years of EMU, spreads subsequently tightened considerably, falling into the low-20s by the mid-2000s. Spanish government bonds traded even tighter. Greece, joining with a delay in 2002, saw spreads tighten inside of 40bp by the mid-2000s.

This spread tightening was primarily due to what appeared to be a material, sustainable improvement in peripheral sovereign finances. Spain in particular achieved a dramatic decline in public deficits and debt by the mid-2000s. The ratings agencies rewarded Spain, Italy, Ireland and Portugal with upgrades. Greece was also rewarded, although we now know that much of the ‘improvement’ in Greek finances was due to opaque swap structures that disguised the true size of the official deficits.


At the time I was among those who were sceptical that these peripheral fiscal improvements were sustainable. While regional property and stock markets were booming, reflecting widespread economic optimism, in fact the entire southern periphery of the euro-area was becoming less competitive. Real unit labour costs, while holding stable in most of the euro-core, were rising rapidly in the periphery, harming competitiveness. Indeed, by the mid-2000s, Germany had undergone nearly a 20% real devaluation of wages relative to the periphery. In the past, such large swings in real effective exchange rates between European countries had triggered currency crises, as in 1992 and 1995, for example. The ‘Trojan horse’ of stable money, intended to bolster rather than erode peripheral competitiveness, was failing in its mission.

This, alongside booming, bubble-like peripheral asset prices led me to recommend to clients, beginning in mid-2006, to initiate short positions in Spanish and Italian government bonds. The cost of doing so, either outright or through credit-default swaps (CDS) was so low it was a cheap option.


In order to support this investment recommendation I constructed an ‘EMU breakup probability calculator’, which I presented to the Lehman Brothers Annual European Hedge Fund conference in fall 2006. The idea was the following: In the event that a country withdrew from EMU, reintroduced a national currency and devalued to the point of reversing the entire rise in the real effective exchange rate vis-à-vis Germany, what borrowing spread would fully compensate investors for the devaluation? By then comparing this implied spread to the actual, market spread it was possible to calculate the implied breakup probability.

At the time, due to narrow spreads, the implied probabilities that Italy, Spain, Portugal or Greece would leave EMU within five years were tiny, sub-10%. I then asked the audience if they thought that this was a fair pricing, with only a few hands rising in response. Far more hands went up when I asked if they thought the probability should be higher.

The most interesting part of the ensuing discussion was when I asked those investors who thought the pricing was fair why they held that view. Universally they held that, in the event of a peripheral sovereign debt crisis, some combination of the ECB and EU would come to the rescue. Bailouts would be forthcoming, notwithstanding their explicit prohibition under the 1992 Maastricht treaty. These investors thus had strong faith that, while a crisis might indeed be on the way, the second euro Trojan horse would prevail in any future battle with the first.

It was less than a year before spreads began to widen, slowly at first, then spectacularly as the events of 2008 unfolded to the horror of those who had been riding on and profiting from the euro-area ‘convergence trade’. And yet, as some of those fund managers had predicted correctly, the ECB and EU did come to the rescue, albeit in exchange for varying degrees of ‘austerity’.1 And so the first phase of the Trojan horse battle ended in something of a stalemate.


The recent Greek elections and subsequent attempts by the new government to substantially renegotiate the terms of the 2010 debt restructuring with their EU counterparts threaten to break the stalemate. While debt forgiveness for hopelessly overindebted Greece is entirely reasonable, to proceed in this way would provide a precedent no doubt highly desirable for other overindebted euro members, present and future. With their support, in time a more formal mechanism of automatic transfers and universal euro-area bank deposit insurance could follow.

Thus those who have always pinned their hopes on a sovereign debt crisis catalysing a major step towards greater political union see a huge opportunity in Greece. But this counterattack by the second euro Trojan horse forces against those of non-inflationary fiscal sustainability is highly risky, because it takes the fight to what is the ultimate support for the euro itself: German public opinion, sharply divided over the issue, which cuts across traditional party lines and is thus difficult to control.

