As stated in the preceding column, here, eminent labor economist Jared Bernstein recently called, in the New York Times, for the dethroning of “King Dollar,” claiming that the reserve currency status of the dollar has cost the United States as many as “six million jobs in 2008, and these would tend to be the sort of high-wage manufacturing jobs.”
Six million is about as many jobs as presidents Bush and Obama together, over 13+ years, created. So this is a big claim. Whether or not one accepts the magnitude of the jobs deficit proclaimed by Dr. Bernstein, reserve currency status comes with heavy costs.
As former president of the Federal Reserve Bank of Dallas Bob McTeer wrote in a Forbes.com column entitled Reserve Currency Status — A Mixed Blessing:
The advantages of reserve currency status for the dollar are well known. The world’s willingness to accumulate dollar reserves in the post World War II period first removed and later reduced the requirement of maintaining balance of payments equilibrium, or, more specifically, current account balance. By removing or weakening this restraint, U.S. policymakers had more freedom than policymakers in other countries to pursue strictly domestic objectives. We ran current account deficits year after year, balanced, or paid for, by capital inflows from our trading partners. The good side of that was that we could import real goods and services for domestic consumption or absorption and pay for them with paper, or the electronic equivalent. In other words, our contemporary standard of living was enhanced by others’ willingness to hold our currency without “cashing it in” for goods and services, or, before 1971, gold.
The bad side of our reserve currency status, although seldom recognized, was that the very leeway that enhanced our current standard of living built up debt (and/or reduced foreign assets) to dangerous levels. I remember well when, in 1985, the United States ceased being a net creditor nation to the rest of the world and, instead, became a net debtor nation. Our net indebtedness has only grown over the years, and hangs over us like the legendary sword of Damocles.
Sword of Damocles? Lehrman, in his Money, Gold, and History states:
[W]hen one country’s currency — the dollar reserve currency of today — is used to settle international payments, the international settlement and adjustment mechanism is jammed — for that country — and for the world. This is no abstract notion. …
The reality behind the “twin deficits” is simply this: the greater and more permanent the Federal Reserve and foreign reserve facilities for financing the U.S. budget and trade deficits, the greater will be the twin deficits and the growth of the Federal government. All congressional, administrative and statutory attempts to end the U.S. deficit have proved futile, and will prove futile, until the crucial underlying flaw — namely the absence of an efficient international settlements and adjustment mechanism — is remedied by international monetary reform inaugurating a new international gold standard and the prohibition of official reserve currencies.
By pinning down the future price level by gold convertibility, the immediate effect of international monetary reform will be to end currency speculation in floating currencies, and terminate the immense costs of inflation hedging. Gold convertibility eliminates the very costly exchange of currencies at the profit-seeking banks. Thus, new savings will be channeled out of financial arbitrage and speculation, into long-term financial markets.
Increased long-term investment and improvements in world productivity will surely follow, as investment capital moves out of unproductive hedges and speculation — made necessary by floating exchange rates — seeking new and productive investments, leading to more quality jobs.
The sobering views expressed by McTeer and by Lehrman more than neutralize Heritage Foundation’s Bryan Riley and William Wilson’s valiant championship of the dollar’s reserve currency status, in opposition to Bernstein. Heritage’s championship is gallant but … unpersuasive.
John Mueller, who served as gold standard advocate Jack Kemp’s chief economist and now as the Ethics and Public Policy Center’s Lehrman Institute Fellow in Economics and Director, Economics and Ethics Program, crisply observes in an interview for this column:
As Kenneth Austin lucidly reminded us, it is a necessity of double-entry bookkeeping that any increase in foreign official dollar reserves equals the increase in combined US current and private capital account deficits. Denying the connection requires magical thinking. The entire decline in the international investment position since 1976 is due to Congress’s borrowing from foreign central banks–that is, the dollar’s official reserve currency role–while the books of private US residents with the rest of the world have remained close to balance.
There are differing schools of thought among the gold standard’s most prominent adherents as to the significance of merchandise deficit account. Their theoretical differences about current accounts are likely to prove, operationally, immaterial.
Both the Forbes and Lehrman schools share mortal opposition to mercantilism. Both passionately oppose the cheapening of the dollar. Both see the gold standard as a critical mechanism to restoring the brisk growth of, as Lehrman termed it, “quality jobs” … and the restoration of median family income growth that began, profoundly, to stagnate with Nixon’s destruction of Bretton Woods.
