“Sir, Arnaud Montebourg, the former French economy minister and the sourest note in the Hollande repertoire, dares to complain of “absurd” austerity policies ? (“Hollande purges cabinet following leftwing revolt”, August 26.) If those policies are absurd, it is because they were not accompanied by the structural reforms so badly needed to make the French economy healthy. I am speaking of long outdated redundancy and seniority labour laws, oppressive regulations for the business sector and the unbearable bureaucratic roadblocks that stand in the way of start-ups.
“To these, one can also add the traditional Gallic mindset of envy, if not outright hostility, towards those French citizens and other Europeans who are willing to work longer, harder and smarter and want to make good money; a mindset that Mr Montebourg never hesitated to parade before the world. Now that he and his cohorts on the left of the Socialist party have departed the government, perhaps François Hollande can move forward and leapfrog France from the 19th to the 21st century.” Letter to the FT from Stan Trybulski, Branford, Connecticut, 28th August 2014.
“There’s a great deal of ruin in a nation.” Adam Smith.
“You will never understand bureaucracies until you understand that for bureaucrats, procedure is everything and outcomes are nothing.” Thomas Sowell.
Much of what we think we know isn’t necessarily so. The invention of the printing press with movable type ? Traditionally credited to fifteenth-century Germany and Johannes Gutenberg, it was actually invented in eleventh-century China. Paper also originated in China long before it was used in the West. As did paper money and toilet paper (albeit today, these are pretty much interchangeable). English agriculturalist Jethro Tull is widely credited with the discovery of the seed drill in 1701. It was in fact invented by the Chinese 2,000 years beforehand. The first blast furnace for iron smelting is associated with Coalbrookdale – tragically close to schools in the West Midlands. It was actually introduced by the Chinese before 200 BC. The Chinese were also first to use the fishing reel, matches, the magnetic compass, playing cards, the toothbrush and the wheelbarrow. Perhaps even golf. So how did a society apparently so dynamic and innovative by comparison with the West then enter a centuries’ long decline ?
Niall Ferguson, in his excellent book ‘Civilization’ (Penguin, 2012) puts forward six “identifiably novel complexes of institutions and associated ideas and behaviours” that account for the cultural and economic outperformance of the West between, say, the 16th and 20th centuries:
The consumer society
The work ethic.
He defines these trends as follows:
1. Competition: “a decentralization of both political and economic life, which created the launch-pad for both nation-states and capitalism”.
2. Science: “a way of studying, understanding and ultimately changing the natural world, which gave the West (among other things) a major military advantage over the Rest”.
3. Property rights: “the rule of law as a means of protecting private owners and peacefully resolving disputes between them, which formed the basis for the most stable form of representative government”.
4. Medicine: “a branch of science that allowed a major improvement in health and life expectancy, beginning in Western societies, but also in their colonies”.
5. The consumer society: “a mode of material living in which the production and purchase of clothing and other consumer goods play a central economic role, and without which the Industrial Revolution would have been unsustainable”.
6. The work ethic: “a moral framework and mode of activity derivable from (among other sources) Protestant Christianity, which provides the glue for the dynamic and potentially unstable society created by “killer apps” 1 to 5”.
For our purposes we are most interested in Ferguson’s first “killer app”, Competition. But we will also refer to it in a slightly different context – “the lack of bureaucracy”. As the chart below shows, from 1000 AD to its high water mark in the 1960s, UK GDP relative to China’s was a one-way bet. Since then, however, the trend has gone into reverse.
Source: Niall Ferguson / Penguin Books
What can account for this dramatic reversal of economic fortunes ? Economic reforms in China, led by Deng Xiaoping in the late 1970s, are likely to be responsible for at least part of the turnaround. But the relentless and sclerotic expansion of the State in Britain has also played a role.
UK general government expenditure (green) and private expenditure (black) as a proportion of GDP
Source: David B. Smith / Steve Baker MP
As the chart above shows, at the turn of the last century, UK state spending accounted for roughly 10% of the economy and the private sector accounted for the rest. But as the welfare state has swelled, government spending has mushroomed to account, now, for something like half or more of the entire economy. And state spending, by and large, is inefficient spending – at least by comparison with the inevitably more disciplined for-profit sector. In other words, our relative economic prospects have declined in inverse proportion to the expansion (metastasis) of the State. In turn, bureaucratic parasitism likely accounts for productivity differentials in the euro zone; the German State accounts for roughly 45% of its economy, the French State 56%.
This might account for the differential between German and French productivity
As might this
Politicians have been able to swell the State thus far only with assistance by two groups: with the involuntary support of taxpayers, and with the connivance of central bankers. Popular resentment of what is laughably termed ‘austerity’ threatens the ongoing indulgence of the first group; the almost terminal straining of market forces by the latter runs the risk of a disorderly collapse of confidence in bond markets, after which continued Western deficit spending would be virtually impossible.
We seem to be close to the endgame. Even as perversely, record-low bond yields (indiscriminately – across markets as diverse as Austria, Belgium, Germany, Holland, Finland, Ireland, Italy and Spain) have sent desperate investors scurrying into stocks instead, those same investors are, with extra perversity, displaying a similar lack of discrimination and not even attempting to locate relative value within markets. Extraordinarily, the Wall Street Journal points out that
“Investors are pouring money into Vanguard Group, the epitome of the hands-off approach to investing, flocking to funds that track market indexes and aren’t run by stock pickers or star managers. The inflow has pushed the mutual-fund giant to almost $3 trillion in assets under management for the first time. The surge is part of a sea change in the fund business in which investors are increasingly opting for products that track the market rather than relying on managers to pick winners… Investors poured a net $336 billion into passively managed stock and bond funds in 2013, handily beating the $53 billion invested in traditional mutual funds of the same type, according to Morningstar. So far this year through July, investors put a net $177 billion into those passive funds, compared with $74 billion in actively managed funds… Through July, passively managed stock funds have seen a net $128.4 billion in investor inflows, compared with $18 billion for traditional stock funds…”
Nor is this lack of judicious investment a product of bullish US market sentiment. The same arbitrary index-following – at all-time highs – is being pursued in the UK. Trade magazine FTAdviser reports that
“Retail investors put more money into tracker funds in July than in any other month since records began, according to the latest IMA data.”
Index-tracking may have merit at the bottom of the market, but at the top ?
Having singularly failed to reform or restructure their dilapidated economies, many governments throughout the West have left it to their central banks to keep a now exhausted credit bubble to inflate further. Unprecedented monetary stimulus and the suppression of interest rates have now boxed both central bankers and many investors into a corner. Bond markets now have no value but could yet get even more delusional in terms of price and yield. Stock markets are looking increasingly irrational relative to the health of their underlying economies. The euro zone looks set to re-enter recession and now expects the ECB to unveil outright quantitative easing. If the West wishes to regain its economic vigour versus Asia, it would do well to remember what made it so culturally and economically exceptional in the first place.
In recent months talking heads, disappointed with the lack of economic recovery, have turned their attention to wages. If only wages could grow, they say, there would be more demand for goods and services: without wage growth, economies will continue to stagnate. It amounts to a non-specific call to stimulate aggregate demand by continuing with or even accelerating the expansion of money supply. The thinking is the same as that behind Bernanke’s monetary distribution by helicopter. Unfortunately for these wishful-thinkers the disciplines of the markets cannot be bypassed. If you give everyone more money without a balancing increase in the supply of goods, there is no surer way of stimulating price inflation, collapsing a currency’s purchasing power and losing all control of interest rates.
The underlying error is to fail to understand that economising individuals make things in order to be able to buy things. That is the order of events, earn it first and spend it second. No amount of monetary shenanigans can change this basic fact. Instead, expanding the quantity of money will always end up devaluing the wealth and earning-power of ordinary people, the same people that are being encouraged to spend, and destroying genuine economic activity in the process.
This is the reason monetary stimulation never works, except for a short period if and when the public are fooled by the process. Businesses – owned and managed by ordinary people – are not fooled by it any more: they are buying in their equity instead of investing in new production because they know that investing in production doesn’t earn a return. This is the logical response by businesses to the destruction of their customers’ wealth through currency debasement.
Let me sum up currency debasement with an aphorism:
“You print some money to rob the wealth of ordinary people to give to the banks to lend to business to make their products for customers to buy with money devalued by printing.”
It is as ridiculous a circular proposition as perpetual motion, yet central banks never seem to question it. Monetary stimulus fails with every credit cycle when the destruction of wealth is exposed by rising prices. But in this credit cycle the deception was so obvious to the general public that it failed from the outset.