The importance of German public opinion cannot be overstated. Without this support, the euro and possibly even the EU will fail. There is no other large, successful economic anchor for the common market and currency. France has become the elephant in the EU room no one will talk about: It’s economy is in structural decline. One can easily imagine the EU surviving the withdrawal of one or more members but if Germany goes, the EU as we understand it today could well dissolve entirely.

Some fear that Europe would then descend into the perennial nationalism that has plagued Europe for centuries: The German Reformation; the Dutch Revolt; the 30yrs War; 1848; the Napoleonic wars and the dismemberment of the Austrian and German empires post-WWI that would lead to the supremely devastating WWII. In my opinion it is difficult to imagine how, in an age of nuclear weapons and unprecedented economic and social integration, Europe would today choose to take such a suicidal course. Those warning that a German refusal to fund euro bailouts will result in WWIII are scaremongering in my opinion, not to be taken seriously. But the fact remains: The survival of the euro ultimately rests on the support of German public opinion.

To be sure, the new Greek leadership understand this: They launched a clearly well-planned German public relations campaign the moment they assumed office. This included pulling some emotional strings, such as reminding the Germans of the devastation they wrought on occupied Greece in WWII and of Germany’s own devastation and substantial debt forgiveness during and following the war. They are doing all they can to win over an understandably sceptical German public wary of anything that could add to the moral hazard they increasingly suspect was created along with the euro in the first place.

In my opinion, however, the irresistible force of Greece’s demonstrably unserviceable national debt will soon meet the immovable object of German public resistance to further, arguably undemocratic European integration. If so, then in the long battle between the two euro Trojan horses, Greece will default, withdraw and devalue, and those fighting for greater integration will have tried and failed to cross a bridge too far by forcing a common currency on a community of nations that simply did not share a sufficiently common economic and political culture to enable it to succeed. If there is not a retreat soon by a core group of euro members that can close ranks around a defensible position of low public debts and deficits, the entire project is at risk of failure.2


In all probability, the euro-area must therefore either shrink, or dissolve entirely, placing the EU itself at risk. In any variation, this will initiate a series of major macro events not only in Europe but around the world; a cascade of crisis-driven opportunities for those who establish the right positions in advance.

First, if and when Greece faces the music, defaults and/or withdraws and devalues, this will trigger a general peripheral earthquake that will shake loose multiple other member countries, possibly including Spain and even Italy. No, that won’t be the end of the world for either—remember they’ve been through far worse over the past century—but it will lead to substantial losses for those investors directly exposed to their domestic bond markets. Their stock markets should fare somewhat better by comparison, as the devaluations will help to restore competitiveness and profitability. Keep in mind, however, that corporate debt servicing costs will rise along with domestic interest rates generally and leveraged corporations competitive in a low interest rate environment might find they struggle to service debt, much less generate profits amid higher rates. Also of serious concern for these stock markets is that capital controls are imposed for a time. This has been the case in Iceland and Cyprus, for example, and is almost certainly going to be the case with Greece before long.

Second, large German, BeNeLux and French banks are going to take a huge hit, highly exposed as they are to the periphery, if no longer through large holdings of government bonds, then through the interbank or corporate loan markets. In multiple cases I expect banks to be partially if not completely nationalised. This will require increased sovereign debt issuance. But as long as the ECB stands ready to provide the necessary liquidity assistance, as I believe it will, then this need not have a material impact on government bond yields.

Third, the bank recapitalisations within the euro-core will place temporary downward pressure on the euro relative to other major currencies. (The UK may well find its banks need another round of recapitalisations too.) I say temporary because the leaner and meaner euro-core will run a large trade surplus, implying future currency strength.

Fourth, and here I will speculate a bit more freely, I honestly can’t imagine that the above could possibly unfold without multiple large macro hedge funds being caught blindsided in leveraged, positive-carry trades of various kinds. Long-Term Capital Management was taken out by the aftershocks of the Russian debt default of 1998 and, given far higher overall system leverage today and the risks associated with modern financial weapons of mass destruction, including ‘collateral transformation’,3 I would expect the interbank markets in not only euros but also in sterling, dollars and possibly even yen to seize up in varying degrees, with wide-ranging implications for liquidity generally. This nearly occurred in 1998; it did occur in 2008 following the Lehman bankruptcy. While I’m not claiming that a euro restructuring will necessarily trigger something as spectacular as 2008, the possibility certainly exists. In any case no two crises look exactly the same and for all I know things could well be worse, especially in the event that not only Spain but also Italy decide to default and/or withdraw, re-introduce national currencies and devalue.

