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Economics
By Tim Price, on 8 May 13 “We have Stone Age emotions. We have medieval institutions.. And we have god-like technology.” – Edward O. Wilson.
The BBC reported last week that researchers from IBM had created the world’s smallest motion picture after manipulating individual atoms with a scanning tunnelling microscope. They separately reported the proposals of two Dutch engineers to introduce self-lighting weather warnings on motorways, and a dedicated driving lane that could recharge electric cars as they passed over it. As artist Daan Roosegarde pointed out, auto manufacturers spend billions of dollars on car design, research and development,
but somehow the roads.. are completely immune to that process. They are still stuck in the Middle Ages, so to speak.
Another staggering gulf lies between what we as individuals are capable of doing – more or less anything to which we put our minds – and what our governments are capable of doing – more or less nothing, other than mindlessly to continue the dismal and seemingly inexorable cycle of tax, borrow and spend. At a recent City debate hosted by Marcus Ashworth of Espirito Santo Investment Bank, ‘Is monetary activism the answer?’, Steve Baker MP and Ewen Stewart of Walbrook Economics essentially revealed the paucity of government thinking through generations, and across the political spectrum, that gave rise to such a desperate question in the first place.
As the graph below makes clear, in duration – if not necessarily in scale – the current economic crisis is now worse than the Great Depression. There are realistically just two schools of thought as to how an economic depression should be tackled. The neo-Keynesians advocate deficit spending, on the basis that government stimulus is merely taking the other side of a retrenching private sector. As the facile mud-slinging over Reinhart & Rogoff’s recent debt research reveals, the idea that a state can simply have too much debt for its own good gets little traction in the neo- Keynesian camp, which effectively suspends respect for mathematics, logic or sound economics whenever it happens to suit. The Austrians, on the polar opposite side of the debate, advocate a policy of non-interference with the free market process of economic adjustment. Less euphemistically, the Austrian perspective favours what Depression-era US Treasury Secretary Andrew Mellon recommended as painful but ameliorative policy:
Liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate.. it will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people. [Emphasis ours.]
“Recovery”
 Source: http://www.niesr.ac.uk/about-monthly-GDP-estimates; Steve Baker MP As we wrote back in January 2012, we side with the Austrians, specifically Murray Rothbard, and his classic study, ‘America’s Great Depression’:
If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt ? The first and clearest injunction is: don’t interfere with the market’s adjustment process. The more the government intervenes to delay the market’s adjustment, the longer and more gruelling the depression will be, and the more difficult will be the road to complete recovery.
Thus far, on the basis alone of the recession chart above, Rothbard would appear to be winning the debate. There is no counter-factual, of course, from the 1930s – Roosevelt’s ‘New Deal’ intervened (in every sense). But it is both interesting and relevant to note Treasury Secretary Mellon’s earlier objective, namely to tackle the US’ vast federal debt load accumulated from World War One. This he did by taking an axe to income tax rates. The top marginal tax rate was cut
from 73% in 1922 to 24% by 1929. The overall public debt fell from $33 billion immediately after the war to approximately $16 billion by 1929. Note those quaint billions, with a ‘b’.
So, to return to the monetary activism debate, how did we get here ? Steve Baker lays it all out. In essence, the state has eaten itself. Before World War One, as the graph below reveals, UK government spending never accounted for much more than 10% of the economy. Now it accounts for almost half of it.
So we are not merely facing a financial crisis but in Steve Baker’s words, we are also beset by a profound crisis of political economy. Governments whose spending has spiralled out of control typically resort to three expedients: more taxation; more borrowing; and currency debauchery. As government spending crowded out the productive sector throughout the 20th Century, the extent of inflation over recent decades has been monstrous:
 *January 1974 = 100 (linear scale)
Source: Consumer price inflation since 1750, O’Donoghue et al, Office for National Statistics, 10 March 2004 Since a substantial number of the advocates for yet more government borrowing are pressing for a narrowly Keynesian response, it is worth republishing what Keynes himself thought of the inflationary outcome:
By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth..
..There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.
So the business of investing can no longer be conducted in a rational economic environment. Free market cleansing of malinvestments made during the boom years cannot occur because the free market itself has been suspended. Overmighty governments and their economic agents, notably the central banks, are once again showing the futility of a policy of supporting national champions – those champions today, ironically, being banks that would under any other environment be forced into insolvency. This is not a problem existentially limited to the UK. It afflicts most of the “developed” western economies – developed in the sense that a body riddled with cancer can be said to be “developed”.
So we do the best job we can under such extreme circumstances. We take shelter in credit of unimpeachable quality (not Gilts or US Treasuries) as an alternative to sitting idly in useless cash. We sail close to shore within attractively valued listed equity investments of businesses catering to a constituency of rising wealth (the Asian domestic consumer, for example) instead of one catering to the bombed-out, tapped-out, over-indebted and over-taxed western consumer. We diversify further into uncorrelated managed funds, and we diversify still further into currency that cannot simply be printed into exhaustion: the precious, monetary metals whose fundamental values are still so widely misunderstood in such a bleakly dishonest financial landscape. And we wait – and now actively agitate – for the sort of political radicals capable of understanding both how we got into this mess, and how we might shrink the overmighty state in order to get out of it. It may be a long wait. People, notably political zealots, have a tendency to cling to irrational beliefs rather than sound thinking. As Edward O. Wilson once said,
Men would rather believe than know.
This article was previously published at The price of everything.
Economics
By Sean Corrigan, on 7 May 13 Continued from part 2 …
Finally to China where the only thing to note is that the meme of credit exhaustion is starting to spread, given that every CNY100 of reported GDP in the first quarter required the addition of CNY52 in new credit – much of that flooding back in from abroad to play the property boom.
That this is likely to lead to an implosion in fairly short order seems to have been recognised by the new men in charge. Hence the unusual convening of an April session of the Politburo Standing Committee for a meeting dedicated to the economy. From this there emanated an official press release containing the following injunction:
China needs to cement its domestic economic growth momentum and guard against potential risks in financial sectors
It doesn’t sound as if another dash for growth is on the cards, now does it?
After the rout in the gold and silver market, all we can say is that though conspiracy theories inevitably abound, we have warned on numerous occasions that such a sell-off was always possible given the number of stale, trapped longs who have had no return for months while sitting at very elevated real and nominal valuations – and all in the face of ever-mounting equity rises, to boot. One may or may not care much for the idea of technicals as predictive tools, but, just once in a while, the break of an obvious trend line convinces those who do subscribe and gives rise to an avalanche of me-tooism and that was very much the case in gold and silver.
Since then everyone has come up with their own pet, Just So Story about what or who exactly triggered it. In all likelihood there was a multiplicity of overlapping causes, of which the two most important were probably:-
- the absence of a Risk Off spike on Cyprus (with added piquancy of possible forced reserve sale at the ECB’s behest)
- the absence of an immediate inflationary rally on the BOJ move
More fundamentally, we have to face up to the fact that the Sell Side has simply l-o-v-e-d the fact that commodities are weakening while equities and credit are storming ahead since this enables it to spin a new tale to customers about why they should now revert to type and stick with their traditional, fee-generating asset classes.
Much has been made of the recent raft of negative reports from those who were formerly the bull market’s greatest boosters, but in truth, as consummate salesmen, these worthies are only telling their disappointed customers what they already want to hear. No spiel sells as well as the one which allows an after-the-fact rationalization of an unlooked-for outcome. If you can’t be smart about where the market is going, it at least assuages wounded pride (and patches up a tarnished professional reputation) to sound knowledgeable about where it has been.
All this has contributed to a poisonous mix of factors – fundamental, technical, and sentimental – among which we can include the following shifts.
Firstly, in terms of the guiding mantras which the crowd is so wont to adopt, ‘Peak Oil’ has given way to ‘Shale Glut’ and ‘Super-Cycle’ Chinese gluttony has been transmuted to an expression of faith in the all-seeing Confucian Mandarins who will shrewdly rebalance economy and unleash consumer spending, needing no copper in excess of the present quota to do so. (Big Mining itself has been reinforcing this shift, leading to the unusual result that Big Mining share prices are showing even worse returns than are commodities, despite the overall vogue for equities).
Next, financial momentum itself is now a killer, since the more commodities lag, the more people fear being left behind in any less than full commitment to the incipient equity bubble whose warm glow of instant mark-to-market gains they again avidly crave.
Again, given the appalling price action of late, the same trend chasers who did so much to boost commodities on the way up have been liquidating/shorting stuff and buying financial assets for some time, even before the gold/silver purgative. Their potential overstretch is our present best hope.