The last five years have seen all beliefs in the manageability of aggregate demand comprehensively demolished by experience. The unfortunate result of this failure is that central bankers now see no alternative to maintaining things as they are, because the financial system has become horribly over-geared and probably wouldn’t survive the rise in interest rates a genuine economic recovery entails anyway. Price inflation would almost certainly rise well above the 2% target forcing central banks to raise interest rates, throwing bonds and stocks into a severe bear market, and imperilling government finances. The financial system is simply too highly geared to survive a credit-driven recovery.
Japan, which has accelerated monetary debasement of the yen at an unprecedented rate, finds itself in this trap. If anything, the pace of its economic deterioration is increasing. The explanation is simple and confirms the obvious: monetary debasement impoverishes ordinary people. Far from boosting the economy it is rapidly driving us into a global slump.
The solution is not higher wages.
So far in August the differential between the yield on the 10-year Treasury note and the yield on the 3-month Treasury bill stood at 2.38% against 2.95% in December 2013.
Historically the yield differential on average has led the yearly rate of growth of industrial production by fourteen months. This raises the likelihood that the growth momentum of industrial production will ease in the months ahead, all other things being equal.
It is generally held that the shape of the yield curve is set by investors’ expectations. According to this way of thinking – also labeled as the expectation theory (ET) – the key to the shape of the yield curve is the notion that long-term interest rates are the average of expected future short-term rates.
If today’s one-year rate is 4% and next year’s one-year rate is expected to be 5%, the two-year rate today should be (4%+5%)/2 = 4.5%.
It follows that expectations for increases in short-term rates will make the yield curve upward sloping, since long-term rates will be higher than short-term rates.
Conversely, expectations for a decline in short-term rates will result in a downward sloping yield curve. If today’s one-year rate is 5% and next year’s one – year rate is expected to be 4%, the two-year rate today (4%+5%)/2 = 4.5% is lower than today’s one year rate of 5% – i.e. downward sloping yield curve.
But is it possible to have a sustained downward sloping yield curve on account of expectations? One can show that in a risk-free environment, neither an upward nor a downward sloping yield curve can be sustainable.
An upward sloping curve would provoke an arbitrage movement from short maturities to long maturities. This will lift short-term interest rates and lower long-term interest rates, i.e., leading towards a uniform interest rate throughout the term structure.
Arbitrage will also prevent the sustainability of an inverted yield curve by shifting funds from long maturities to short maturities thereby flattening the curve.
It must be appreciated that in a free unhampered market economy the tendency towards the uniformity of rates will only take place on a risk-adjusted basis. Consequently, a yield curve that includes the risk factor is likely to have a gentle positive slope.
It is difficult to envisage a downward sloping curve in a free unhampered market economy – since this would imply that investors are assigning a higher risk to short-term maturities than long-term maturities, which doesn’t make sense.
The Fed and the shape of the yield curve
Even if one were to accept the rationale of the ET for the changes in the shape of the yield curve, these changes are likely to be of a very short duration on account of arbitrage. Individuals will always try to make money regardless of the state of the economy.
Yet historically either an upward sloping or a downward sloping yield curve has held for quite prolonged periods of time.
We suggest an upward or a downward sloping yield curve develops on account of the Fed’s interest rate policies (there is an inverse correlation between the yield curve and the fed funds rate).
While the Fed can exercise a certain level of control over short-term interest rates via the federal funds rate, it has less control over long-term interest rates.
For instance, the artificial lowering of short-term interest rates gives rise to an upward sloping yield curve. To prevent the flattening of the curve the Fed must persist with the easy interest rate stance. Should the Fed slow down on its monetary pumping the shape of the yield curve will tend to flatten. Whenever the Fed tightens its interest rate stance this leads to the flattening or an inversion of the yield curve. In order to sustain the new shape of the curve the Fed must maintain its tighter stance. Should the Fed abandon the tighter stance the tendency for rates equalisation will arrest the narrowing or the inversion in the yield curve.
The shape of the yield curve reflects the monetary stance of the Fed. Investors’ expectations can only reinforce the shape of the curve. For instance, relentless monetary expansion that keeps the upward slope of the curve intact ultimately fuels inflationary expectations, which tend to push long-term rates higher thereby reinforcing the positive slope of the yield curve.
Conversely, an emerging recession on account of a tighter stance lowers inflationary expectations and reinforces the inverted yield curve.
A loose Fed monetary policy i.e. a positive sloping curve, sets in motion a false economic boom – it gives rise to various false activities. A tighter monetary policy, which manifests through an inversion of the yield curve, sets in motion the process of the liquidation of false activities i.e. an economic bust is ensued.
A situation could emerge however where the federal funds rate is around zero, as it is now, and then the shape of the yield curve will vary in response to the fluctuations in the long-term rate. (The fed funds rate has been around zero since December 2008).
Once the Fed keeps the fed funds rate at close to zero level over a prolonged period of time it sets in motion a severe misallocation of resources – a severe consumption of capital.
An emergence of subdued economic activity puts downward pressure on long-term rates. On the basis of a near zero fed funds rate this starts to invert the shape of the yield curve.
At present, we hold the downward slopping yield curve has emerged on account of a decline in long term rates whilst short-term interest rate policy remains intact.
We suggest this may be indicative of a severe weakening in the wealth generation process and points to stagnant economic growth ahead.
Note again the downward sloping curve is on account of the Fed’s near zero interest rate policy that has weakened the process of wealth formation.
“When Nobel Prize-winner Joseph Stiglitz was asked in Germany this week if the country and its neighbours would suffer a lost decade, his response was unequivocal. “Is Europe going the same way as Japan ? Yes,” Mr Stiglitz said in Lindau at a meeting for Nobel laureates and economics students. “The only way to describe what is going on in some European countries is depression.”
‘Spectre of Japan-style lost decade looms over eurozone’, Claire Jones, The Financial Times, August 22, 2014.
Few films have managed to convey the feeling of approaching menace more effectively than Jeff Nichols’ 2011 drama, ‘Take Shelter’. Its blue collar protagonist, Curtis LaForche, played by the lantern-jawed Michael Shannon – whose sepulchral bass tones make his every utterance sound like someone slowly dragging a coffin over a cello – begins to suffer terrifying dreams and visions; he responds by building a storm shelter in his back yard. It transpires that his mother was diagnosed with schizophrenia at a similar stage in her own life. Are these simply hallucinations ? Or are they portents of darker things to come ?
Nichols, the film’s writer and director, has gone on record as stating that at least part of the film owes something to the financial crisis:
“I think I was a bit ahead of the curve, since I wrote it in 2008, which was also an anxious time, for sure, but, yeah, now it feels even more so. This film deals with two kinds of anxiety. There’s this free-floating anxiety that we generally experience: you wake in bed and maybe worry about what’s happening to the planet, to the state of the economy, to things you have no control over. In 2008, I was particularly struck with this during the beginning of the financial meltdown. Then there’s a personal anxiety. You need to keep your life on track—your health, your finances, your family..”
There’s a degree of pretention in claiming to have a reliable read on the psychology of the marketplace – too many participants, too much intangibility, too much subjectivity. But taking market price index levels at face value, especially in stock markets, there seems to be a general sense that since the near-collapse of the financial system six years ago, the worst has passed. The S&P 500 stock index, for example, has just reached a new all-time high, leaving plenty of financial media commentators to breathlessly anticipate its goal of 2,000 index points. But look at it from an objective perspective, rather than one of simple-minded cheerleading: the market is more expensive than ever – the only people who should be celebrating are those considering selling.
There are at least two other storm clouds massing on the horizon (we ignore the worsening geopolitical outlook altogether). One is the ‘health’ of the bond markets. Bloomberg’s Mark Gilbert points out that Germany has just issued €4 billion of two year notes that pay no interest whatsoever until they mature in 2016. The second is the explicitly declining health of the euro zone economy, which is threatening to slide into recession (again), and to which zero interest rates in Germany broadly allude. The reality, which is not a hallucination, is that years of Zero Interest Rate Policy everywhere and trillions of dollars, pounds, euros and yen pumped into a moribund banking system have created a ‘Potemkin village’ market offering the illusion of stability. In their June 2014 letter, Elliott Management wrote as follows:
“..Stock markets around the world are at or near all-time nominal highs, while global interest rates hover near record lows. A flood of newly-printed money has combined with zero percent interest rates to keep all the balls suspended in the air. Nonetheless, growth in the developed world (US, Europe and Japan) has been significantly subpar for the 5 ½ years following the financial crisis. Businesses have been reluctant to invest and hire. The consumer is still “tapped out,” and there are significant suppressive forces from poor policy, including taxes and increased regulation. Governments (which are actually responsible for the feeble growth) are blaming the shortfall on “secular stagnation,” purportedly a long-term trend, which enables them to deny responsibility..