Regardless of its magnitude, this cascading liquidity shock would infect risky assets across the board. Sure, central banks would respond, pumping reserves into their respective banking systems. But the velocity of these reserves could well be even lower than in 2008. Governments might then step in to provide various forms of direct financial assistance to their financial systems and possibly even large non-financial corporations. But in some countries they would almost certainly meet with some resistance, given how the public in many countries has come to believe—quite rightly in my opinion—that similar actions in 2008-09 favoured the wealthy and well-connected over the working middle-class.

What happens though, when the government in question is broke, as Greece admits? One mooted possibility is to seek financial support from Russia or China, which really opens Pandora’s geopolitical box. Might not only Greece but other euro members in debt trouble seek assistance in Beijing and Moscow, if debt forgiveness is not forthcoming from Brussels or Berlin? As it stands now, the EU is already split over how to deal with the situation in Ukraine, which threatens to escalate into a major military confrontation between NATO and Russia, right on the EU’s doorstep.4 Imagine how it would complicate things were one or more EU members to cozy up to Moscow, in particular those that are also NATO members. The entire European post-WWII settlement and associated institutions could be at risk.

Germany and France appear to have sensed the danger and recently broke ranks with the US, seeking to find a way to de-escalate the situation on their own initiative. The result was the second Minsk accord. Many defence analysts are sceptical that it will hold, and rightly so. Just this week there is yet another dispute over Russian gas supplies to Ukraine, which Moscow threatens to cut off if it is not assured that gas will continue to flow specifically to the breakaway regions of Luhansk and Donetsk.

This context makes it increasingly likely that at a minimum Germany and France and probably other EU member countries will consider it necessary to increase their defence budgets in the coming years, as they sense an urgent need for a strategic deterrent independent of that provided by the US via NATO. But financing larger defence budgets alongside likely bank recapitalisations and other burdens associated with sorting out the mess the euro has become will only serve to increase the debt. Notwithstanding Germany’s prodigal economic and export competitiveness, should rational investors really accept near zero bond yields for the myriad risks associated with the future of the euro: economic, political and even national security?

The better bet is to take a good look at quality European companies trading at what are low valuations when compared to their US or global counterparts. Yes, the German stock market may be at an all time high, but with the euro now somewhat weaker and with the valuations of some peripheral markets clearly distressed, there are almost certainly opportunities. As written above, I consider it highly unlikely that even a general breakup of the EU would result in a return to pre-21st century conditions of rabid nationalism and war. Indeed, one could argue that it would ignite a period of more aggressive competition amongst European countries to attract foreign and retain domestic capital with a general rationalisation of economic policies. The structural reforms associated with austerity seen to date may only be the beginning of a more thorough European economic renaissance.

Am I being too optimistic? Perhaps. But economic competition is without question a good thing. People used to believe the EU promoted it. Many now believe the opposite. Perhaps a good shaking up of European institutions is exactly what is required to unleash some healthy, Schumpeterian creative destruction. As long as it is not of the militaristic variety, investors in European companies would almost certainly benefit from it.

1 In my opinion much of which is presented as ‘austerity’ is really just a slowing or stabilisation of expeditures, rather than real cuts. If you want to know what real austerity looks like, Bulgaria is a prime example. See here for a description.

2 I have long held that were only Germany, the BeNeLux, France, Austria and Finland to have formed the initial monetary union, this would have incentivised the periphery to implement far more thorough structural reforms to improve competitiveness prior to joining at some unspecified point in the future. While this would have resulted in a more sustainable currency union I appreciate that, EU politics being what it is, this idea just couldn’t fly politically in Brussels. It may yet see its day, however.

3 For a discussion of the potentially dangerous financial engineering practice of collateral transformation, see here.

4 George Kennan, arguably the most famous and influential American career diplomat of the 20th century, warned many years ago of the grave danger of expanding NATO eastwards, with a specific warning not to include Ukraine. He claimed this would result in a new Cold War and possibly something even worse. So far he has been spot on. Kennan’s prescient warning can be found here.