Finally, a glance at break-evens shows that inflation fears have dissipated, possibly in a very premature fashion. For our part, we have always argued that the CB actions will be slow burners, as in the 1960s, until debt re-gearing and bank expansion again come to magnify solo CB pumping. It will be the inevitable reluctance to withdraw stimulus that will lead to catastrophe more than the initial decision to provide it and then, as monetary trust first falls and then is entirely lost, velocity will rise, CPI will accelerate, and real commodity prices will turn.
The widespread impatience with the inflationary argument arises partly because no one understands that for there to be ANY price rises, however CPI-modest, in a world awash in un(der)employment and surplus capacity, this can only be evidence of a deliberate monetary excess. Alas, for us, as investors, the fact that we understand the root of this error does not make its consequences any less significant for the pricing calculus with which we must contend or for the timescale over which we must deal with it.
Thus, QExtreme is now exclusively bidding up financial assets (the Herd comfort zone, as we have said) and real estate (the default for the Ordinary Joe). Yet all the while it is preventing a genuine re-invigoration by keeping zombie companies alive and bad governments in funds, thus depressing organic, vigorous ‘growth’ and so acting without immediately igniting an inflationary holocaust which may well require a much longer gestation process than most are prepared to countenance. Not a great near-term mix for tangibles, it must be said.
Economics
By Alasdair Macleod, on 6 May 13 Regular readers will know I am in the inflation, possibly hyperinflation camp; but there are those that think the future is more likely to be deflationary. In the main this is the view of neoclassical economists, Keynesians and monetarists, who generally foresee a 1930s-style slump unless the economy is stimulated out of it.
Rather than repeatedly go into the errors of their ways, we must accept that they are in charge. They have decided that prices must not fall, and they see moderate price inflation as a necessary stimulant to business: this is the reasoning behind Helicopter Ben Bernanke’s defining statement, when he made it clear that central banks could spray the economy with endless fiat money if need be.
Given this determination to stop prices falling, worries that the outlook is deflationary are unlikely to be realised. But there is a second group of commentators which believes that in a slump there will be an unstoppable credit contraction as banks are forced to foreclose on failing businesses. This, they say, will lead to a mad dash for cash to pay off debt, leading to fire-sales of assets as credit contraction spreads to otherwise sound businesses. The imperative to pay down debt will overwhelm central banks’ attempts to replace it with cash.
The error here is to misunderstand where we are in this sorry tale. The belief common to all deflationists, that the developed world has so far avoided a severe economic contraction, is wrong. The fact that this is not often recognised must be blamed on the irrelevance of nearly all government statistics. Not only are they self-serving, but they do not allow for the increasing meaninglessness of government money. The only hard statistics are unemployment, which despite official attempts to water them down, cannot conceal the fact that there has been a slump since the banking crisis.
The banking crisis marked a sudden increase in consumer preferences in favour of money, assuredly egged on by banks who switched almost overnight from risk-tolerant to risk-averse. This is why GDP numbers in most major countries took such a heavy knock, reflecting money being withdrawn from economic activity. That was the event deflationists are worrying about today.
So deflationists are forecasting an event that happened five years ago and their fears have already been disproved by massive monetary intervention. That is not to say the slump is over: far from it. Current indications are that things are about to get worse everywhere. But the nightmare cycle of falling asset prices becoming self-feeding and a dash for cash has already been prevented.
So successful was the Fed leading other central banks to save the world in 2009 that the precedent is established: if things take a turn for the worse or a systemically important financial institution looks like failing, Superman Ben and his cohort of central bankers will save us all again.
Call it kryptonite, or failing animal spirits if you like. It is closer to the truth to understand we are witnessing the early stages of erosion of confidence in government and ultimately its paper money. Ordinary people are finally beginning to suspect this, signalled by the world-wide rush into precious metals last month.
This article was previously published at GoldMoney.com.
Economics
By Sean Corrigan, on 3 May 13 Continued from part 1 …
Away from the brouhaha over fiscal policy, the intertwined issue of its monetary equivalent comes into focus. Perhaps in belated recognition of what we have been calling ‘biflation’ – i.e., the sharp divergence in monetary growth between Germanic and Latin Europe – Frau Merkel was moved to remark at a savings bank conference in Dresden that if the ECB were to be setting rates solely with an eye to conditions in the Heimat, it would probably have to raise, not lower, rates at the moment.
For their part, the two most senior Bundesbankers concurred – albeit in their typically divergent fashion. The ever urbane Asmussen, in a speech entitled, ‘Saving the euro’, alluded in no equivocal fashion to the lack of a one-size-fits-all approach, declaring that:-
…a more recent feature of our financial structure is financial fragmentation. This implies that lower interest rates have asymmetric effects, and not in the direction that we want them. Due to impaired monetary policy transmission, the pass-through of rate cuts to the periphery would be limited, and this is where they are most needed. At the same time, rate cuts would further relax already unprecedentedly easy financing conditions in the core. This is not per se a problem – but interest rates that are too low for too long can eventually lead to distortions…
Ah, yes! The ‘distortions’ to be expected from monetary incontinence. Nothing we Austrians ever allude to, of course!
In contrast, the imprimatur of Asmussen’s far more forthright colleague, Jens Weidmann, was all over the leaked copy of the Bundesbank’s submission to the Constitutional Court regarding the legality of the ESM. In what amounted to a veritable Philippic, as Handelsblatt reported it, the Bank strongly denied it was any part of its mission to prevent any given member state from exiting the single currency. In asserting that ‘higher finance costs for the private sector’ in certain countries ‘are related to greater national fiscal risks’, this report effectively launched a thinly disguised attack on the casuistry of Draghi’s argument that his monetary interventions are all about levelling the European playing field – and so are ostensibly undertaken with the aim of ensuring greater ‘transmissibility’ of monetary settings – and nothing whatsoever to do with financing otherwise bankrupt states.
Though all this would seem to close the door to an imminent easing of interest rates (a development which, for all the market’s Pavlovian enthusiasm, is in any case likely to be little more than symbolic in its import), there are ominous signs of a looming deceleration in German growth. Domestic monetary velocity has declined sharply of late – with or without the noise created by the build-up of Target balances – largely as a consequence of a decline in business revenues of 3% YOY in the domestic market and of around 4.5% v-a-v its Eurozone export markets.
Nor was the final quarter of 2012 much more cheery for the category ‘property and entrepreneurial income’ in the national accounts. This registered its worst result since the panic-stricken first quarter of 2009, and was at a level first attained eight years previously. No doubt this combination of stagnant sales and dwindling profits goes some way to explaining why it is that, after 8 years of fairly consistent co-movement, the GEX index of owner-controlled, smaller, ‘entrepreneurial’ companies has revisited GFC lows and so has diverged sharply from the record-setting MDAX, to the point that latter speculative vehicle has run up 174% in relative terms in the past two years.
The test, as ever, will come when it is deemed to be to Germany’s benefit to seek a relaxation in policy and, by extension, when it is in Merkel’s narrow political self-interest to signal her acquiescence to the other members of the ECB council and so to free herself from the opposition of her own troublesome, monetary priests. That day may well not be long delayed, but we would hazard it has not yet arrived.
Incredibly, there was a palpable sense of expectation going into the BOJ meeting this week, as the insatiable stimulus junkies conjured up fantasies of some new initiative being announced, barely weeks after ‘Corroder’-san’s QExtreme measures were launched. Embarrassingly, the meeting coincided with the release of a set of national CPI numbers which were falling at their fastest (if still decidedly moderate) pace in three years. More troubling for those who never cease to exult in the boost which Abenomics will supposedly give to asset markets everywhere, it is not at all evident that Mrs. Watanabe is familiar with her part in the playbook, either.
We say this because, far from unleashing the expected torrent of outward investment, the weakening yen has so far triggered what look to be the highest sustained liquidation of foreign portfolios in at least the last 15 years – a cumulative repatriation these last twelve weeks of around $85 billion USD. Meanwhile, foreign inflows have been sufficiently vigorous to push the invested sums to within a few percentage points of their 2007 highs, albeit that this has coincided with a rise in margin positions on the TSE which suggests that much of the money is being borrowed for the purpose.
That the vaunted ‘carry trade’ seems to be benefiting only the Nikkei so far, may have two separate, but not inconsistent explanations. The first is that, in contradistinction to the previous episode of yen-fuelled, global asset inflation which was instituted during the reign of Eisuke Sakakibara – that is, in the period between the 1994-5 Tequila Crisis (to which it was a response) and the 1997-8 LTCM collapse-Asian Contagion (in which it was a proximate cause) – the Japanese are not actively driving the yen lower (not least by not encouraging, as they did then, the big macro hedge funds and prop desks to participate in a one-way bet) and so residual forex risks remain unabated.