“The orchestra conductors for this remarkable epoch are the central bankers in the US, UK, Europe and Japan. The cost of debt of all maturities issued by every country, corporation and individual in the world (except outliers like Argentina) is in the process of converging at remarkably low rates. In Greece (for goodness sake), long-term government debt is trading with a yield just north of 5%. In France, 10 year bonds are trading at a yield of 1.67%.
“..Sadly, financial market conditions are not the result of the advancement of human knowledge in these matters. Rather, they are the result of policymaker groupthink and a mass delusion. By reducing interest rates to zero and having central banks purchase most of the debt issued by their governments, they think that inflation can be encouraged (but without any risk that it will spin out of control) and that economic activity consequently can be supported and enhanced. We are 5 ½ years into this global experiment, which has never been tried in its current breadth and scope at any other time in history.. the bald fact is that the entire developed world is growing at a sluggish pace, if at all. But governments, media, politicians, central bankers and academics are unwilling to state the obvious conclusion that their policies have failed and need to be revised. Instead, they uniformly state, with the kind of confidence only present among the truly clueless, that in the absence of their current policies, things would be much worse.”
Regardless of the context, stock markets at or near all-time highs are things to be sceptical of, rather than to be embraced with both hands. Value investors prefer to buy at the low than at the high. The same holds for bonds, especially when they offer the certainty of a loss in real terms if held to maturity. But as Elliott point out, the job of asset managers is to manage money, and not to “hold up our arms and order the tide to roll back”. (We have written previously about those who seem to believe they can control the tides.) So by a process of logic, selectivity and elimination, we believe the only things remotely worth buying today are high quality stocks trading at levels well below their intrinsic value.
We recently wrote about the sort of metrics to assess stocks that can be reliably used over the long run to generate superior returns. Among them, low price / book is a stand-out characteristic of value stocks that has generated impressive, market-beating returns over any medium term time frame. So which markets currently enjoy some of the most attractive price / book ratios ?
The four tables below, courtesy of Greg Fisher and Samarang Capital, show the relative attractiveness of the Japanese, US, Vietnamese and UK markets, as expressed by the distributions of their price / book ratios. Over 40% of the Japanese market, for example, trades on a price / book of between 0.5 and 1. We would humbly submit that this makes the Japanese market objectively cheap. The comparative percentage for the US market is around 15%.
Various stock markets as expressed in price / book ratios
Source: Bloomberg LLP
Even more strikingly, nearly 60% of the Vietnamese stock market trades on a price / book of between 0.5 and 1. The comparative figure for the UK market is approximately 20%.
Conversely, nearly 60% of the US market trades on a price / book of above 2 times. We would humbly submit that this makes the US market look expensive. There is clearly a world of difference between a frontier market like Vietnam which is limited by way of capital controls, and a developed market like that of the US which isn’t. But the price / book ratio is a comparison of apples with apples, and US stock market apples simply cost more than those in Japan or Vietnam. We’d rather buy cheap apples.
As clients and longstanding readers will appreciate, we split the investible universe into four asset classes: high quality credit; value equity; uncorrelated funds; and real assets, notably precious metals. As a result of the extraordinary monetary accommodation of the past six years or so, both credit markets and stocks have been boosted to probably unsustainable levels, at least in the West. Uncorrelated funds (specifically, trend-following funds) and gold and silver have recently lagged more traditional assets, though we contend that they still offer potential for portfolio insurance when the long-awaited storm of reality (financial gravity) finally strikes. But on any objective analysis, we think the merits of genuine value stocks are now compelling when set against any other type of investment, both on a relative and absolute basis. Increasingly desperate central banks have destroyed the concept of safe havens. There is now only relative safety by way of financial assets. The mood music of the markets is becoming increasingly discordant as investors (outside the euro zone at least) start to prepare for a turn in the interest rate cycle. There is a stark choice when it comes to investment aesthetics. Those favouring value and deep value investments are, we believe, more likely to end up wearing diamonds. Those favouring growth and momentum investments are, we believe, more likely to end up wearing the Emperor’s new clothes. We do not intend to end up as fashion victims as and when the storm finally hits.
This month we observe the 40th anniversary of the resignation, under threat of imminent impeachment, of President Richard M. Nixon. Nixon aide and loyalist Pat Buchanan sums up, in a column in USA Today Liberal Elites Toppled Nixon his view:
“Richard Nixon was not brought down by any popular uprising. The breaking of his presidency was a product of the malice and collusion of liberal elites who had been repudiated in Nixon’s 49-state landslide in 1972.”
Nixon, as it happens, was not 1974’s only casualty. As William Safire recalls, Nixon’s secretary of the treasury, John Connally, “was indicted for taking graft on the same day the President was charged by the House Judiciary Committee for abuse of power.”
Both men were instrumental in the repudiation of the Bretton Woods gold-dollar monetary system that had undergirded post-war American (and world prosperity). Bretton Woods, indeed, was coming apart (as a gold+paper pastiche standard inevitably is prone to do). A gold-based international monetary order called out, however, to be mended not ended. Nixon ended it.
The House Judiciary Committee’s charges and the Connally indictment uncannily fulfill a prophecy by Tom Paine. Paine’s Common Sense triggered the American Revolution. Paine later wrote a tract, Dissertations On Government; The Affairs of the Bank; and Paper Money in 1786. It was issued the year before the Constitutional Convention that would send the confederated former colonies into the epic called the United States of America. It was, in part, a perfect diatribe against paper-based (rather than gold or silver defined) money.
But the evils of paper money have no end. Its uncertain and fluctuating value is continually awakening or creating new schemes of deceit. Every principle of justice is put to the rack, and the bond of society dissolved: the suppression, therefore; of paper money might very properly have been put into the act for preventing vice and immorality.
As to the assumed authority of any assembly in making paper money, or paper of any kind, a legal tender, or in other language, a compulsive payment, it is a most presumptuous attempt at arbitrary power. There can be no such power in a republican government: the people have no freedom, and property no security where this practice can be acted: and the committee who shall bring in a report for this purpose, or the member who moves for it, and he who seconds it merits impeachment, and sooner or later may expect it.
Of all the various sorts of base coin, paper money is the basest. It has the least intrinsic value of anything that can be put in the place of gold and silver. A hobnail or a piece of wampum far exceeds it. And there would be more propriety in making those articles a legal tender than to make paper so.
The laws of a country ought to be the standard of equity, and calculated to impress on the minds of the people the moral as well as the legal obligations of reciprocal justice. But tender laws, of any kind, operate to destroy morality, and to dissolve, by the pretense of law, what ought to be the principle of law to support, reciprocal justice between man and man: and the punishment of a member who should move for such a law ought to be death.
The death penalty for proposing paper money? Paine called for the criminal indictment as a capital crime, and for impeachment, of any who even would call for tender laws.
Connally was acquitted on the charges of graft and perjury. Later he underwent bankruptcy before dying in semi-disgrace. Nixon resigned rather than undergoing impeachment, also living out his life in disgraced political exile. The spirit of Paine’s declaration was fulfilled in both cases. Connally and Nixon engineered this violation, abandoning the good, precious-metal, money contemplated by the Constitution. Nemesis followed hubris.
The closing of the “gold window” was based, by Connolly, on deeply wrong premises. It was sold to the public, by Nixon, on deeply false promises.
On August 15, 1971 President Nixon came before the American people to announce:
We must protect the position of the American dollar as a pillar of monetary stability around the world.
In the past 7 years, there has been an average of one international monetary crisis every year. Now who gains from these crises? Not the workingman; not the investor; not the real producers of wealth. The gainers are the international money speculators. Because they thrive on crises, they help to create them.
In recent weeks, the speculators have been waging an all-out war on the American dollar. The strength of a nation’s currency is based on the strength of that nation’s economy–and the American economy is by far the strongest in the world. Accordingly, I have directed the Secretary of the Treasury to take the action necessary to defend the dollar against the speculators.
I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets, except in amounts and conditions determined to be in the interest of monetary stability and in the best interests of the United States.
Now, what is this action–which is very technical–what does it mean for you?
Let me lay to rest the bugaboo of what is called devaluation.
If you want to buy a foreign car or take a trip abroad, market conditions may cause your dollar to buy slightly less. But if you are among the overwhelming majority of Americans who buy American-made products in America, your dollar will be worth just as much tomorrow as it is today.
The effect of this action, in other words, will be to stabilize the dollar.
Now, this action will not win us any friends among the international money traders. But our primary concern is with the American workers, and with fair competition around the world.