Bitcoin, Bit-by-Bit, Pitches Silicon Valley Against Washington As Our True Capital

Washington, DC, is the capital of the United States. Yet Silicon Valley is the true capital of the America of the present and the future.  Silicon Valley and its satellites gave us personal computers, web browsing, email, Amazon, eBay, PayPal, Facebook, Uber, Airbnb, iPhones, iPads, and other technologies that have transformed and are transforming our lives for the better.

These developments are unlike anything out of Washington, usually a bastion of the status quo and the retrograde. So when the leaders of Silicon Valley start making amazing claims about something it pays to pay attention. Silicon Valley’s latest Next Big Thing: the mysterious bitcoin.

In the New York Times, technology titan and venture capitalist Marc Andreessen writes:

A mysterious new technology emerges, seemingly out of nowhere, but actually the result of two decades of intense research and development by nearly anonymous researchers.

Political idealists project visions of liberation and revolution onto it; establishment elites heap contempt and scorn on it.

On the other hand, technologists – nerds – are transfixed by it. They see within it enormous potential and spend their nights and weekends tinkering with it.

Eventually mainstream products, companies and industries emerge to commercialize it; its effects become profound; and later, many people wonder why its powerful promise wasn’t more obvious from the start.

What technology am I talking about? Personal computers in 1975, the Internet in 1993, and – I believe – Bitcoin in 2014.

Wasn’t Bitcoin a passing mania, colored by the abundant drama of the collapse of Mt Gox, the takedown of Silk Road, and its collapse in value from a peak over $1100 to the mid-$200s range today?  Not quite.  The evidence is thatbitcoin now is just beginning to emerge from it’s “Wild West” era.  The smart money says it is just getting started in transforming the world.

Those of us who are not technogeeks but wish to understand this phenomenon now have two wonderful “guides for the perplexed.”  Dominic Frisby’s gripping thriller-like narrative Bitcoin and Jeffrey Tucker’s lyrically philosophical Bit ByBit.  These two works teach us everything we wanted to know about bitcoin but were afraid to ask.

Apart from a certain High Coolness factor, though … why should we care?

As a recent article in the New York Observer, The Race to Replace Bitcoin, An epic battle between two bitcoin 2.0 contenders grips the crypto world neatly puts it:

There’s an epic battle for the future of money, and the outcome is murky. It might have several winners. It might have no winners. …

The coining of digital money (“cryptocurrency”) has the potential to be the most important financial development of this century. On one side are governments, fiat currencies and the world banking industry. On the other side are hundreds of young companies backed by brilliant cryptographers, complex programming and security protocols and varying degrees of anti-establishment fervor.

… The result of this fight will decide, among other things, the fate of developing economies, access to financial services, inflation, terrorism, all forms of economic crime from insider trading to drug dealing, the ability of governments to spy on citizens’ financial transactions, tax collection and the relationship between governments and the governed.

The best-known cryptocurrency is Bitcoin. … Bitcoin has a massive head start and has already developed significant brand equity. But among aficionados, there is wide consensus that the weaknesses in Bitcoin are fatal and unfixable. …

There will be a “Bitcoin 2.0,” and it will likely emerge from one of the hundreds of currencies that have been started in the past couple years.

Last year Perianne Boring — one of the two leading envoys of this tech to Washington, founder and CEO of the Chamber of Digital Commerce – spent considerable time tutoring me in, and introducing me to some of the players of, thebitcoin universe next door.

I came out of it with the impression that Bitcoin lacks “moneyness” (especially as its profound volatility makes it unsuitable as a unit of account, the preeminent quality of moneyness). Bitcoin seemed to me more a “fiat commodity” than an anarchic “fiat currency.” This impression was reinforced by the analysis of Prof. Kevin Dowd and journalist Martin Hutchinson at the 32nd Annual Monetary Conference presented by the Cato Institute.  Their paper crisply and unambiguously was entitled Bitcoin Will Bite The Dust.

That said, the lack of moneyness of Bitcoin may be beside the point.

It may prove itself a “fiat commodity” with superpowers.