Secondly, it should be noted that, 15-20 years ago, Japanese interest rates were around 600bps below those prevailing in the UK, 500bps below those in the US, and 300bps below those in Germany: today those spreads are 40bps, 4bps, and -5bps, respectively. In other words, back then it clearly did not pay those using yen to buy foreign assets to hedge exposures, even if they had chosen to ignore the explicit policy of their own government to weaken it. Today, by contrast, there is no meaningful penalty attached to so doing and no strong disincentive to desist since a lower parity is not officially an objective. Thus, easy money in Japan may well induce leveraged asset purchases, but it is hard to see why this should drive a self-aggravating spiral of devaluation and further, induced carry trades, especially when sources of speculative finance are not exactly lacking in any other currency you could name.
Note here in passing that with gold at an all time high versus the yen, and with the Topix coming off a 90%, 21st century decline to a three-decade low in gold ounce-equivalent value, a similar urge to book profits and/or reduce exposure to overseas assets offering much less prospective gain could have been at work in pushing the yellow stuff to the edge of last week’s precipice.
Economics
Following on from John Butler’s review, here’s Detlev’s take on “The Great Deformation” …
David Stockman’s new book is a brilliant, penetrating analysis of the present state of the US economy and the US political system, and a detailed account of how the nation got into this mess. The book will upset Democrats and Republicans alike, and quite a few other constituencies as well, which can, in this case, be safely accepted as proof that Stockman’s narrative is spot on.
Stockman is an angry man and he admits so himself early in his 719-page tome. That anger adds bite and verve to his writing and keeps what is in fact a detailed historical account and economic analysis always highly entertaining. The book is long but never boring. Furthermore, Stockman does not let his anger cloud his judgement, which remains, in my view, relentlessly accurate throughout.
When dissecting Washington politics and Wall Street deal-making Stockman naturally draws on his experience as the director of the Office of Management and Budget under Ronald Reagan and his many years as an investment banker and private equity investor, and in so doing he reflects on much of his own professional life with commendable candor. But the book goes beyond these specific periods, and Stockman applies the analytical skills and insights acquired on these jobs to the critical examination of a wide spectrum of policy areas and historic periods. Stockman’s command of these topics and the masses of statistics and financial reports involved, and his powers of analytical dissection are impressive. But what is probably even more important for the success of his analysis is that it is based on an accurate understanding of essential economic relationships, in particular the importance of sound money. This is why the narrative that he develops captures America’s present challenges so truthfully and comprehensively. I very much shared Stockman’s anger when I started reading, but even more so when I had finished.
Public service
Stockman does a great service to his fellow Americans for he is providing a much-needed dose of realism that stands in stark contrast to the contrived optimism emanating from much of the political ‘debate’, from stock-pushing Wall Street experts on financial TV, and from the various Keynesian snake-oil merchants from both parties, all of whom want the public to believe that America is fundamentally healthy and just another round of ‘quantitative easing’, another deficit-funded tax break, or another ‘stimulus’ spending measure away from a bright future of self-sustained recovery. Instead, Stockman says it like it is. The US economy in 2013 is fundamentally weakened and structurally deformed by decades of artificially cheap money and a pathological debt addiction. Not the occasional artificial booms of the past twenty years, driven by Fed-induced bubbles in stocks, high-yield bonds and housing, give a correct picture of America’s long-term economic potential but the intermittent periods of slack when the fire-works on Wall Street inevitably end (and end in tears), and the persistent Main Street reality of declining employment prospects, stagnant real income and impaired competitiveness can no longer be covered up.
The Fed’s policy of cheap and then ever-cheaper credit has not only destroyed the free market by constantly distorting price signals, encouraging reckless debt accumulation and rewarding financial speculation (and consequently widening income and wealth gaps, as Stockman illustrates aplenty), it has thoroughly corrupted the political process as well. Stockman portrays a political system that, courtesy of the Fed’s cheap credit policies and interest rate repression, is now chronically incapable of living within its means, and is thus easy prey for hordes of crony capitalists – from the healthcare industry and the military-industrial complex to the ‘labor aristocracy’ of the united autoworkers union to the ‘too-big-to-fail’ banks, private-equity shops and hedge funds that play the system for a quick profit.
Crucially, Stockman puts his unsentimental assessment of America’s present reality into a broader historical context. Stockman identifies correctly the act of original sin that led America astray from the path of broadly free market economics and limited and fiscally responsible government, namely the abandonment of sound money. As America moved away from hard money, epitomized originally by the gold standard and a Federal Reserve with a strictly limited role as a bankers’ bank, and later, in already watered-down form, by the Bretton Woods gold-exchange-standard, and embraced an unconstrained fiat money system and ‘free-floating’ global paper monies it robbed the free market of its essential inner compass and ‘true north’ of market-based interest rates and market-enforced financial prudence.
The Fed, the central-banking branch of the federal government, was unleashed from its golden shackles in two historic steps in 1933 (by a Democrat president) and in 1971 (by a Republican president) but it was only over the past twenty years under the leaderships of Greenspan and Bernanke that the full destructive potential of unconstrained central banking has come to be felt. As Stockman shows with great clarity, both central bankers turned the Fed into a machine for macro-economic fine-tuning and prosperity management. Greenspan promised to watch the speculating classes’ backs by allowing them to blow bubbles and then shield them from the consequences. Bernanke took the mission one step further as he began (and still continues) to use his vast powers of fixing interest rates and printing limitless amounts of new money to steer the markets to the ‘correct’ yields on government bonds, the ‘correct’ spreads on mortgage-backed-securities, and the ‘appropriate’ shape of the yield curve, and by so doing to centrally manage the overall economy. Needless to say, such socialism for speculators, courtesy of the printing press, is happily explained by Wall Street economists as being in the public interest.
It is this deformation of money that is the root cause of the numerous deformations in the broader economy and the deformations in the political system. I am grateful that Stockman has fulfilled the important task of documenting in detail the many ways in which unsound money undermines the market economy and corrupts society.
Myth buster
Stockman is a myth buster par excellence. He busts myths that are cherished by Democrats and myths that are cherished by Republicans, and some cherished by both. Never pulling any punches and always happy to name names, he exposes as complicit in the deformation of American capitalism politicians, central bankers, and self-important economists of the Keynesian, monetarist and supply-side persuasion. He also identifies the many crony-capitalists, who shamelessly exploit the system’s many deformations for their own gain. But Stockman not only identifies the villains – the advocates and profiteers of unsound money – he also gives us the heroes, the defenders of sound money, people like Dwight Eisenhower, William McChesney Martin, and Paul Volcker, even if their efforts ultimately did not avert the corruption of American capitalism.
Here are the main myths that Stockman exposes:
Myth one: The 2008 financial crisis was the result of unregulated markets. TARP and the Fed saved the country from Great Depression 2.0
Nonsense, says Stockman. The financial crisis was the consequence of the Fed’s serial bubble blowing, and it should have been allowed to burn itself out in the corridors of Wall Street. Instead, Paulson and Bernanke panicked, declared economic martial law, namely that all rules of fiscal prudence and free market capitalism be tossed aside, and demanded that, via the bail-out of ‘insurance’ giant AIG, firms like Goldman Sachs, Morgan Stanley and others be saved from choking on their own outsized speculations.
Myth two: There was such a thing as the ‘Reagan Revolution’ and it revitalized American capitalism.
This is obviously a favourite whenever Republicans sit around the campfire. The reality looks different. Despite all the charisma and the eloquent free market rhetoric, the true legacy of the Reagan presidency is a Republican party that is now largely desensitized to fiscal profligacy and reconciled with endless deficits (Cheney’s famous dictum that “deficits don’t matter.”), as the party has happily joined the Democrats in the ‘aggregate demand’ management business. No longer to be outdone by ‘pro-active’ Democrats advocating Keynesian ‘spending’ to ‘stimulate’ growth, the Republicans came to embrace their own version of top-down GDP management: the Art-Laffer-inspired slashing of taxes at all cost. Fiscal prudence – and a true “hands-off” approach to the economy – was finally expunged from Republican DNA.
Myth three: The Great Depression was caused by the gold standard and was ended by Roosevelt’s Keynesian policies.
Ridiculous. The correction of the early 1930s was the combination of delayed effects of the First World War (a US agricultural boom that had led to overinvestment and distorted prices and had already ended in a bust in the 1920s) and the bursting of various bubbles blown during the Jazz-Age-version of bubble finance, such as the foreign bond market that provided funding for the purchase of then-sizable US exports, and the hot-money driven domestic equity boom. These distortions did not come about because of the gold standard but despite the gold standard, which had been severely weakened as a disciplinary force not least due to the growing role of the Fed since 1914, and in particular since the central bank funded the war effort through money-printing in 1917-1918. By 1929 liquidation and correction were unavoidable. But what should have been a quick and decisive cleansing was turned into a drawn-out economic catastrophe by bad policy. First, there was economic nationalism – tariffs and other forms of protectionism – and then Roosevelt’s disastrous interventionism and relentless tinkering with the economy. As Stockman illustrates, Roosevelt did not enact a Keynesian textbook program at all. In fact, the clueless president had no coherent program whatsoever but instead implemented the type of potpourri of populist anti-market measures so fashionable at the time among Europe’s fascist leaders: odd infrastructure programs, price and wage fixing, state-directed resource use.