To our friends abroad, including the many responsible members of the international banking community who are dedicated to stability and the flow of trade, I give this assurance: The United States has always been, and will continue to be, a forward-looking and trustworthy trading partner. In full cooperation with the International Monetary Fund and those who trade with us, we will press for the necessary reforms to set up an urgently needed new international monetary system. Stability and equal treatment is in everybody’s best interest. I am determined that the American dollar must never again be a hostage in the hands of international speculators.
Nixon’s promise that “your dollar will be worth just as much tomorrow as it is today” has, of course, completely falsified. The 2014 dollar is worth only 15 cents in 1971 terms, buying 85% less than it did in 1971. Some bugaboo. All of Nixon’s other rationalizations for going off gold also have been falsified.
The closing of the gold window turned out to be the slamming of the golden door to social mobility and equitable prosperity. In the wake of the closing of the gold window median family income stagnated, never again experiencing secular recovery. Meanwhile the income of the wealthy has continued apace. This has produced the very income inequality so loudly denounced by progressives who, ironically, are the last defenders of the very policy which is the probable cause of our inequitable prosperity.
Brother Pat Buchanan states that Nixon
…ended the Vietnam War with honor, brought all our troops and POWs home, opened up China, negotiated historic arms agreements with Moscow, ended the draft, desegregated southern schools, enacted the 18-year-old vote, created the EPA, OSHA and National Cancer Institute, and was rewarded by a grateful nation with a 61% landslide.
Even as Watergate broke, he ordered the airlift that saved Israel in the Yom Kippur War, for which Golda Meir called him the best friend Israel ever had.
His enemies were beside themselves with rage and resentment.
Buchanan, while admirably loyal, ignores the correlation between Nixon’s embrace of paper money and Paine’s prophetic call for impeachment for that high crime. Let us now, in this month of the 40th anniversary of Nixon’s resignation and the 43rd of his abandonment of the gold standard, pause to wonder. It is bewildering circumstance that the very liberal elites Buchanan indicts as malicious in their treatment of Nixon today represent the most reactionary of defenders of the most pernicious, and only enduring, residue of the Nixon Shock: paper money, “a most presumptuous attempt at arbitrary power.”
Originating at http://www.forbes.com/sites/ralphbenko/2014/08/18/pat-buchanan-ignores-the-underlying-reason-richard-nixon-was-forced-to-resign/
First it was the government’s miraculous ability to deliver on-target GDP growth that got the permabulls bellowing again, then it was the striking (world-beating, one might even say), 12% currency-adjusted rally in its stock market that got them triumphantly pawing the ground. Nor did the drop in interest rates serve in any way to dampen the eternal hope that China was once again deferring meaningful structural reform in the face of a threat to near-term output.
Quite what was actually behind the equity rally is not easy to say. There were whispers that the Russians (who else?) were piling in, now that their assets were subject to arbitrary seizure as part of Nova Roma’s vilification of their leader and proxy war against their homeland. There was also talk that the imminent linkage of the Shanghai and HK bourses was driving an arbitrage between the unusually-discounted mainland A-shares and their offshore H-share equivalents. Finally, in a typically neat piece of circular reasoning, the imminent rebound in the economy which we have even seen some brave (or foolhardy, according to preference) souls project at a startling 8.5% (sic) early next year was held to be at work to push up what was an otherwise under-owned and thus optically ‘cheap’ emerging market.
On the face of it, news that, over the first seven months of the year, the increase in SOE earnings had accelerated from June’s 8.9% YOY to July’s 9.2% – well up on the first quarter’s paltry 3.3% pace – may have seemed to have offered some much-needed confirmation of this optimistic thesis. However, a closer glance at the figures would not have proven quite so reassuring, had anyone bothered to actually take one.
Over the past, supposedly brighter three months, revenues advanced a modest 6.2% compared to the like period in 2013, though with as-reported profits up an ostensibly more creditable 12.1%. There, all grounds for positive spin, alas, were exhausted. For one, operating profits were, in fact, only up 4.0% like-for-like (a wide discrepancy which can only excite suspicion as to the nature of the headline surplus) while financing costs vaulted a fifth higher.
Worse still, in eking out even this degree of improvement since May, liabilities have soared by an incredible CNY2.320 trillion (around $125 billion a month) – an increment fully half as big again as that registered twelve months ago and a sum which is actually greater than the entire reported sum of ‘total social finance’ over the trimester (that latter ‘only’ managed CNY 2.240 trillion after last month’s thoroughly unexpected swoon).
And what did our proud commanders of the economic heights achieve for shouldering such a hefty weight of obligations? An addition to revenues of CNY719 billion (extra debt to extra ‘sales’ therefore coming in at a ratio of 3.2:1); a pick-up in ‘profit’ of CNY76 billion (d[Debt]:d[Income] = 30:1); and a blip up in operating profit of just CNY16 billion (at a truly staggering ratio of 144 to 1).
Reversing these latter relationships, we can see that while swallowing up all of the nation’s available new credit since the spring, China’s SOEs added 31 fen per one renminbi in sales, 3.3 fen in reported profit, and a bare 0.7 fen in the operating version of income. Just the sort of performance on which to base expectations of a significant coming rise in growth and prosperity!
Armed with such an underwhelming use of resources – both physical and financial – it is perhaps no wonder that MIIT is again trying to shut down swathes of superfluous capacity, issuing what are effectively cease-and-desist orders against 132 firms in a whole range of heavy industries – iron, steel, coke, ferroalloy, calcium carbide, aluminium, copper and lead smelting, cement, flat glass, paper, leather, printing and dyeing, chemical fibres, and lead-acid batteries. Shipbuilding may not be far behind, either, given that it formed the main topic of discussion at a meeting of the National Committee of the CPPCC this week.
The language used was, in some cases, pretty uncompromising, too: “Total industrial capacity in cement and plate glass is still growing, but the industry-wide sales rate is in decline and accounts receivable are increasing… there are to be no new projects in the sector for any reason,” thundered the MIIT communique.
This time around, given Chairman Xi’s rigorous ‘anti-corruption’ campaign, there might well be a little less of the back-sliding and wilful defiance which has greeted such edicts in the past. The emperor is no longer quite so fare away, nor the mountain quite so high, if you are a recalcitrant local cadre these days!
Even before this, the signs were there for those with eyes to see. Despite the much-bruited pick-up in activity, Chinese power use, excluding the residential component, SLOWED to 4.5% YOY in the three months to July from 8.1% in the preceding three months. Nor did this come without a significant deceleration in so-called ‘tertiary’ industry sector (loosely, that encompassing services and light indstry) which is henceforth supposed to be the torchbearer for growth and employment. Here, consumption dropped from the spring’s 10%-plus rates to just 7.4% YOY last month. Added buring of lights and turning of lathes in the secondary industry category – essentially manufacturing – was a tardy 4.2% even though growth in industrial production, we were told, had averaged 9.0% in that same period.
Hmmmm. No wonder the PMI seems to be shedding some of its recent, rather inexplicable exuberance.
Round and round the circle of vicious consequences swirls. As Wang Xianzheng, President of the China Coal Industry Association, admitted: ‘Currently, more than 50 percent of enterprises are in payment arrears and have delayed paying wages.’ Of 26 large companies spread across nine provinces, he revealed that 20 are making losses, only 9 are still in the black, and the remainder are hovering uneasily between (commercial) life and death.
Other obvious signs of distress are to be had among the loan guarantee networks which had everywhere come into being with the then-laudable aim of persuading constitutionally reluctant banks to lend to customers other than SOEs when times were good. Now trapped in flagging businesses which are more correlated than perhaps the participants had realised – and often having succumbed to the diversion of funds to less commendable ends in the interim – they are all going sour together and the same interconnectedness which was once their mainstay is proving instead a sheet anchor with which to drag them all under.
As Zhou Dewen, president of Zhejiang Federation of Private Enterprise Investment, told the Global Times, the rash of bankruptcies in Zhejiang and Jiangsu provinces has disrupted production and led to lay-offs, with 80% of all sour loans in the area associated with such mutual guarantee schemes. So elevated is the level of distrust, as bad debts have risen at an annualized 30% pace this year, that banks are now trying to call loans in early and obtaining court orders to freeze the assets of those firms that are unable to comply with their demands.
The banks themselves are beginning to accelerate write-offs dramatically – even though the official NPL ratios still look woefully understated. They are also drawing heavily upon the markets in order to bolster their capital as a precaution. As the WSJ reported, the four largest state-owned lenders have started raising a planned $73 billion in debt and equity this year – a call which is expected to jump to more than $300bn in the next five years, according to the banking regulator.