Everett Rosenfeld, at CNBC, writes Forget currency, bitcoin’s tech is the revolution:

Most people think of bitcoin, if they think about it at all, as a currency — a means of digital exchange, or perhaps a speculative investment.

But forget everything you know, because the technology underlying bitcoin has the potential to be a much greater disruptive force than the cryptocurrency itself. Investors and technologists think the technology could replace huge aspects of the financial and insurance industries, and eventually even corporate management teams. In fact, big names like Google and IBM are reportedly already looking to invest in applications.

“Bitcoin is a token, a currency, but that’s not all it is. That’s the first of many many applications of this blockchain technology,” said Jeff Garzik, one of five bitcoin core developers who have taken over maintenance of the technology from mysterious creator Satoshi Nakamoto. “[Currency] is not the killer app, it’s just the first app.”

Frisby, in Bitcoin: The Future of Money writes:

Ethereum’s Charles Hoskinson says to me, ‘I think it’s going to have probably as big of an impact on the world as the internet. The internet made communications super easy, but it showed that our money system doesn’t work very well. And now we have a new money system that’s started to materialize’.

This money system will grow bigger and better. It’s going to improve and increase commerce. It could unleash a huge global economic boom, as good for developing nations as it is for the developed.

The Bitcoin technology has laid the foundations for a dramatic increase in exchange. And, of course, exchange is the crucial process by which mankind prospers and progresses.

Tucker (founder of the vibrant online community, in Bit By Bit: How P2P Is Freeing The World, writes:

What does a modern, digital-age, Internet-based system of money and payment look like? Bitcoin shows us just that, and it is amazing to behold.

As compared with the dollar and dollar-based systems of payment transfer, we are looking at a Maserati as compared with a Model T. Fees are near zero, time of transfer is very quick, exchange takes place peer-to-peer with no third party, you move real property and not trust relationship, there is perfect transparency, quantity of creation is limited, divisibility is potentially infinite, and anyone in the world with an Internet connection can use it.

eCommerce titan and philosophical visionary Patrick Byrne, founder and CEO of, eloquently introduces Tucker’s work:

The digital revolution has taken place with astounding speed — happening at a much faster pace than any social and economic transformation that preceded it in history. Even the Industrial Revolution pales in comparison. Those of us who grew up before the Internet cannot but marvel at the opportunities technology has opened up for the world.

And yet we don’t live in the grand sweep of history. We live day to day, right where we are, and we improve what we can, when we can, striving to make our lives and our world just a bit better at the margin. It is the accumulation of all of these efforts, stretching across the globe and spread out over time, coordinated through emergent institutions, that have remade our daily lives in little more than one generation, granting more people access to economic opportunity and empowerment than at any time in history.

We see this in the data — income, education, health, longevity, peace — and we feel it in our hearts.

Some of the greatest minds in the capital of America’s future, Silicon Valley, are investing enormous sums in its development and the search for its killer app.

Washington, as is its wont, likely will be slow-footed in responding to, or ham-handed in attempting to thwart, the next big leap in technology. Between the capital of the past, Washington, and the capital of the future, Silicon Valley, now unfolds a colossal drama. This clash will affect your life.  Pay attention.

Read Dominic Frisby’s gripping Bitcoin, indispensable to understanding exactly what is occurring on the most important battlefield in the world — the battlefield of ideas. Read Jeffrey Tucker’s Bit By Bit, a delight of a book, invaluable to understanding just how sky high are the stakes.

Originating at


The euro may be riskier than you think

Finance ministers in the Eurozone appear to have had a free lesson in game theory from Professor Yanis Varoufakis, the Greek finance minister.

At the time of writing Greece’s future in the Eurozone is far from secured, but it appears that Greece has achieved something.

He gave his fellow finance ministers a deal they dared not refuse, though it still has to be ratified by some parliaments, including Germany’s today. Varoufakis almost certainly understands that the Eurozone is in a weaker position than the bureaucrats and finance ministers themselves believed. It was important for them to become aware of this reality, which was central to his approach. It appears that under the Lisbon Treaty, Eurozone states cannot expel Greece: she can only leave with everyone’s unanimous agreement, including her own. And they probably didn’t realise that playing hardball against Greece would force the ECB to write off debts approaching ten times her equity capital of only €10.8bn. This would require all member states to increase their capital subscriptions, including the other Eurozone states subject to austerity packages.