“Having triggered the demise of the old international order, the Roosevelt program of necessity was a purely domestic grab bag of experiments, gimmicks, and nonstarters. These ad-hoc Washington interventions – the Tennessee Valley Authority (TVA), National Recovery Act (NRA), Agricultural Adjustment Act (AAA) – did little to revive the dormant machinery of market capitalism and economic wealth creation and, instead, mainly shuffled income and resources randomly among regions, industries, and even individual business firms.”
(Stockman, page 159)
Intermezzo
The New Deal had meant curtains for the ‘Old Republic’ and any commitment to sound money and sound public finances. However, and luckily for America, the newly expanded tool kit for interventionist politicians and central bankers remained largely unused for two decades after the end of World War II. A happy interregnum of monetary and fiscal discipline commenced, largely due to the good fortune of having people with strong traditional beliefs in positions of power, such as Dwight D. Eisenhower in the White House and William McChesney Martin at the Fed, two of Stockman’s heroes. Eisenhower slashed military spending after the Korean War and established the ‘Eisenhower minimum’ of strictly contained military outlays. Eisenhower was a soldier who hated war. A highly decorated general himself he famously warned his fellow Americans of the growing powers of the military-industrial complex and stared down a few generals himself when letting them resign in protest of his spending cuts. (By comparison, today’s Commander-in-Chief, former community organizer Barack Obama, oversees a military budget that is twice the size of even Bill Clinton’s.)
Over at the Fed, Martin not only coined the phrase “taking the punch bowl away when the party gets started”, he actually meant it and implemented it. Martin was deeply committed to the monetary discipline of the Bretton Woods system.
Needless to say, such discipline did not last long. America’s military adventures in Far East Asia and LBJ’s great society project put new demands on state spending and, by extension, on the printing press. The last link to gold – and the last remaining constraint on paper dollar creation- was severed in August 1971.
Myth four: Free floating paper monies are a sign of free market capitalism
The importance of what happened at Camp David in August 1971 can hardly be overestimated, and Stockman conveys the magnitude of these events vividly:
“Nixon’s estimable free market advisors who gathered at the Camp David weekend were to an astonishing degree clueless as to the consequences of their recommendation to close the gold window and float the dollar. In their wildest imaginations they did not foresee that this would unhinge the monetary and financial nervous system of capitalism. They had no premonition at all that it would pave the way for a forty-year storm of financialization and a debt-besotted symbiosis between central bankers possessed by delusions of grandeur and private gamblers intoxicated with visions of delirious wealth.”
(Stockman, page 281)
Stockman is particularly scathing of Milton Friedman’s influence on these events.
“The great irony, then, is that the nation’s most famous modern conservative economist became the father of Big Government, chronic deficits, and national fiscal bankruptcy. It was Friedman who first urged the removal of the Bretton Woods gold standard restraints on central bank money printing, and then added insult to injury by giving conservative sanction to perpetual open market purchases of government debt by the Fed. Friedman’s monetarism thereby institutionalized a regime which allowed politicians to chronically spend without taxing.”
(Stockman, page 272)
Famous academic economists who willingly throw themselves into the machinery of policy-making or policy-advice are among the most tragic-comic figures in Stockman’s narrative.
Thus we meet, on the political Left, John Maynard Keynes’s vicar on earth, the pompous Larry Summers pulling really big numbers out of the air, such as $800 billion, and demanding that this be spent instantly by Washington to stimulate the economy. There is, of course, Paul Krugman, who has never met a deficit-spending program that he thought was big enough. On the political Right, there is Art Laffer, who taught the Republicans not to worry about deficits if they result from tax-cutting as tax cuts are always stimulative and thus inherently self-financing. There is Milton Friedman who could explain the evils of rent-control better than anybody else but got free market money horribly wrong and provided intellectual cover for Tricky Dick’s dollar debasement. And then, naturally, there is Ben Bernanke, the veritable Dr. Strangelove of central banking, who believes this is 1930 all over again and who uses the present crisis to re-enact the policy program he believes, based on his own subjective and highly flawed interpretation of the Great Depression, the Fed should have enacted back then. One can only hope that this litany of abject failure serves as a warning to those economists waiting in the wings for their moment in the limelight, such as John Taylor who believes his eponymous rule is the answer to all central banking problems, or those economists who currently embrace the new Keynesian fad of ‘nominal GDP targeting’ (God help us!).
The deserving heroes of Stockman’s account are instead those statesmen and bankers who stuck by the old (and indeed ancient) rules of hard money and ‘balancing the books’.
Myth five: Modern financial markets represent free market capitalism.
Of course, in a proper free market, speculation, trading and the use of leverage would not only be permissible but would have an important role to play in the process of allocating savings and channeling scarce capital to productive uses. These activities would, however, be tightly controlled and strictly limited by the free market’s most effective regulators: profit and loss. Those regulators are now largely weakened or even removed entirely by the present system of costless fiat money, unlimited central bank backstops (Greenspan/Bernanke put) and artificially low interest rates. Without proper capitalist money, hard and apolitical, at the core of the monetary system, a free market in the rest of finance is impossible. Stockman does an excellent job illustrating the extent to which manipulated money and artificially cheap credit are corrupting the entire financial infrastructure by encouraging excessive risk-taking and the misuse of capital with severely adverse long-term consequences.
“…capital markets eventually lose their capacity to honestly price securities under a regime of unsound money; they end up dancing to the tune of the central bank; that is, pricing the trading value of financial assets based on expected central bank interventions, not the intrinsic value of their cash flows, rights, and risks.”
(Stockman, page 383)
Stockman analyses a range of leveraged buy-out deals (LBOs) to show how, in our deformed financial system, these can often lead to huge pay-outs for highly leveraged investors while at the same time leaving the firms financially weakened and sometimes even bankrupt. This chapter may appear long and technically challenging for some readers but it is important as it gives the lie to frequent claims by those who operate in this arena that these activities are simply the free market at work, and that they lead to more efficient allocation of corporate control, to investment in productive capital and to jobs. Stockman exposes the full irony of the Republican Party putting forward Mitt Romney as their 2012 presidential candidate and trying to sell him as an experienced business man and ‘job creator’ when, as the former head of private-equity firm Bain Capital, he would be much more suitable as a poster boy for the lucky few who disproportionally benefitted from three decades of bubble finance and all the deformations it created, a system that stands in sharp contrast to the traditional capitalism the Republicans claim to advocate.
Stockman certainly does not make many friends on the political Left with his – brilliant and entirely justified – annihilation of the Roosevelt myth and the childish ‘Keynes 101’–programs of ‘spending ourselves to prosperity’, but his account supports to a considerable degree the allegation that the ‘1 percent’ live high on the hog at the expense of the rest of the population. However, as Stockman demonstrates at length, this is not the result of free market capitalism, and the answer to it is not regulation and confiscatory taxation. The root cause is unsound money and the possibilities that unsound money provides for the flourishing of ‘crony capitalism’.
Stockman’s outlook is not a happy one. As the nation runs out of balance sheets to leverage up and as, inevitably, ‘austerity’ sets in, he foresees ongoing political strife, further financial market manipulations, on-and-off print-operations by the Fed, and new financial crises. He closes the book with a few pages of policy recommendations, all of them sensible, I guess, and naturally following from the preceding extensive analysis. But Stockman is under no illusion – he knows that his policy ideas do not stand a snowball’s chance in hell of being implemented. In any case, the book is not really, first and foremost, about a new policy program but about shifting the parameters of the debate by providing a thorough and accurate description of America’s economic and political problems. And here the book succeeds with flying colors.
This is an important book. I wish it a wide readership.
This article was previously published at DetlevSchlichter.com.
Economics
By Sean Corrigan, on 1 May 13 In what was a banner week for the many serial inflationists and fans of Big Government out there, equity markets largely reversed the declines of the previous period on the hope for – what else? – yet more pump priming. Adding their vote of approval, fixed income players have also pushed junk and EM yields to new lows and touched new, post-Mario depths in BTP/Bono-Bund spreads.