In addition, five local governments in the south and east of the country are setting up so-called ‘asset-management companies’ – effectively state-sponsored ‘bad banks’ – in a mirror of the system used by Zhu Rongji in the 1990s to shuffle the more toxic stuff off its originators’ balance sheets and thus allow them to continue to lend while the bitter fruits of their previous mistakes were hidden away elsewhere.
Though this only disguises and does not in any way alleviate the economic waste spawned by the boom, it might at least allow banks to issue new equity-like capital – perhaps to the insurers who are themselves being heavily promoted by Beijing as the next battalion of systemic saviours – at above notional book value and hence to enable them to remain a viable source of new credit. Note that the last time this was done, the losses were essentially fiscalized: banks simply swapped the bad loans on their books for what have since proven to be irredeemable – but nonetheless fully par-valued – loans to the state entities which, in turn, financed the obliging AMCs. Balance sheets will not shrink, therefore, only become sanitised, by the operation of this mechanism.
Here, however, is where it all gets fraught once more, because the same local governments who are being marshalled to assume the banks’ bad debts (many of them ensuing from extending credit to LGFPs) are themselves becoming desperate for funds given that all too many of their own, sure-fire investment gambits are turning out to be the dampest of damp squibs.
As the Economic Information Daily reported, an audit of 448 eastern township platform companies found that two-fifths of them were curently loss making, while a further thirty percent barely broke even. With these bodies so heavily dependent on land sales to generate the revenues needed to cover their current outlays, much less their ambitious capital expansion plans and ongoing debt service costs – and with such ‘sales’ only being possible in large part if the authorities extend the credit to the purchasers in the first place – a decidedly negative feedback loop has begun to tighten around their necks as the property market itself enters a slump.
Indeed, according to research conducted by brokerage company Centaline Property Agency, twenty major developers have between them spent CNY182.5 billion yuan so far this year to purchase new sites – a drastic 38% down on the like period last year.
‘Worsening property sales have undercut the willingness of developers to buy land. Their focus now is on raising cash from the sales of what they’ve already built. Few are in the mood to buy more,’ said Zhang Dawei who headed up the company’s research team.
In July alone, aggregate land sales revenue for 300 Chinese cities was off by a half from the same month in 2013, as reported by the China Index Academy. Sales in the four largest cities of Beijing, Shanghai, Guangzhou, and Shenzhen – normally a slam-dunk – sank by a staggering 70%.
‘The downturn means that the scale of land sales for the remainder of this year could continue to contract. Developers have pushed the “conservative” button,’ said Zhang with commendable understatement.
And quite right, too, as anecdotal evidence grows that formerly avid house-buyers are beginning to adopt that age-old American practice of ‘jingle mail’ – that is, they are simply walking away from properties they either cannot afford or do not believe will again appreciate in price.
At one end of the scale, one Nanjing online estate agent recorded a growing back-log of such defalcations and referred to the ‘unspeakable pain’ in the local market – an agony apparently shared in at least six other of the districts neighbouring his.
Despite the widespread belief that Chinese buyers are sitting on a typical equity cushion of 30-40% of the property value – and hence, unlike their less well-endowed US, Irish, and Spanish cousins, are impervious to all bar the most extreme events in the market – the scary truth is that much of the real estate to which they do hold title has been, how shall we say, ‘rehypothecated’ – i.e., pledged as collateral for a range of business loans as well as for the more speculative use of funds.
‘In the past few years, many small business owners blindly invested in real estate, mining and other industries. These industries are now suffering from overcapacity and falling asset prices, so business owners are unable to pay their debts,’ said one general manager of a Wenzhou microfinance company.
‘Many [of these] use the house as collateral when business loans go wrong,‘ Ge Ningbo, a county bank manager, told a journalist.
To get a feel for the scale of the problem, consider press reports that in Wenzhou, 1,000 homes were abandoned as a result of the decline, homes with an ostensible market value of more than Y6.4 Billion – or roughly $1 million a pop! No scrabbling rural migrants, these, but possibly members of an increasingly scrutiny–shy party apparatus! Clearly, the banks will need to suck in even more money from their gullible preference shareholders if this phenomenon starts to spread and, in the meanwhile, it is hard to see how they will be empowered to make sufficient revenue-positive new loans to keep the whirligig in motion in such a climate of confusion and disabusal.
Sadly, we have not finished our tale of woe there because there are also stories circulating in the official media that those same local governments, who are in many ways the lynchpins of the whole merry-go-round, may be far deeper into the mire than has been recognised to date.
As the articles detail, a member of the relevant NPC standing committee confided to a press contact that when hidden liabilities are taken into account alongside those uncovered in a recent audit, the true total of LG debt almost doubles to a wince-inducing Y30 trillion. Just for sheer size – some 50% of national GDP – this would be a matter of concern, but it also should not be overlooked that far too much of that monstrous total is comprised of short-term obligations against which are held long-term, illiquid, and often economically redundant ‘assets’.
Given that the last NAO study showed that are some 3,700 governmental bodies across various categories which had debts in excess of 100% of their local GDP, something patently needs to be done if the mad Chinese juggler is to keep his profusion of balls bobbing in the air.
So, welcome to local scrip issues. Yes, it seems that ingenious local cadres have dusted off their depression-era news clippings and revisited the age of the mediaeval mint and simply started using their own IOUs as media of exchange wherever their writ may run.
Economic Information Daily reported that in Hubei, Hunan and Guangdong, among others, government IOUs have become a ‘discount currency.’ In fact, commentary on Caijing suggests that not only are even small, rural communities now doing likewise, but that some companies, too, are paying their workers in scrip – just as in the early days of the Western factory age when resort by employers to what was called the ‘truck’ or ‘Tommy’ system was widespread.
As the early 19th century English radical, William Cobbett noted, ‘… when this tommy system… makes its appearance where money has for ages been the medium of exchange, and of payments for labour; when this system makes its appearance in such a state of society, there is something wrong; things are out of joint; and it becomes us to inquire into the real cause of its being resorted to…’
His answer? The state of economic depression brought about by the costs imposed upon entrepreneurs by the dead-weight of government:-
‘It is not the fault of the masters, who can have no pleasure in making profit in this way: it is the fault of the taxes, which, by lowering the [net] price of their goods, have compelled them to resort to this means of diminishing their expenses, or to quit their business altogether, which a great part of them cannot do without being left without a penny… Everything was on the decline… I was assured that shop-keepers in general did not now sell half the quantity of goods in a month that they did in that space of time four or five years ago… need we then wonder that the iron in Staffordshire has fallen, within these five years, from thirteen pounds to five pounds a ton [metal-bashers were similarly bearing the brunt, it appears]… and need we wonder that the iron-masters, who have the same rent and taxes to pay that they had to pay before, have resorted to the tommy system, in order to assist in saving themselves from ruin!’
‘Here is the real cause of the tommy system; and if [we wish] to put an end to it… prevail upon the Parliament to take off taxes to the amount of forty millions a year.’
Caijing devoted quite some space to ‘netizen’ comments on this state of affairs, several of which reflected a considerable degree of awareness that this had come about because of the unbridled spending and lavish self-indulgence of the relevant officials, while some were also aware that such an emission of fiat money was a direct parallel of the official money-creation process and further that it could only persist for so long as some minimal degree of trust resided in the councils’ ability one day to redeem the claims. Moreover, it was noted that since people ultimately expect the discount between township paper and that issued by the PBOC to widen, they were using the former preferentially to buy and sell and clinging on to the latter – a classic, Gresham’s Law example of bad money driving out good.
If the localities are in such dire straits as these, then it is hard to resist the temptation to believe that we are approaching some sort of end-game. But what, we should ask ourselves, might be the trigger for its no-doubt jarring denouement?
Well, here we come full circle with the latest act of Xi Jinping’s grand ‘anti-corruption’ drive. For, as well as Our Glorious Leader’s insistence at last week’s Leading Group get-together that everyone must ‘truly push forward reform with real guns and knives’ (ulp!), news has come out that the National Audit Commission will next conduct a full, ‘rigorous’ check of all land sales and related transactions carried out between 2008-13 and that, moreover, the results will be to hand when the top men convene for their next Plenum this coming October.
One can only imagine the consternation in the ranks which this announcement has unleashed. After all, there is unlikely to be overmuch evidence that any of these deals were conducted transparently, competitively, honestly, and legally, in the absence of any and all inducements, kickbacks, or displays of favouritism, not only since such was the accepted practice during the reign of Wen and Hu – especially during the infamous, no questions asked, frenzy of post-Crash stimulus – but also because this is a sphere notoriously subject to peculation in what we fondly imagine to be our more enlightened polities, too.