Equally, Varoufakis would have known that he could not push his opposite numbers too far because the Brussels establishment also have their national parliaments to consider and the positions of Italy, Spain, Portugal and even Ireland. A revolt against previously-agreed austerity packages by any of these other states would have untold ramifications not only for the future of the Eurozone, but the euro itself.

In the wake of this episode the status of the euro as money is likely to be increasingly questioned, not just in the foreign exchanges, but by its users as well. This should be put into context by referring to Ludwig Von Mises’s regression theorem. Put simply, the theorem states that the validity of any currency as money is based on its history and the basis of the value it had before it was accepted as money. This unfashionable view is demonstrably true of gold and silver, but is it true of paper currencies?

The US dollar and pound sterling have both survived more than one hundred years, having based their original value on extended periods of gold convertibility, and in the case of sterling long before that on silver. This in the minds of the users gives them a pedigree few would question. However, they are very much the exceptions in today’s fiat currencies which are the motley survivors of some 57 hyperinflations, and there are plenty of examples of how a lack of regression coincides with a temporary character. Look no further than the Ukraine, which is suffering its second hyperinflation in 25 years. After Britain gave her African colonies independence in the 1960s, the value of all their currencies fell sharply in black-market dealings (the sole exception being Botswana which didn’t introduce the pula until long after independence).

Logic, if not familiarity, suggests that there is something in the regression theorem, which brings us back to the euro. Like the Kenyan shilling, the Zambian kwacha or the Ukrainian hryvnia, the euro lacked any pedigree on its creation. There was no period when people had a choice of national currencies to aid the transition. While bonds and financial instruments were denominated in euros from January 1999 onwards, notes and coins replaced national notes and coins three years later overnight.

So, if Von Mises’s regression theorem has any validity, holders of euros should be considering their options. It is also unfortunate timing that the ECB is about to embark on its most aggressive bout of monetary expansion to date, which could end up sealing the euro’s fate. If so, the euro will turn out to be the Achilles heel of the global monetary system.


Understanding True Credit and False Credit

[Editor’s Note: This piece first appeared here]

There are two kinds of credit: that which would be offered in a market economy with sound money and banking (true credit), and that which is made possible only through a system of central banking, artificially low interest rates, and fractional reserves (false credit).

Banks cannot expand true credit as such. All that they can do in reality is to facilitate the transfer of a given pool of savings from savers (i.e., those lending to the bank) to borrowers.

Consider the case of a baker who bakes ten loaves of bread. Out of his stock of real wealth (ten loaves of bread), the baker consumes two loaves and saves eight.

He lends his eight remaining loaves to the shoemaker in return for a pair of shoes in one-week’s time.

Note that credit here is the transfer of ”real stuff,” i.e., eight saved loaves of bread from the baker to the shoemaker in exchange for a future pair of shoes.

Also, observe that the amount of real savings determines the amount of available credit. If the baker had saved only four loaves of bread, the amount of credit would have only been four loaves instead of eight.

Note that the saved loaves of bread provide support to the shoemaker. That is, the bread sustains the shoemaker while he is busy making shoes.

This means that credit, by sustaining the shoemaker, gives rise to the production of shoes and therefore to the formation of more real wealth. This is the path to real economic growth.

Money and Credit

The introduction of money does not alter the essence of what credit is. Instead of lending his eight loaves of bread to the shoemaker, the baker can now exchange his saved eight loaves of bread for eight dollars and then lend them to the shoemaker.

With eight dollars the shoemaker can secure either eight loaves of bread or other goods to support him while he is engaged in the making of shoes. The baker is supplying the shoemaker with the facility to access the pool of real savings, which among other things also has eight loaves of bread that the baker has produced. Also note that without real savings the lending of money is an exercise in futility.

Money fulfills the role of a medium of exchange. Thus, when the baker exchanges his eight loaves for eight dollars he retains his real savings, so to speak, by means of the eight dollars.

The money in his possession will enable him, when he deems it necessary, to reclaim his eight loaves of bread or to secure any other goods and services.