On the fiscal front, much heart has been taken at EU Commission President Barroso’s assertion that the time has come to move beyond an exclusive reliance on ‘austerity’ and to begin to focus on encouraging growth. Indeed, such was the frenzy of press speculation whipped up on this account – not least by the bien pensant Guardian newspaper as part of its campaign to effect a change in British policy – that the EU’s official website quickly published a full transcript of Barroso’s remarks under the revealing title of “What President Barroso actually said” [our emphasis].
Needless to say, this was far less radical than anything whipped up by the journalists – the crux being that it was mainly matter of paying lip service to the ongoing need to trim debts and deficits, while calling for a range of largely unspecified microeconomic reforms and, as such, representing more of an exercise in expectations management than the signal of a clear break with the line being toed across the Rhine.
In the circumstances, however, the wilful desire to over-interpret (if not actively misinterpret) the message was far too powerful to resist, especially in the wake of the academic catfight going on over the state of Reinhardt and Rogoff’s Excel skills.
For those who have real lives to lead, the briefest of synopses of this spat will suffice and, indeed, it is only introduced here to illustrate the heedless Flucht nach Vorne mentality of the Krugmanites, ever eager as they are to peddle the line that the only reason stimulus has ‘failed’ is because there has been nowhere near enough of it, that the violation of both the principles of accounting and the tenets of good housekeeping on the part of the Provider State has somehow been too timid.
Loosely, R&R wrote a paper which suggested that high government debt is detrimental to growth but managed to overweight one particular input from little old New Zealand at the dawn of their sample. A caricature of the paper’s results had meanwhile been employed to argue that growth would evaporate the minute a 90% debt/GDP ratio was reached, but not an iota before. Since this, naturally, was being put about with as much conviction as would be accorded a cross between Holy Writ and Newton’s Third Law of Motion, the Left instantly seized upon the revelation of R&R’s faux pas to claim that the collapse of this particular straw man somehow ‘proved’ that all attempts at public economy were therefore misplaced and that Leviathan should return with renewed vigour to the fulfilment of its sacred duty to collectivise as much of the market as possible.
What larks, Pip, are to be had when positivists and macromancers fall out over their flawed pursuit of what Mises called ‘scientism’ – viz., the pretence affected by most of the mainstream that economics can be made into a simulacrum of physics or fluid mechanics!
But, as a focus of this war of the scholastics, the whole debt issue surely misses the crucial point that debt only swells in a polity where not only is government over large to begin with, but where it is serially profligate – i.e., where the political class persists in spending more than it dares ask its electors to contribute to the fulfilment of its whims.
Given that this diverts resources away from hard-budget, dispersed-knowledge, voluntarily-contracted endeavours (hence ones which must, over time, at the very least pay their way) and into the crony-ridden, cost-plus, soft budget quagmire of top-down, fatal conceit compulsion – every one of its endless stream of programmes a would-be Great Leap Forward – can it really be a matter of dispute that existence of a high debt level should be taken as convincing evidence of a country where the petty tyrants in office and the host of public drones which they employ have enjoyed far too much sway for far too long and so have clogged up the machinery of wealth creation with a plethora of regulations, a nest of subsidies, a tangle of vested interests, and a legacy of malinvested capital every bit poisonous as that left behind by a private sector credit bubble (itself a plague which can only be transmitted by means of a pervasive state interference in the free market)?
As Thomas Gordon wrote long ago in Discourse X of his 1753 publication, “The Works of Tacitus with Political Discourses” :-
Wars beget great Armies; Armies beget great Taxes; heavy Taxes waste and impoverish the Country
Just substitute ‘Welfare’ for ‘Wars’ and ‘Public employees’ for ‘Armies’ and the argument remains in full 260 years later.
And, since you ask, evidence of real ‘austerity’ remains elusive. Government revenues, it is true, fell – for obvious reasons – in Greece, Spain, Portugal, and Ireland in the five years after 2007, but they were still up an average of 7.2% across the Eurozone as a whole. Expenditures, meanwhile, have continued to expand, rising an average of 15%. Only Ireland has here managed to record a decrease and that of a paltry 1%. Debt has, needless to say, climbed ever upward to reach a Eurozone-wide level of 118% of non-government GDP (we prefer to measure the obligation shouldered by the Ants alone, not by them and the Grasshoppers who prey upon them). Debt/pGDP itself has climbed by an astonishing median 30% in that same quinquennium.
Now it may well be that the rise in debt during this sorry period is a consequence, rather than a cause, of the growth slowdown, but the reason for the crisis which entrained this slump nonetheless lies in the too great accumulation of debt during the boom years. That much of the offending mountain of unpayable claims was initially a private sector folly is hardly to the point: what we have always maintained is that the blank refusal to renegotiate or liquidate that debt at the earliest possible stage, instead of engaging upon an obstinate course of macroeconomic Micawberism, is why the crisis has generated a grinding depression which shows few signs of being alleviated almost five dreary years after the event.
If nothing else, today’s debt stands as a testimony to economic incomprehension and political stupidity on a tremendous scale. But then again, since we are supposed to be drawing all of our lessons from what the Americans did in the 1930s, it is no surprise that we, too, have managed to perpetuate our misery, as did the monetary cranks and bureaucratic meddlers of FDR’s crackpot Brain Trust, way back then.
Economics
By Alasdair Macleod, on 29 April 13 There is a new campaign to end austerity. First, the IMF lets it be known it has second thoughts about it; then we are told the threshold of 90% government debt to GDP which must not be crossed, set by Professors Reinhart & Rogoff, is based on an excel spread-sheet error. Lastly, Bill Gross of PIMCO, the largest bond fund in the world, tells us austerity is not working.
The new mood is spreading, to the relief of beleaguered countries like Spain and Italy. Austerity is painful, and politicians don’t like it because it makes them unpopular. Nor do Keynesian and monetarist economists, who see its failure as justification for more intervention.
Austerity, as practised by Western governments, involves maintaining public spending at the cost of the private sector. It is therefore hardly surprising that it leads to the destruction of the wealth-creation necessary to support government finances. Its only, if questionable virtue, is statistical: the maintenance of government spending ensures that its share of GDP does not fall, thereby not undermining “growth”. But government spending is simply a constraint on the productive private sector, because any economic resource diverted from it to pay for government is effectively squandered.
If an economy is to progress at all, there has to be as much austerity as possible, aimed squarely and solely at the government sector. Give individuals and businesses a lighter tax burden, the result of smaller government, and economic prospects will rapidly improve. Instead, the new anti-austerity mood will translate into a new licence for governments to relax their spending restraints.
Anyway, central banks including the ECB have shown they are ready to underwrite government spending if the markets are not prepared to, at almost zero interest cost. This explains why the yield on Italian debt, for example, has fallen despite the political drift of its non-government away from spending restraint.
One reason this is tolerated by bond investors such as PIMCO is the simple assumption that inflation is only a problem if there is a pick-up in demand. With all major economies either slowing or moving into recession that fear is increasingly remote. But history tells us this is a mistake, and that prices are capable of rising even in a recession, and a proper understanding of price theory also demonstrates the falsity of the assumption.
For the moment, ordinary people and their banks are showing a preference for money over goods, and have been since the banking crisis five years ago, which is why demand remains subdued. However, increasing risks to bank deposits from bank failures are likely to trigger a flight into physical cash and goods. And with economies all over the world stalling under the burden of the cost of government, this risk to banks and bank deposits is both increasing and becoming more immediate.
Complacency over inflation and interest rates also has to face the new impetus given to the expansion of the money supply implied by the abandonment of austerity. And this is merely another reason for monetary expansion, added to all the others. What we are seeing played out in front of us is no more than the compelling political reasons behind nearly every hyperinflation in modern history, which will almost certainly end in the collapse of today’s paper currencies.
This article was previously published at GoldMoney.com.
Economics
By The Cobden Centre, on 28 April 13 This excerpt from Omnipotent Government by Ludwig von Mises was recently featured at Mises.org.
The gold standard was an international standard. It safeguarded the stability of foreign exchange rates. It was a corollary of free trade and of the international division of labor. Therefore those who favored etatism and radical protectionism disparaged it and advocated its abolition. Their campaign was successful.
Even at the height of liberalism governments did not give up trying to put easy money schemes into effect. Public opinion is not prepared to realize that interest is a market phenomenon which cannot be abolished by government interference. Everybody values a loaf of bread available for today’s consumption higher than a loaf which will be available only ten or a hundred years hence. As long as this is true, every economic activity must take it into account. Even a socialist management would be forced to pay full regard to it.
In a market economy the rate of interest has a tendency to correspond to the amount of this difference in the valuation of future goods and present goods. True, governments can reduce the rate of interest in the short run. They can issue additional paper money. They can open the way to credit expansion by the banks. They can thus create an artificial boom and the appearance of prosperity. But such a boom is bound to collapse sooner or later and to bring about a depression.