We can therefore not only expect the bodycount to rise substantially as officials fearful of censure seek to avoid their imminent disgrace and subsequent punishment, but we should also be prepared for the possibility that when this most capacious of all cylindrical metallic containers of vermiform invertebrae is opened, it will be accompanied by a blast of sufficient megatonnage to bring the whole flawed edifice crashing to the ground.
Under such circumstances, we find it very hard to shake off the presentiment that, on the one side, some commentators’ touching faith in an incipient re-acceleration are horribly misplaced while, on the other, the tired old ‘Goldilocks’ scenario whereby all bad news is good because it presages the launch of another round of sustained, indiscriminate ‘stimulus’ seems equally out of key with what Xi tells us he is trying to achieve.
Having dealt at such length with China, let us try and dispose of the rest of the globe in as short a space as possible.
Japan: Abenomics is still a horrible failure as drooping machine orders, frozen store sales, and exports back at 4 ½ year (currency-adjusted), one-quarter-from-the-peak lows reveal. So, guess what? As the PM’s approval ratings slip, another ‘stimulus’ package is said to be in the offing (sigh!)
Europe: Even one of Hollande’s own ministers confided to the press a couple of weeks back, ‘the truth is, he thinks we don’t have a chance’ – who are we to disagree? Meanwhile, the chap at the head of the other Sick Man, Matteo Renzi, has undergone a moment of almost Caligulan delusion, assuring supporters that the hour had come for Italy ‘to tow Europe out of the crisis’ and ‘to assume… the leadership’ of the Continent.
And what of his first steps to make good on such a vaunting claim? Why, in an Onion-like act of farce, to insist that ISTAT no longer releases the GDP numbers a week ahead of its peers and thereby afford underemployed analysts and commentators more opportunity to be critical of the country’s performance! And then there’s the Neocon-inspired catastrophe unfolding on the bloc’s eastern fringe from which the emergence of a bout of renewed economic difficulty is the very least of our worries.
USA: Chairperson Yellen is currently holding court at Jackson Hole as the US numbers continue their rebound from the winter’s retardation. What a moment for her to take the stage. Non-financials (large cap-led) are at new records, Tech at new, post-Bubble highs; junk spreads have narrowed sharply; vol has again crashed, correlations fallen, and put-call ratios evaporated. With the Bund-UST spread at a 15-year high and equities outperforming, the USD stands on the verge of a break out and up from what is already its best level in a year. The cycle is still running in favour of the States on a comparison basis, no matter how ninety-Nth percentile many of its valuations are when considered in isolation.
With money supply still swelling rapidly – and amid hints that it is being more actively utilised than of late—it is hard to see quite what will bring that run to an end in the near term. Were we to really be critical, one of the few clouds ‘no bigger than a man’s hand’ is that the growth of both inventories and payroll expenses are outstripping sales in the durable goods sector. Thus, while US assets are hardly ‘investible’ in the Benjamin Graham sense, they are also a tough short in the Sell’em Ben Smith one.
Britain: While MPC member David Miles saw fit to describe the EU as ‘dead in the water’ as a trade partner, closer to home some of the gloss is finally coming off the reputation of one of the country’s most expensive recent imports, its egregious Bank governor.
No doubt, dear reader, you too were shocked – shocked! – to hear local Tory Mark Field, the Honourable Member for the Cities of London and Westminster, opine to his mates in Grub Street that “…from the moment Mark Carney became governor in July 2013, it was pretty clear forward guidance was an indication rates would not rise this side of the election – for all the talk of Bank of England independence, there was a clear bargain between him and George Osborne.” Be that as it may, it is surely not too cynical to note that Fred Carney’s Army will not want to contibute to a possible defeat by Alex the Bruce’s forces in the coming Scottish independence vote.
You can just hear it now, that ringing oration:-
‘Aye, vote ‘Yes’ and interest rates may rise. Vote ‘No’ and they’ll stay as is … at least a while. And dying in your beds, many years from now, would you be willin’ to trade ALL the days, from this day to that, for one chance, just one chance, to come back here and tell our neighbours that they may take our pound and their nuclear subs, but they’ll never take… OUR FREEDOM!
Truth be told, it has not been the kindest of summers for commodities. Since reaching their late June peak, returns have suffered a 7.5% slump to touch six month lows even as US equities have added 2%. For the record, in that crumbling eight week stretch EM stocks put on 4.7%, US bonds were up 1% and junk was flat.
Within commodities themselves, what some commentators have been calling a ‘Garden of Eden’ summer in the US grain belt has ensured that the corn is as high as an elephant’s eye almost everywhere you look, while oilseeds and wheat have been similarly profuse. A loss of 11.3% and, in fact, the casting into jeopardy of the entire cyclical bull market in prices has been the result.
Energy, too, has suffered, as the record longs in oil finally began to liquidate, triggering the biggest 6-week sell-off of positions in WTI on record. IN notional value terms, net spec longs in Brent and WTI combined crashed from close to $97 billion worth of contracts to $59 billion. It is possible to read the charts to declare that this swoon has violated the uptrend in place for the last five years, as well as breaking all major MAs. Against that, we are arguably a touch oversold and the last four years’ sideways stationary, Arab Spring range remains intact. Tacticians, Faites vos jeux!
Dollar strength, the subsidence of financial market anxieties alluded to above, and the cessation of labour unrest in SA have hardly been conducive to higher PM prices (palladium — and Russia—excepted). Gold has also broken 200, 100, 50-day MAs and is threatening the uptrend drawn from the June 30-Dec 31 $1180 double bottom and June 3rd’s $1240 probe. Lease rates remain positive and net specs—at 43% of total O/I – as long as they have been on average throughout the last 12 years’ bull market.
Only Base metals seem to offer any hope (they rallied 4.2% while everything else was collapsing). Strength has partly been predicated upon what we think are decidedly ephemeral signs of a Chinese renaissance, but also on evidence of dwindling stockpiles and the litany of capex cuts and asset disposals emanating from the mining industry. They appear, therefore, to offer the least dirty shirt in the laundry basket.
Despite all the massive monetary pumping over the past six years and the lowering of interest rates to almost zero most commentators have expressed disappointment with the pace of economic growth. For instance, the yearly rate of growth of the EMU real GDP fell to 0.7% in Q2 from 0.9% in the previous quarter. In Q1 2007 the yearly rate of growth stood at 3.7%. In Japan the yearly rate of growth of real GDP fell to 0% in Q2 from 2.7% in Q1 and 5.8% in Q3 2010.
In the US the yearly rate of growth of real GDP stood at 2.4% in Q2 against 1.9% in the prior quarter. Note that since Q1 2010 the rate of growth followed a sideways path of around 2.2%. The exception is the UK where the growth momentum of GDP shows strengthening with the yearly rate of growth closing at 3.1% in Q2 from 3% in Q1. Observe however, that the yearly rate of growth in Q3 2007 stood at 4.3%.
In addition to still subdued economic activity most central bankers are concerned with the weakness of workers earnings.
Some of them are puzzled that despite injecting trillions of dollars into the financial system so little of it is showing up in workers earnings?
After all, it is held, the higher earnings are the more consumers can spend and consequently, the stronger the economic growth is going to be, so it is held.
The yearly rate of growth of US average hourly earnings stood at 2% in July against 3.9% in June 2007.
In the EMU the yearly rate of growth of weekly earnings plunged to 1.3% in Q1 from 5.4% in Q2 2009.
In the UK the yearly rate of growth of average weekly earnings fell to 0.7% in June this year from 5% in August 2007.
According to the Vice Chairman of the US Federal Reserve Stanley Fischer the US and global recoveries have been “disappointing” so far and may point to a permanent downshift in economic potential. Fisher has suggested that a slowing productivity could be an important factor behind all this.
That a fall in the productivity of workers could be an important factor is a good beginning in trying to establish what is really happening. It is however, just the identification of a symptom – it is not the cause of the problem.
Now, higher wages are possible if workers’ contribution to the generation of real wealth is expanding. The more a particular worker generates as far as real wealth is concerned the more he/she can demand in terms of wages.
An important factor that permits a worker to lift productivity is the magnitude and the quality of the infrastructure that is available to him. With better tools and machinery more output per hour can be generated and hence higher wages can be paid.
It is by allocating a larger slice out of a given pool of real wealth towards the buildup and the enhancement of the infrastructure that more capital goods per worker emerges (more tools and machinery per worker) and this sets the platform for higher worker productivity and hence to an expansion in real wealth and thus lifts prospects for higher wages. (With better infrastructure workers can now produce more goods and services).
The key factors that undermine the expansion in the capital goods per worker are an ever expanding government and loose monetary policies of the central bank. According to the popular view, what drives the economy is the demand for goods and services.