There is one provision here that the flow of production of goods continues. Without the existence of goods, the money in the baker’s possession will be useless.

The existence of banks does not alter the essence of credit. Instead of the baker lending his money directly to the shoemaker, the baker lends his money to the bank, which in turn lends it to the shoemaker. In the process the baker earns interest for his loan, while the bank earns a commission for facilitating the transfer of money between the baker and the shoemaker.

The benefit that the shoemaker receives is that he can now secure real resources in order to be able to engage in his making of shoes.

Despite the apparent complexity that the banking system introduces, the essence of credit remains the transfer of saved real stuff from lender to borrower.

Without an increase in the pool of real savings, banks cannot create more credit. At the heart of the expansion of good credit by the banking system is an expansion of real savings.

Now, when the baker lends his eight dollars we must remember that he has exchanged for these dollars eight saved loaves of bread. In other words, he has exchanged something for eight dollars. So when a bank lends those eight dollars to the shoemaker, the bank lends fully “backed” dollars, so to speak.

False Credit: An Agent of Economic Destruction

Trouble emerges when instead of lending fully backed money, a bank engages in issuing empty money (fractional reserve banking) that is backed by nothing.

When unbacked money is created, it masquerades as genuine money that is supposedly supported by real stuff. In reality however, nothing has been saved. So when such money is issued, it cannot help the shoemaker since the pieces of empty paper cannot support him in producing shoes — what he needs instead is bread.

Since the printed money masquerades as proper money it can be used to divert bread from some other activities and thereby weaken those activities. This is what the diversion of real wealth by means of money out of “thin air” is all about.

If the extra eight loaves of bread weren’t produced and saved, it is not possible to have more shoes without hurting some other activities, which are much higher on the priority list of consumers as far as life and well-being is concerned. This in turn also means that unbacked credit cannot be an agent of economic growth.

Rather than facilitating the transfer of savings across the economy to wealth generating activities, when banks issue unbacked credit they are in fact setting in motion a weakening of the process of wealth formation.

It has to be realized that banks cannot pursue unbacked lending on an ongoing basis without the existence of the central bank. The central bank, by means of monetary pumping, makes sure that the expansion of unbacked credit doesn’t cause banks to bankrupt each other.

We can thus conclude that as long as the increase in lending is fully backed by real savings it must be regarded as good news since it promotes the formation of real wealth. False credit, which is generated out of “thin air,” is bad news since credit which is unbacked by real savings is an agent of economic destruction.


Does Walmart Prove Minimum Wage Laws Will Help Workers?

[Editor’s Note: this piece was first published by Mises Canada here]

In a recent column Paul Krugman has one of the most curious arguments supporting the minimum wage that I’ve everwalmart seen from a professional economist:

A few days ago Walmart, America’s largest employer, announced that it will raise wages for half a million workers. For many of those workers the gains will be small, but the announcement is nonetheless a very big deal, for two reasons. First, there will be spillovers….Second, and arguably far more important, is what Walmart’s move tells us — namely, that low wages are a political choice, and we can and should choose differently.

Some background: Conservatives — with the backing, I have to admit, of many economists — normally argue that the market for labor is like the market for anything else. The law of supply and demand, they say, determines the level of wages, and the invisible hand of the market will punish anyone who tries to defy this law.

But labor economists have long questioned this view. …[B]ecause workers are people, wages are not, in fact, like the price of butter, and how much workers are paid depends as much on social forces and political power as it does on simple supply and demand.

…[Walmart’s justification for its wage hike] echoes what critics of its low-wage policy have been saying for years: Paying workers better will lead to reduced turnover, better morale and higher productivity.

What this means, in turn, is that engineering a significant pay raise for tens of millions of Americans would almost surely be much easier than conventional wisdom suggests…

The point is that extreme inequality and the falling fortunes of America’s workers are a choice, not a destiny imposed by the gods of the market. And we can change that choice if we want to.

As with all of Krugman’s jaw-dropping pieces, other economists have jumped in on this one too. For example, David R. Henderson challenges Krugman’s history of unions and his claim that supply and demand don’t work when it comes to labor, and in the comments of his post points people to my own assessment of the minimum wage empirical literature that is decidedly more nuanced than Krugman’s summary.