The gold standard put a check on governmental plans for easy money. It was impossible to indulge in credit expansion and yet cling to the gold parity permanently fixed by law. Governments had to choose between the gold standard and their—in the long run disastrous—policy of credit expansion. The gold standard did not collapse. The governments destroyed it. It was as incompatible with etatism as was free trade. The various governments went off the gold standard because they were eager to make domestic prices and wages rise above the world market level, and because they wanted to stimulate exports and to hinder imports. Stability of foreign exchange rates was in their eyes a mischief, not a blessing.
No international agreements or international planning is needed if a government wants to return to the gold standard. Every nation, whether rich or poor, powerful or feeble, can at any hour once again adopt the gold standard. The only condition required is the abandonment of an easy money policy and of the endeavors to combat imports by devaluation.
The question involved here is not whether a nation should return to the particular gold parity that it had once established and has long since abandoned. Such a policy would of course now mean deflation. But every government is free to stabilize the existing exchange ratio between its national currency unit and gold, and to keep this ratio stable. If there is no further credit expansion and no further inflation, the mechanism of the gold standard or of the gold exchange standard will work again.
All governments, however, are firmly resolved not to relinquish inflation and credit expansion. They have all sold their souls to the devil of easy money. It is a great comfort to every administration to be able to make its citizens happy by spending. For public opinion will then attribute the resulting boom to its current rulers. The inevitable slump will occur later and burden their successors. It is the typical policy of après nous le déluge. Lord Keynes, the champion of this policy, says: “In the long run we are all dead.” But unfortunately nearly all of us outlive the short run. We are destined to spend decades paying for the easy money orgy of a few years.
Inflation is essentially antidemocratic. Democratic control is budgetary control. The government has but one source of revenue—taxes. No taxation is legal without parliamentary consent. But if the government has other sources of income it can free itself from this control.
If war becomes unavoidable, a genuinely democratic government is forced to tell the country the truth. It must say: “We are compelled to fight for our independence. You citizens must carry the burden. You must pay higher taxes and therefore restrict your consumption.” But if the ruling party does not want to imperil its popularity by heavy taxation, it takes recourse to inflation.
The days are gone in which most persons in authority considered stability of foreign exchange rates to be an advantage. Devaluation of a country’s currency has now become a regular means of restricting imports and expropriating foreign capital. It is one of the methods of economic nationalism. Few people now wish stable foreign exchange rates for their own countries. Their own country, as they see it, is fighting the trade barriers of other nations and the progressive devaluation of other nations’ currency systems. Why should they venture to demolish their own trade walls?
Some of the advocates of a new international currency believe that gold is not fit for this service precisely because it does put a check on credit expansion. Their idea is a universal paper money issued by an international world authority or an international bank of issue. The individual nations would be obliged to keep their local currencies at par with the world currency. The world authority alone would have the right to issue additional paper money or to authorize the expansion of credit by the world bank. Thus there would be stability of exchange rates between the various local currency systems, while the alleged blessings of inflation and credit expansion would be preserved.
These plans fail, however, to take account of the crucial point. In every instance of inflation or credit expansion there are two groups, that of the gainers and that of the losers. The creditors are the losers; it is their loss that is the profit of the debtors. But this is not all. The more fateful results of inflation derive from the fact that the rise in prices and wages which it causes occurs at different times and in different measure for various kinds of commodities and labor. Some classes of prices and wages rise more quickly and to a higher level than others. While inflation is under way, some people enjoy the benefit of higher prices on the goods and services they sell, while the prices of goods and services they buy have not yet risen at all or not to the same extent. These people profiteer by virtue of their fortunate position. For them inflation is good business. Their gains are derived from the losses of other sections of the population. The losers are those in the unhappy situation of selling services and commodities whose prices have not yet risen at all or not in the same degree as the prices of things they buy for their own consumption. Two of the world’s greatest philosophers, David Hume and John Stuart Mill, took pains to construct a scheme of inflationary changes in which the rise of prices and wages occurs at the same time and to the same extent for all commodities and services. They both failed in the endeavor. Modern monetary theory has provided us with the irrefutable demonstration that this disproportion and nonsimultaneousness are inevitable features of every change in the quantity of money and credit.
Under a system of world inflation or world credit expansion every nation will be eager to belong to the class of gainers and not to that of the losers. It will ask for as much as possible of the additional quantity of paper money or credit for its own country. As no method could eliminate the inequalities mentioned above, and as no just principle for the distribution could be found, antagonisms would originate for which there would be no satisfactory solution. The populous poor nations of Asia would, for instance, advocate a per capita allotment, a procedure which would result in raising the prices of the raw materials they produce more quickly than those of the manufactured goods they buy. The richer nations would ask for a distribution according to national incomes or according to the total amount of business turnover or other similar standards. There is no hope that an agreement could be reached.
Economics
By John Butler, on 27 April 13 David Stockman’s The Great Deformation is a tour de force of historical revisionism that demolishes the conventional economic and political wisdom prevailing both prior to and in the aftermath of the 2008 global financial crisis. Approaching his subject from many different angles, he demonstrates in thorough and specific detail, including much direct personal experience, that the roots of the crisis stretch back many decades. Few if any stones are left unturned; few if any major US political actors escape criticism; and all are subject to healthy scrutiny regardless of their orientation on the left-right spectrum. Indeed, Stockman makes clear that the facile left-right distinction of US politics obscures a deeper crisis of capitalism that spans the breadth of the American economic and political landscape. While he admits he has little hope that America can now change course, in closing he does offer a few specific policy recommendations that might, just might, lay the foundation for a Great American Reformation, were they to be implemented in future.
A most credible source
There is no more credible source for a book detailing the myriad policy failures collectively contributing to America’s decent into crony capitalism than David Stockman. Elected to Congress in the 1970s while still in his 20s, he was selected by President Reagan to be his first budget director at age 31 and was thus the youngest Cabinet-level US official to serve in the entire 20th century.
Bright-eyed and bushy-tailed in comparison to the seasoned older guard dominating the Reagan White House, Stockman became rapidly disillusioned by the striking contrast between Reagan’s lofty rhetoric on the one hand and the reality of White House policies on the other. He left politics in 1985 for the private sector and entered the world of private equity as a partner at the Blackstone Group.
As Stockman himself admits, however, he is not entirely above the criticism he levels repeatedly at others throughout the book. Three prominent examples include his admission of avoiding the Vietnam draft by enrolling in Harvard Divinity School; being repeatedly outmanoeuvred by highly experienced political operatives while serving in the Reagan White House; and bearing at least some responsibility for a handful of poor investment decisions while working at Blackstone.
This honest introspection only serves to make the book more credible. Stockman is an American taking a long look in the mirror and asking the tough questions that few in power will ask, associated as they all are, in some way, with the great tragedy he describes in thorough detail.
The first polemical punch
Stockman wastes no time in landing his first polemical punch: on the first page, he observes that the US ‘Fiscal Cliff’, around which there was such high political drama late last year, is both “permanent and insoluble,” and that the chronic US deficit and debt problem is “the result of capture of the state, especially its central bank, the Federal Reserve, by crony capitalist forces deeply inimical to free markets and democracy.”
What follows is page after page of shocking detail regarding the metastatising crony-capitalist cancer consuming the US economy’s once great potential. While primarily concerned with recent developments, a great strength of the book is that it seeks always to trace the roots of The Great Deformation back to their beginnings, for example, in early 20th century Progressivism; in President Roosevelt’s New Deal; or in the Republican Party’s fateful decision in the 1960s to sever its small-government roots.
Debunking the conventional wisdom
Throughout the book, Stockman relentlessly attacks the economic conventional wisdom. In one instance he reaches back into the Great Depression to demonstrate that numerous policy errors both in the United States and abroad contributed to the 1929 stock market crash and subsequent banking crises of the early 1930s. Moreover, he demonstrates convincingly that it was not the military Keynesianism of the 1940s that ended the Depression but rather a severe and prolonged household and corporate deleveraging facilitated by a combination of women entering the workforce en masse, a general shortage or outright absence of many consumption goods and the associated, unusually high national savings rate.
This goes directly against the mainstream interpretation that increased rates of savings only serve to make financial crises even worse. But Stockman does not stop there. He shows how the rapid public sector deficit reduction in the immediate postwar period and the general fiscal prudence of the Truman and Eisenhower years enabled the rapid, healthy, sustainable growth of the 1950s and 1960s to proceed absent any material increase in the public debt and absent inflationary pressures on prices.