If, for whatever reasons, insufficient demand emerges it is the role of the government and the central bank to strengthen the demand to keep the economy going, so it is held. There is, however, no independent category such as demand that drives an economy. Every demand must be funded by a previous production of wealth. By producing something useful to other individuals an individual can exercise a demand for other useful goods.
Any policy, which artificially boosts demand, leads to consumption that is not backed up by a previous production of wealth. For instance, monetary pumping that is supposedly aimed at lifting the economy in fact generates activities that cannot support themselves. This means that their existence is only possible by diverting real wealth from wealth generators.
Printing presses set in motion an exchange of nothing for something. Note that a monetary pumping sets a platform for various non-productive or bubble activities – instead of wealth being used to fund the expansion of a wealth generating infrastructure, the monetary pumping channels wealth towards wealth squandering activities.
This means that monetary pumping leads to the squandering of real wealth. Similarly a policy of artificially lowering interest rates in order to boost demand in fact provides support for various non-productive activities that in a free market environment would never emerge.
We suggest that the longer central banks world wide persist with their loose monetary policies the greater the risk of severely damaging the wealth generating process is. This in turn raises the likelihood of a prolonged stagnation.
All this however, can be reversed by shrinking the size of the government and by the closure of all the loopholes of the monetary expansion. Obviously a tighter fiscal and monetary stance is going to hurt various non-productive activities.
The data was not really surprising and neither was the response from the commentariat. After a run of weak reports from Germany over recent months, last week’s release of GDP data for the eurozone confirmed that the economy had been flatlining in the second quarter. Predictably, this led to new calls for ECB action. “Europe now needs full-blown QE” diagnosed the leader writer of the Financial Times, and in its main report on page one the paper quoted Richard Barwell, European economist at Royal Bank of Scotland with “It’s time the ECB took control and we got the real deal, instead of the weaker measure unveiled in June.”
I wonder if calls for more ‘stimulus’ are now simply knee-jerk reactions, mere Pavlovian reflexes imbued by five years of near relentless policy easing. Do these economists and leader writers still really think about their suggestions? If so, what do they think Europe’s ills are that easy money and cheap credit are going to cure them? Is pumping ever more freshly printed money into the banking system really the answer to every economic problem? And has QE been a success where it has been pursued?
The fact is that money has hardly been tight in years – at least not at the central bank level, at the core of the system. Granted, banks have not been falling over one another to extend new loans but that is surely not surprising given that they still lick their wounds from 2008. The ongoing “asset quality review” and tighter regulation are doing their bit, too, and if these are needed to make finance safer, as their proponents claim, then abandoning them for the sake of a quick – and ultimately short-lived – GDP rebound doesn’t seem advisable. The simple fact is that lenders are reluctant to lend and borrowers reluctant to borrow, and both may have good reasons for their reluctance.
Do we really think that Italian, French, and German companies have drawers full of exciting investment projects that would instantly be put to work if only rates were lower? I think it is a fairly safe bet that whatever investment project Siemens, BMW, Total and Fiat can be cajoled into via the lure of easy money will by now have been realized. The easy-money drug has a rapidly diminishing marginal return.
In most major economies, rates have been close to zero for more than five years and various additional stimulus measures have been taken, including some by the ECB, even if they fell short of outright QE. Yet, the global economy is hardly buzzing. The advocates of central bank activism will point to the US and the UK. Growth there has recently been stronger and many expect a rise in interest rates in the not too distant future. Yet, even if we take the US’ latest quarterly GDP data of an annualized 4 percent at face value (it was a powerful snap-back from a contraction in Q1), the present recovery, having started in 2009, still is the slowest in the post-World-War-II period, and by some margin. The Fed is not done with its bond-buying program yet, fading it out ever so slowly and carefully, fearful that the economy, or at any rate overstretched financial markets, could buckle under a more ‘normal’ policy environment, if anybody still knows what that may look like. We will see how much spring is left in the economy’s step once stimulus has been removed fully and interest rates begin to rise — if that will ever happen.
Then there is Japan, under Abe and Kuroda firmly committed to QE-square and thus the new poster-boy of the growth-through-money-printing movement. Here the economy contracted in Q2 by a staggering 6.8% annualized, mimicking its performance from when it was hit by a tsunami in 2011. This time economic contraction appears to have been mainly driven by an increase in the country’s sale tax (I guess the government has to rein in its deficit at some stage, even in Japan), which had initially caused a strong Q1, as consumers front-loaded purchases in anticipation of the tax hike. Now it was pay-back time. Still, looking through the two quarters, the Wall Street Journal speaks of “Japan’s slow recovery despite heavy stimulus”.
Elsewhere the debate has moved on
In the Anglo-Saxon countries the debate about the negative side-effects of ultra-easy money seems to be intensifying. Last week Martin Feldstein and Robert Rubin, in an editorial for the Wall Street Journal, warned of risks to financial stability from the Fed’s long-standing policy stimulus, pointing towards high asset values and tight risk premiums, stressing that monetary policy was asked to do too much. Paul Singer, founder of the Elliott Management hedge fund and the nemesis of Argentina’s Cristina Fernandez de Kirchner, was reported as saying that ultra-easy monetary policy had failed and that structural reforms and a more business-friendly regulatory environment were needed instead. All of this even before you consider my case (the Austrian School case) that every form of monetary stimulus is ultimately disruptive because it can at best buy some growth near term at the price of distorting capital markets and sowing the seeds of a correction in the future. No monetary stimulus can ever lead to lasting growth.
None of this seems to faze the enthusiasts for more monetary intervention in Europe. When data is soft, the inevitable response is to ask the ECB to print more money.
The ECB’s critics are correct when they claim that the ECB has recently been less accommodative than some of its cousins, namely the Fed and the Bank of Japan. So the eurozone economy stands in front of us naked and without much monetary make-up. If we do not like what we see then the blame should go to Europe’s ineffectual political elite, to France’s socialist president Hollande, whose eat-the-rich tax policies and out-of-control state bureaucracy cripple the country; to Ms Merkel, who not only has failed to enact a single pro-growth reform program since becoming Germany’s chancellor (how long can the country rest on the Schroeder reforms of 2002?) but now embraces a national minimum wage and a lower retirement age of 63, positions she previously objected to; to Italy’s sunny-boy Renzi who talks the talk but has so far failed to walk the walk. But then it has been argued that under democracy the people get the rulers they deserve. Europe’s structural impediments to growth often appear to enjoy great public support.
Calls for yet easier monetary conditions and more cheap credit are a sign of intellectual bankruptcy and political incompetence. They will probably be heeded.
[Editor's note: this article, by Mateusz Machaj, first appeared at mises.org]
One often wonders whether differences in economic schools of thought are big enough to justify strict theoretical segregations. One such case is “marginal economics.” Most textbooks point to the triumvirate of Walras, Jevons, and Menger, who independently discovered the notion of marginal utility and its relevance to the pricing process. Quite often these brilliant thinkers are homogenized as more or less indistinguishable figures who paved the way for modern microeconomic theory.
The usual simplification of the history of economic thought will tell us that the big three introduced concepts of marginalism and marginal utility into economic science (the exact name “marginal utility” came from Friedrich von Wieser). In general, marginalism was introduced to combat the belief of classical economists that prices have not much to do with individual utility and consumer satisfaction (since many useful things have low prices, as the so-called paradox of value demonstrated). The biggest contribution of the marginal revolutionaries was to invite the concept of utility back into newly-rebuilt consumer theory. Consequently, economics became a much more universal science than it had been.
It cannot be denied that Walras, Jevons, and Menger all played major roles in the advancement of modern consumer theory. Marginal units and marginal utility well-explained how prices are shaped in accordance with subjective preferences and consumer choice. Yet it would be a mistake to say there were no major differences between them. Well-established economist William Jaffé published a famous article about “dehomogenization” of those thinkers. His main point was that Menger differed significantly from Walras and Jevons in presenting marginal theory with Menger’s usage of a non-mathematical apparatus. Various other authors describing the development of marginal theory also referred to this difference. Unfortunately, many of them focused on this aspect as if it somehow illustrated a deficiency of Menger’s thought in that he did not mathematized his theory. Famous Chicago economist George Stigler criticized Menger and argued that it was his main “weakness,” because he could not arrive at the concept of “maximizing want satisfaction.” In other words, Stigler claims Menger’s theory is inferior because he did not write equations and present his conclusions in the form of a mathematical apparatus.