However, in this post I want to focus on two other points that I haven’t seen Krugman’s critics address. First, it is a very strange argument to say, as Krugman does, that since we observe Walmart raising wages voluntarily, that therefore having the government force other firms to do so involuntarily won’t cause any major problems.

Look, Target just announced that it will lay off thousands of workers as part of a package to save $2 billion over two years. So should Stephen Moore write an op ed arguing that the government should require all existing firms to lay off thousands of workers, because the possible downsides are obviously smaller than what conventional wisdom suggests?

Or, if my Target analogy is too extreme for you–even though it’s exactly what Krugman did with Walmart–try this one: Chick-fil-A doesn’t serve food on Sundays. So that means the government could pass a law forcing all fast food restaurants to stay closed on Sundays, since clearly the gains to the workers (in the form of more time with their families) is higher than any potential downsides, such as convenience to consumers and paychecks for the workers. Right?

But moving beyond the absurdity of the basic premise of Krugman’s piece–namely, looking at a particular decision by one company in the market and then enforcing it upon every firm in the market–let’s focus on his other trademark, where he accuses people of swallowing naive economic doctrines that sophisticated thinkers like Krugman know are wrong.

Specifically, Krugman is rolling at his eyes at those conservatives–who, he admits, actually can find some economists out there to back up this view–who think supply & demand works in labor markets the same way it works in the butter market.

Indeed, I have found an economics textbook that pushes exactly this kind of simplistic view–even down to the specific example of a “butter mountain”! Here is a screenshot from the textbook that I grabbed from Google Books:

Krugman Butter Mountain

Man, this textbook does EXACTLY what Krugman is complaining about, doesn’t it? In case some readers are using their smart phones and the above screenshot is hard to read, let me summarize: The text’s discussion first uses supply & demand to illustrate the problems of a price floor in the butter market, and explains how historically this caused the European Commission to find itself “the owner of a so-called butter mountain, equal in weight to the entire population of Austria.” Then, after explaining how price floors screw up agricultural markets, it goes right into the minimum wage, saying “when the minimum wage is above the equilibrium wage rate, some people who are willing to work–that is, sell labor–cannot find buyers–that is, employers–willing to give them jobs.”

Those of you familiar with my critiques of Krugman over the years, will not be surprised to learn that the above textbook discussion comes from…Paul Krugman’s micro text (co-authored with Robin Wells). So when in his op ed Krugman admitted that the conservatives who thought you could analyze the minimum wage the same way you look at price floors on butter could actually cite some economists to support this view…one of those economists would be Paul Krugman.

Let me conclude this post by saying that in economics, as in other disciplines, there are varying degrees of sophistication. Sometimes you have to teach beginners things that are not quite right, in order to get the underlying lesson across, and then only later (for example students who are econ majors or those getting advanced degrees) do you introduce more nuances. So my problem isn’t that Krugman might fairly be arguing that the simplistic things we teach in Econ 101 are not the end of the story for what government policymakers should do.

Rather, my problem is with the tone and spirit of Krugman’s discussion. The casual reader would have NO IDEA that Krugman himself in his own textbook first talked about butter mountains, and then moved right on to minimum wage causing unemployment. (Go click the Google Books link and look around; there are no caveats surrounding the discussion.) Indeed, this is so much standard operating procedure for Krugman that I went looking for it. It’s not that I had this butter mountain example in my back pocket. No, I Googled “krugman wells minimum wage” to see what they said about it in their book, and foundJeremy Hammond’s discussion.

For those readers who still might think I’m exaggerating just how outrageous Krugman’s behavior here is, go look again at the discussion from his op ed, particularly this sentence: “Setting a minimum wage, it’s claimed, will reduce employment and create a labor surplus, the same way attempts to put floors under the prices of agricultural commodities used to lead to butter mountains, wine lakes and so on.” That is not a standard talking point. In my textbook, for example, I don’t use the term “butter mountain” or “wine lake.” No, the reason that example was in Krugman’s head, is that he was remembering how he himself treated the issue in his own textbook. It is really something amazing to behold.