This began to change during the Kennedy administration but it was under Johnson and Nixon that traditional American fiscal convervatism was shown the door for good. From this point forward, the tone of the book changes dramatically as Stockman initiates a devastating assault on the conventional wisdom: The entire left-right narrative of US politics is demonstrated to be a great charade. Even the early Reagan years in which Stockman was a direct policy participant are shown to be an exercise in the relentless growth of government, associated deficits and debt. As he explains it, “Rather than a permanent era of robust free market growth, the Reagan Revolution ushered in two spells of massive statist policy stimulation.” Indeed, Stockman characterises the Reagan and Bush years as a ‘Keynesian Boom’.
As Stockman explains, for all the talk to this day of Reagan’s fiscal conservatism, the only meaningful conservative policy victory of the time was achieved by the Fed, not the government. Paul Volcker did what was required to stabilise the dollar and bring down inflation following the disastrous stagflationary 1970s, the inevitable consequence of Johnson’s and Nixon’s fiscal largesse, the hugely expensive Vietnam war, soaring government deficits, de-pegging the dollar’s link to gold and the Fed’s accommodation of, among other associated phenomena, higher crude oil prices via OPEC.
As is the consistently the case throughout the book, however, Stockman highlights the links between failed economic policies and their unfortunate social consequences: The relentless growth of moral hazard and crony capitalism. Once Volker had left the stage, replaced by Alan ‘Bubbles’ Greenspan (sic), he explains how the Fed began de facto to target asset prices, in particular the stock and housing markets, and that “Under the Fed’s new prosperity management regime … the buildup of wealth did not require sacrifice or deferred consumption. Instead, it would be obtained from a perpetual windfall of capital gains arising from the financial casinos.” Wow.
That’s right, for decades the stock market has been a financial casino, rigged as desired by the Fed to (mis)manage the economy, and now all that is left is a “bull market culture” that has “totally deformed the free market.”
Stockman also points out how the decades leading up to 2008 were replete with ‘foreshocks’ of the eventual financial earthquake. For example, there was the S&L crisis of the late-1980s and early 1990s. There was the Long-Term-Capital debacle. And each and every time that the Fed’s economic management led, either directly or not, to near-calamity, the bailout beneficiaries were enriched anew.
With most of Stockman’s criticism is directed at Washington, Wall Street and the Fed, he nevertheless reserves some for the non-financial corporate sector. As he explains:
Alongside the Fed’s cheap credit regime, there arose a noxious distortion of the tax code best summarized as ‘leveraged inside buildup’. The linchpin was successive legislative reductions of the tax rate on capital gains that resulted in a wide gap between high rates on ordinary income and negligible taxes on capital gains. This huge tax wedge became a powerful incentive to rearrange capital structures so that ordinary income could be converted into capital gains.
In Stockman’s view there is thus plenty of blame to go around. On a few occasions he even criticises the defence establishment, holding up Eisenhower as the last example of Pentagon budgetary discipline. While he hardly comes across as a dove in foreign policy, he is certainly not as hawkish as recent administrations and he points out a handful of examples of failed defence policies and budgetary largesse past and present.
Beyond left and right
Readers who attempt to understand this book according to any variation of the current economic policy mainstream or through the obsolete left-right narrative of US politics will struggle to understand Stockman’s independent perspective. The Great Deformation is written by an old-school, small-government ‘Eisenhower Republican’ and champion of the free-market who perceives more clearly than most just how far the insidious crony-capitalist rot has spread, whether it be facilitated by purportedly left-leaning ‘regulation’ or encouraged by right-leaning tax-reform. As Stockman repeatedly demonstrates, the concept of ‘capture’ applies equally to both.
Perhaps unsurprisingly given the horrifying state of affairs he so cogently describes, Stockman is not sanguine about America’s future. The US is travelling down Hayek’s fabled ‘Road to Serfdom’ as the government and central bank respond to the damaging effects of failed interventionism with escalating interventionism. Indeed, since at least 2008, the evidence is overwhelming that America has been accelerating down that tragic road.
In closing, Stockman offers some ideas that might help the US to reverse course, although he strongly doubts that they will be adopted. If anything, the political winds from both left and right continue to blow in the other direction. No doubt his polemic will be rebuffed by those in power on both sides of the aisle in Congress and his recommendations for reform will go unheeded. That Stockman knows this, but wrote this book regardless, demonstrates his love for America. Anyone sharing that love should read it.
Economics
By Alasdair Macleod, on 26 April 13 Introduction
In this article I will argue that the recent slide in the gold price has generated substantial demand for bullion that will likely bring forward a financial and systemic disaster for both central and bullion banks that has been brewing for a long time. To understand why, we must examine their role and motivations in precious metals markets and assess current ownership of physical gold, while putting investor emotion into its proper context.
In the West (by which in this article I broadly mean North America and Europe) the financial community treats gold as an investment. However, of the global pool of gold, which GoldMoney estimates to be about 160,000 tonnes, the amount actually held by western investors in portfolios is a very small fraction of this amount. Furthermore investor behaviour, which in itself accounts for just part of the West’s bullion demand, is sharply at odds with the hoarders’ objectives, which is behind underlying tensions in bullion markets. To compound the problem, analysts, whose focus incorporates portfolio investment theories and assumptions, have very little understanding of the economic case for precious metals, being schooled in modern neo-classical economic theories.
These economic theories, coupled with modern investment analysis when applied to bullion pricing, have failed to understand the growing human desire for protection from monetary instability. The result has for a considerable time been the suppression of bullion prices in capital markets below their natural level of balance set by supply and demand. Furthermore, the value put on precious metals by hoarders in the West has been less than the value to hoarders in other countries, particularly the growing numbers of savers in Asia.
These tensions, if they persist, are bound to contribute to the eventual destruction of paper currencies.
The ownership of gold
The amount of gold bullion that backs investor-driven markets is not statistically recorded, but we can illustrate its significance relative to total stocks by referring back to the time of the oil crisis of the mid-1970s. In 1974 the global stock of gold was estimated to be half that of today, at about 80,000 tonnes. Monetary gold was about 37,000 tonnes, leaving 43,000 tonnes in the form of non-monetary bullion, coins and jewellery. Let us arbitrarily assume, on the basis of global wealth distribution, that two thirds of this was held by the minority population in the West, amounting to about 30,000 tonnes.
This figure probably grew somewhat before the early 1980s, spurred by the bull market and growing fear of inflation, which saw investors buy mainly coins and mining shares. Demand for gold bars was driven by the rapid accumulation of dollars in the oil-exporting nations, as well as some hoarding by wealthy investors from all over the world through Switzerland and London.
The sharp rise in global interest rates in the Volcker era, the subsequent decline of the inflation threat and the resulting bear market for gold inevitably led to a reduction of bullion holdings by wealthy investors in the West. Swiss and other private banks, employing a new generation of fund managers and investment advisors trained in modern portfolio theories, started selling their customers’ bullion positions in the 1980s, leaving very little by 2000. In the latter stages of the bear market, jewellery sales in the West became a replacement source of bullion supply, but this was insufficient to compensate for massive portfolio liquidation.
So by the year 2000, Western ownership of non-monetary gold suffered the severe attrition of a twenty-year bear market and the reduction of inflation expectations. Portfolios, which routinely had 10-15% exposure to gold 40 years ago even today have virtually no exposure at all. Given that jewellery consumption in Europe and North America was only 400-750 tonnes per annum over the period, by the year 2000 overall gold ownership in the West must have declined significantly from the 1974 guesstimate of 30,000 tonnes. While the total gold stock in 2000 stood at 128,000 tonnes, the virtual elimination of portfolio holdings will have left Western holders with little more than perhaps an accumulation of jewellery, coins and not much else: bar ownership would have been at a very low ebb.
Since 2000, demand from countries such as India and more recently China is known to have increased sharply, supporting the thesis that gold has continued to accumulate at an accelerating pace in non-Western hands.
Western bullion markets have therefore been on the edge of a physical stock crisis for some time. Much of the West’s physical gold ownership since 2000 has been satisfied by recycling scrap originating in the West, suggesting that total gold ownership in the West today barely rose before the banking crisis despite a tripling of prices. Meanwhile the disparity between demand for gold in the West compared with the rest of the world has continued, while the West’s investment management community has been actively discouraging investment.
The result has been that nearly all new mine production and Western central bank supply has been absorbed by non-Western hoarders and their central banks. While post-banking crisis there has presumably been a pick-up in Western hoarding, as evidenced by ETF and coin sales and some institutional involvement, it is dwarfed by demand from other countries. So it is reasonable to conclude that of the total stock of non-monetary gold, very little of it is left in Western hands. And so long as the pressure for migration out of the West’s ownership continues, there will come a point where there is so little gold left that futures and forwards markets cease to operate effectively. That point might have actually arrived, signalled by attempts to smash the price this month.
This admittedly broad-brush assessment has important implications for the price stability essential to bullion banks operating in paper markets as well as for central banks attempting to maintain confidence in their paper currencies.