Mathematical marginalism can indeed appear to be more rigorous. But just because it looks more complicated does not mean it is a better description of the valuation process. Menger’s so-called weakness is actually his strength, because it adds a more fruitful dimension to marginal theory, which was completely absent in the mathematical approaches of Jevons and Walras. Even though all three economists are seen as referring to “marginal units,” in Menger, this concept means something other than what it does in Jevons and Walras. In the case of Jevons and Walras, marginal units are infinitely small, continuous, and in consequence almost irrelevant. It becomes a part of a broader utility function which can be “maximized” as Stigler wishes with the use of various derivatives.
In the case of Menger, “marginal” units are something else. They are finite and discrete, not continuous, and therefore it is not part of some broader already-existing utility function which can be maximized with the use of derivatives (since only continuous functions can have derivatives).
It may all sound as a minor technical detail; nevertheless, the next steps in the reasoning process are significant and lead us to the vital role of social institutions for economizing scarce resources. If a marginal unit is irrelevant and seen as a part of an already-existing utility function, one can solve on paper the utility equations and offer an optimal solution for allocations. If, on the other hand, a marginal unit is something discrete, not subjected to an already-existing function, the “optimal” resolution cannot be derived a priori on paper. The concrete and discrete unit is possessed by someone and that someone has to make a choice to allocate it. Hence the main difference between marginal units in Menger and marginal units in Walras is Walras’s theory leads to an economics of assumed functions, whereas Menger’s theory leads to an economics of real choices. The term “marginal unit” in the Austrian and neoclassical theory may be the same. The content is radically different.
Through finite marginal units, Menger firmly opens the door for the explanation of how various units of goods are being monetarily appraised by acting individuals. If marginal units are scatters of Walrasian equations they do not have to be appraised by entrepreneurs — the mathematical function is in a way doing it for them. It is no surprise that Menger’s heir, Mises, was the one to build a theory of entrepreneurship and demonstrate entrepreneurial roles in solving problems of proper allocations for consumer satisfaction. It also comes as no surprise that Walras’s successors did not see the strength of Mises’s theory of entrepreneurship, because for them the process of optimal allocation can be simply solved by maximization of functions. Mengerian marginal units need to be acted upon and selectively valued. The driving force for their valuation is human choice. Their value is not pre-determined. Walrasian marginal units, on the contrary, are part of valuation equations, therefore they are already appraised once we mathematically describe their economic place. There is no room left for choice. Why bother then with examining the personal valuations of entrepreneurs if marginal units have already assigned roles?
Here in fact lies the main difference between the Austrian microeconomic theory and the neoclassical economic theory. Surely it cannot be denied there are similarities, but differences are not only of a pedagogical nature. Discrete marginalism, despite being non-mathematical, is superior to neoclassical marginalism. Usage of derivatives is not a sign of a more scientific method.
“Anything can happen in stock markets and you ought to conduct your affairs so that if the most extraordinary events happen, you’re still around to play the next day.”
Vice Admiral James Stockdale has a good claim to have been one of the most extraordinary Americans ever to have lived. On September 9th, 1965 he was shot down over North Vietnam and seized by a mob. Having broken a bone in his back ejecting from his plane he had his leg broken and his arm badly injured. He would spend the next seven years in Hoa Lo Prison, the infamous “Hanoi Hilton”. The physical brutality was unspeakable, and the mental torture never stopped. He would be kept in solitary confinement, in total darkness, for four years. He would be kept in heavy leg-irons for two years, on a starvation diet, deprived even of letters from home. Throughout it all, Stockdale was stoic. When told he would be paraded in front of foreign journalists, he slashed his own scalp with a razor and beat himself in the face with a wooden stool so that he would be unrecognisable and useless to the enemy’s press. When he discovered that his fellow prisoners were being tortured to death, he slashed his wrists to show his torturers that he would not submit to them. When his guards finally realised that he would die before cooperating, they relented. The torture of American prisoners ended, and the treatment of all American prisoners of war improved. After being released in 1973, Stockdale was awarded the Medal of Honour. He was one of the most decorated officers in US naval history, with 26 personal combat decorations, including four Silver Stars. Jim Collins, author of the influential study of US businesses, ‘Good to Great’, interviewed Stockdale during his research for the book. How had he found the courage to survive those long, dark years ?
“I never lost faith in the end of the story,” replied Stockdale.
“I never doubted not only that I would get out, but also that I would prevail in the end and turn the experience into the defining moment of my life, which in retrospect, I would not trade.”
Collins was silent for a few minutes. The two men walked along, Stockdale with a heavy limp, swinging a stiff leg that had never properly recovered from repeated torture. Finally, Collins went on to ask another question. Who didn’t make it out ?
“Oh, that’s easy,” replied Stockdale. “The optimists.”
Collins was confused.
“The optimists. Oh, they were the ones who said, ‘We’re going to be out by Christmas.’ And Christmas would come, and Christmas would go. Then they’d say, ‘We’re going to be out by Easter.’ And Easter would come, and Easter would go. And then Thanksgiving. And then it would be Christmas again. And they died of a broken heart.”
As the two men walked slowly onward, Stockdale turned to Collins.
“This is a very important lesson. You must never confuse faith that you will prevail in the end – which you can never afford to lose – with the discipline to confront the most brutal facts of your current reality, whatever they might be.”
As Collins’ book came to be published, this observation came to be known as the Stockdale Paradox. For Collins, it was exactly the same sort of behaviour displayed by those company founders who had led their businesses through thick and thin. The alternative was the average managers at also-ran companies that enjoyed average returns at best, or that failed completely.
At the risk of stating the blindingly obvious, this is hardly a ‘good news’ market. Ebola. Ukraine. Iraq. Gaza. In a more narrowly financial sphere, the euro zone economy looks to be slowing, with Italy flirting with a triple dip recession, Portugal suffering a renewed banking crisis, and the ECB on the brink of rolling out QE. If government bond yields are a reflection of investor confidence, the fact that two-year German rates have gone below zero is hardly inspiring.
And we have had interest rates held at emergency levels for five years now – gently igniting who knows what form of as yet unseen problems to come. In Europe interest rates seem set to stay low or go even lower. But in the UK and the US, the markets nervously await the first rate hike of a new cycle while central bankers bluster and dither.
What are the implications for global asset allocation and stock selection ?
Both in absolute terms and relative to equities, most bond markets (notably the Anglo-Saxon) are ridiculously overvalued. Since the risk-free rate has now become the return-free risk, cash now looks like the superior asset class diversifier.
As regards stock markets, price is what you pay, and value (or lack thereof) is what you get. On any fair analysis, the US market in particular is a fly in search of a windscreen. Using Professor Robert Shiller’s cyclically adjusted price / earnings ratio for the broad US stock market, shown below, US stocks have only been more expensive than they are today on two occasions in the past 130 years: in 1929, and in 2000. The peak-to-trough fall for the Dow Jones Industrial Average from 1929 equated to 89%. The peak-to-trough fall for the Dow from 2000 equated to “just” 38%. Time will tell just how disappointing (both by scale and by duration) the coming years will be for US equity market bulls.
But we’re not interested in markets per se – we’re interested in value opportunities incorporating a margin of safety. If the geographic allocations within Greg Fisher’s Asian Prosperity Fund are any guide, those value opportunities are currently most numerous in Japan and Vietnam. In the fund’s latest report he writes:
“Interestingly, and despite China’s continued underperformance, the Asian markets in aggregate have done better at this stage in 2014 than last year, while other global markets have fared less well. In our view the reason is simple – a combination of more attractive valuations than western markets, especially the US, but also, compared with 12-18 months ago, recognisably poor investor sentiment and consequently under-positioning in Asia, leading to the chance of positive surprises.”
Cylically adjusted price / earnings ratio for the S&P 500 Index
The Asian Prosperity Fund is practically a poster child for the opportunity inherent in global, unconstrained, Ben Graham-style value investing. Its average price / earnings ratio stands at 9x (versus 18x for the FTSE 100 and 17x for the S&P 500); its price / book ratio stands at just one; historic return on equity is an attractive 15%; average dividend yield stands at 4.2%. And this from a region where long-term economic growth seems entirely plausible rather than a delusional fantasy.
Vice Admiral Stockdale was unequivocal: while we need to confront the “brutal facts” of the marketplace, we also need to keep faith that we will prevail. To us, that boils down to avoiding conspicuous overvaluation (in most bond markets, for example, and a significant portion of the developed equity markets) and embracing equally conspicuous value – where poor sentiment is likely to intensify subsequent returns. In this uniquely oppressive financial environment, with the skies darkening with the prospect of a turn in the interest rate cycle, we think optimism could be fatal. Or as Warren Buffett once observed,
“You pay a very high price in the stock market for a cheery consensus.”