In this columnist’s own earnest, if much less erudite, view the most significant element of the reserve currency curse derives from how it subtracts capital from the real, e.g. goods and services, economy. Corporate earnings are taken, in return for local currency, into the coffers of the relevant international central bank. That central bank then promptly loans the proceeds directly to the federal government of the United States by purchase of treasury instruments.
The way the world of central banking works thus subverts a process extolled by Adam Smith (in the context of his analysis of the benefits of fractional reserve money) in Wealth of Nations. Smith:
When, therefore, by the substitution of paper, the gold and silver necessary for circulation is reduced to, perhaps, a fifth part of the former quantity, if the value of only the greater part of the other four-fifths be added to the funds which are destined for the maintenance of industry, it must make a very considerable addition to the quantity of that industry, and, consequently, to the value of the annual produce of land and labour.
The mechanics of the reserve currency system preempt these funds’ ready availability for “the maintenance of industry.” The mechanics of the dollar as a reserve asset, therefore, finance bigger government while insidiously preempting productivity, jobs, and equitable prosperity.
This columnist agrees wholeheartedly with Bernstein on what seem his three most important points. The reserve currency status of the dollar causes American workers, and the world, big problems. The exorbitant privilege deserves and demands far more attention than it receives. Moving the dollar away from being the world’s reserve currency would be a great deal easier than many now assume.
Bernstein, in his blog, identifies four mechanisms as “out there” (without explicitly endorsing, or critiquing, them): by legislation (which this columnist views as playing with tariff fire); taxation (thereby “raising the price of currency management,” which this columnist finds hardly an obvious source of job creation); reciprocity (demanding the right to buy foreign treasuries); and an international reserve currency.
Mueller says of Bernstein’s legislative and tax proposals, “you simply can’t solve a monetary problem with a fiscal solution.”
As for reciprocity, the United States Treasury, even under a Joe Biden or even a Bernie Sanders presidency, is never going to turn away ready lenders. This homely truth seems about as self-evident as it gets. Beyond that, even if China were to undertake market-oriented reforms — and, according to the Wall Street Journal, the political winds seem to be blowing the other way just now — the RMB accounts for only 1.64% of global payments. It is not even close to being a power player. Beyond the beyond … it is well beyond dubious to expect international central banks enthusiastically to bulk up on the debt instruments of the People’s Republic of China for the indefinite future.
An “international reserve currency,” however, is a sound proposition if well designed. Proposing SDRs for that role does not hold up. As then-Treasury Secretary Tim Geithner, during a hearing of the House Appropriations Subcommittee on Foreign Operations on March 9, 2011, stated, “There is no risk of the SDR playing that [a reserve currency] role. The SDR is not a currency. It’s a unit of account. And it can’t provide the role that many people aspire to it. There is no risk of that happening.” Mueller, elucidating why this is so, states:
It’s not possible to solve the problems caused by tying other nations’ domestic currencies to one nation’s inconvertible domestic currency (the dollar), by tying them all to a basket of inconvertible domestic fiat currencies–that is, to a subset of themselves. The result has no anchor. And the world economy always gravitates to a single “final asset,” because using several multiplies transactions costs.
There appear to be but two technically plausible ways of getting there. One is Nobel economics laureate Robert Mundell’s proposal of a world currency. The other, of course, represents a sort of “reversion to the mean.” Restore a 21st century international gold standard.
While the gold standard is very unfashionable it by no means is absurd. Then-World Bank Group president Robert Zoellick, in 2010, was dead on when he observed in an FT column that “Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.” About a year later, the Bank of England issued a startling but meticulous white paper demonstrating that the “Federal Reserve Note standard” materially has underperformed, in every area considered, both the Bretton Woods gold-exchange standard and the classical gold standard itself.
As previously referenced in this column Bundesbank president Jens Weidmann, in a 2012 speech, forthrightly stated:
Concrete objects have served as money for most of human history; we may therefore speak of commodity money. A great deal of trust was placed in particular in precious and rare metals – gold first and foremost – due to their assumed intrinsic value. In its function as a medium of exchange, medium of payment and store of value, gold is thus, in a sense, a timeless classic.