Precious metals in capital markets
In the West itself, the attitudes of the investment community are fundamentally different from even those of the majority of Western hoarders, who are looking for protection from systemic and currency risks as opposed to investment returns. Western investors are generally oblivious to the implications, the most fundamental of which is that falling prices actually stimulate physical demand. Before the recent dramatic slide in prices the investment community undervalued precious metals compared with Western hoarders, let alone those in Asia, encouraging physical bullion to migrate from financial markets both to firmer hands in the West as well as the bulk of it to non-West ownership. There is now irrefutable evidence that these flows have accelerated significantly on lower prices in recent weeks, as rational price theory would lead one to expect.
Pricing bullion is therefore not as simple as the investment community generally believes. It is being put about, mostly on grounds of technical analysis, that the bull markets in gold and silver have ended, and precious metals have entered a new downtrend. The evidence cited is that medium and longer-term moving averages have been violated and are now falling; furthermore important support levels have been breached.
These developments, which arise out of the futures and forward markets, have rattled Western investors who thought they were in for an easy ride. However, a close examination of futures trading shows the bearish case even on investment grounds is flawed, as the following two charts of official statistics provided by weekly Commitment of Traders data clearly show.
The Money Managers category is the clearest reflection in the official data of investor portfolio positions, representing sizeable mutual and hedge funds. In both cases, the number of long contracts is at historically low levels, and shorts, arguably the better reflection of money-manager sentiment, remain close to high extremes. On this basis, investor sentiment is clearly very bearish already, with the investment management community already committed to falling prices. Put very simplistically there are now more buyers than sellers.
Money Managers are in stark opposition to the Commercials, who seek to transfer entrepreneurial risk to Money Managers and other investor and speculator categories. The official statistics break Commercials down into two categories: Producer/Merchant/Processor/User, and Swap Dealers. Both categories include the activities of bullion banks, which in practice supply liquidity to the market. Because investors and speculators tend to run bull positions, bullion banks acting as market-makers will in aggregate always be short. A successful bullion bank trader will seek to make trading profits large enough to compensate for any losses on his net short position that arise from rising prices.
A bullion bank trader must avoid carrying large short positions if in his judgement prices are likely to rise. He will be more relaxed about maintaining a bear position in falling markets. Crucially, he must keep these opinions private, and the release of market statistics are designed to accommodate these dealers’ need for secrecy.
Bullion banks’ position details are disclosed at the beginning of every month in the Bank Participation Reports, again official statistics. They are broken down into two categories, based on the individual bank’s self-description on the CFTC’s Form 40, into US and Non-US Banks. Their positions are shown in the next two charts (note the time scale is monthly).
 
In both gold and silver, the bullion banks have managed to reduce their exposure from extreme net short over the last four months. The reduction of their market exposure suggests that they have been deliberately transferring this risk to other parties, and is consistent with an anticipation that bullion prices will rise. It is the other side of the high level of bearishness reflected in the Money Manager category shown in the first two charts. The bullion banks control the market; the Money Managers are merely tools of their trade.
There has been little reduction in open interest in gold and it has remained strong in silver, because risk has been transferred rather than extinguished. Daily official statistics on open interest are provided by the exchange and summarised in the next two charts (note that data is daily).
 
From these charts it can be seen that recent declines in the gold price are failing to reduce open interest further, and in silver open interest remains stubbornly high. Therefore, attempts by bullion banks to reduce their net short exposure by marking prices down are showing signs of failure.
We can therefore conclude that investor sentiment is at bearish extremes and the bullion banks have reduced their net short exposure to levels where it risks rising again. Therefore the downside for precious metals prices appears to be severely limited, contrary to sentiments expressed by technical analysts and in the media.
This market position is against a background of a growing shortage of physical bullion, which is our next topic.
Physical markets
Casual observers of precious metal prices are generally unaware that the headline writers focus on activity in the futures markets and generally ignore developments in physical bullion. This is consistent with the fact that market data is available in the former, while dealing in the latter is secretive. However, as with icebergs, it is not what you see above the water that matters so much as that which is out of sight below.
It is not often understood in investment circles that gold and silver are commodities for which the laws of supply and demand are not overridden by investor psychology. Therefore, if the price falls, demand increases. Indeed, the increase in demand has far outweighed selling by nervous investors; even before the price-drop, demand for both silver and gold significantly exceeded supply. Evidence ranges from readily available statistics on record demand for newly-minted gold and silver coins and the net accumulation of gold by non-Western central banks, to trade-based information such as imports and exports of non-monetary gold as well as reports from trade associations reporting demand in diverse countries such as India, China, the UK, US, Japan and even Australia.
All this evidence points in the same direction: that physical demand is increasing on every price drop. There is therefore a growing pricing conflict between futures and forward markets, which do not generally involve settlement but the rolling-over of speculative positions, and of the underlying physical metal. Furthermore, analysts make the mistake of looking at gold purely in terms of mining and scrap supply, when nearly all gold ever mined is theoretically available to the market, in the right conditions and at the right price. The other side of this larger coin is that if the price of gold is suppressed by activity in paper markets to below what it would otherwise be, the stimulus for physical demand, being based on a 160,000 tonne market, is likely to be considerably greater on a given price drop than analysts who are myopic beyond 2,750 tonnes of annual mine production might expect. The numbers that are available confirm this to have been the case, particularly over the last few weeks, with reports from all over the world of an unprecedented surge in demand.
This is at the root of a developing crisis of which few commentators are as yet aware. Demand for physical has accelerated the transfer of bullion from capital markets to hoarders everywhere and from the West’s capital markets to other countries, which has been the trend since the oil crisis in the mid-Seventies. This is what’s behind an acute shortage of physical gold in capital markets, explaining perhaps why bullion banks feel the need to reduce their short positions.
While we can detail their exposure in futures markets, meaningful statistics are not available in over-the-counter forward markets, particularly for London, which dominates this form of trading. Forwards are considerably more flexible than futures as a trading medium, generating trading profits, commissions, fees and collateralised banking business. The ability to run unallocated client accounts, whereby a client’s gold is taken onto a bank’s balance sheet, is in stable market conditions an extremely profitable activity, made more profitable by high operational gearing. The result is that paper forward positions are many multiples of the physical bullion available. The extent of this relationship between physical bullion and paper is not recorded, but judging by the daily turnover in London there is an enormous synthetic short physical position. For this reason a sharply rising price would be catastrophic and any drain on bullion supplies rapidly escalates the risk.
Overseeing this market is the Bank of England co-operating with other Western central banks and the Bank for International Settlements, whose combined interest obviously favours price stability. They have been quick to supply the market if needed, confirmed by freely-admitted leasing operations in the past, and by secretive supply into the market, which has been detected by independent supply and demand analysis over the last 15 years. Furthermore, as currency-issuing banks, central banks are unlikely to take kindly to market signals that suggest gold is a better store of value than their own paper money.
We can only speculate about day-to-day interventions by Western central banks in gold markets. In this regard it seems that the slide in prices on the 12th and 15th April was triggered by a very large seller of paper gold; if this market story and the amount mentioned are correct, it can only be central bank intervention, acting to deliberately drive prices lower. Given the market position, with Money Managers in the futures markets already short and highly vulnerable to a bear squeeze, the story seems credible. The objective would be to persuade holders of physical ETFs and allocated gold accounts to sell and supply the market, on the assumption that they would behave as investors convinced the bull market is over.
Conclusions
For the last 40 years gold bullion ownership has been migrating from West to elsewhere, mostly the Middle East and Asia, where it is more valued. The buyers are not investors, but hoarders less complacent about the future for paper currencies than the West’s banking and investment community. There was a shortage of physical metal in the major centres before the recent price fall, which has only become more acute, fully absorbing ETF and other liquidation, which is small in comparison to the demand created by lower prices. If the fall was engineered with the collusion of central banks it has backfired spectacularly.
The time when central banks will be unable to continue to manage bullion markets by intervention has probably been brought closer. They will face having to rescue the bullion banks from the crisis of rising gold and silver prices by other means, if only to maintain confidence in paper currencies. Any gold held by struggling eurozone nations, theoretically available to supply markets as a stop-gap, will not last long and may have been already sold.
This will likely develop into another financial crisis at the worst possible moment, when central banks are already being forced to flood markets with paper currency to keep interest rates down, banks solvent, and to finance governments’ day-to-day spending. Its importance is that it threatens more than any other of the various crises to destabilise confidence in government-backed currencies, bringing an early end to all attempts to manage the others systemic problems.
History might judge April 2013 as the month when through precipitate action in bullion markets Western central banks and the banking community finally began to lose control over all financial markets.
This article was previously published at GoldMoney.com.
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