The gold standard, notwithstanding Churchill’s not-to-be-repeated 1925 blunder, is in no way a prescription for austerity. The classical gold standard, properly constructed, is a recipe for workers, and median income families, to flourish economically.
We have not flourished, consistently, since its last remnants were destroyed by President Nixon on August 15, 1971. So… what to do?
The first thing to do is to address the important issue, squarely. By shrewdly posing the right question Jared Bernstein has raised the odds, perhaps significantly, that we finally will find our way to the right answer. Getting out of the woods may be no more complicated than following JFK/LBJ economic advisor Walter Heller’s most famous dictum: “Put aside principle and do what’s right.”
Adroitly resolving the reserve currency issue as part of implementing an international reserve currency is far more likely to be fruitful in generating quality jobs, by the millions, than are earnest jeremiads, such as that by Dr. Bernstein himself, that “American political elites have completely failed to understand what the Fed should be doing right now.” Relying on central bankers consistently to get discretionary management right represents a triumph of hope over experience. Or as novelist Rita Mae Brown memorably observed, “insanity is doing the same thing over and over again but expecting different results.”
Let us take Keynes, in The Economic Consequences of the Peace, chapter VI, to heart:
Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. 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. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. … Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.
As Steve Forbes pithily puts it, “You’ve got to get the money right.” Time to lift the reserve currency curse. Time to fix the dollar.
Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/09/30/the-rise-and-fall-and-rise-and-fall-of-king-dollar-part-2/
Dr David Andolfatto, who is Vice President of the St. Louis Fed, has been one of the most forward-looking people at central banks around the world when it comes to crypto-currencies. Here he speaks with Max Rangeley, Editor at The Cobden Centre, and gives his views on what Bitcoin means for commerce, finance, and the dollar itself.
Max: How have you found the reactions to Bitcoin within the Fed?
David: Bitcoin is barely on the radar screen for most Fed researchers and policymakers. This is to be expected, given the large size of the Fed’s balance sheet and the debate over how to conduct monetary policy with the existence of large excess reserves. But I am aware of a small group of researchers scattered throughout the Fed system that seem interested in the Bitcoin phenomenon. Some, like Francois Velde of the Chicago Fed, have written nice primers on the phenomenon. I am also aware of a cryptocurrency workshop that meets monthly at the New York Fed. The reaction of most people (who study it) might be described as “academic agnosticism” in the sense that people are curious, but not enthusiastically in favor or against the idea.
Max: How do you see Bitcoin being used in the future? Do you foresee private currencies being commonly used on the high street alongside state-backed currencies, or remaining largely online phenomena?
David: Who can say how the future will evolve, especially in this space? My best guess is that Bitcoin will find a niche market. It’s cool to use bitcoin to pay for your Starbucks latte on university campuses (this is what my university is doing). It may very well find a place on the high street, at least among some shops catering to the “cool” crowd. But for advanced economies, at least, it is hard to see how consumers will benefit directly by using bitcoins instead of dollars or pounds. As Satoshi Nakamoto wrote in his seminal 2008 paper introducing Bitcoin, “…the [current] system works well enough for most transactions…”
Max: If the use of private currencies became more widespread, do you think that central banks would ever track monetary aggregates in circulation, even if just approximately, much as M2, M3 etc are tracked now?
David: Anything is possible, but I doubt it. One issue is that there many of these “wildcat” currencies, with more appearing every day (every online game has its own currency for example, as do most social media sites). In a sense, these currencies are “local” monies (much like the local currencies that have always existed, like the Ithaca hour, for example). I’m not sure how a statistical agency could keep track of all these little local currencies, or whether it would even be worthwhile to do so. But who knows?
Max: If private currencies were to become widely used around the world, do you think that this could have an effect on the business cycle, since central banks would not have as much control over monetary factors?
David: I do not think it would have much of an effect on the business cycle, which I think is rooted more in “real” and “financial” factors, rather than “monetary” factors, per se.
Max: You mentioned in your presentation on Bitcoin that although supply is fixed, demand can fluctuate significantly, which causes volatility, would you say this is a weakness inherent in private currencies, or is there the possibility that algorithms could evolve to incorporate a degree of elasticity?
David: Remember that Bitcoin is *more* than a private currency: it is a payment system and monetary policy with *no trusted intermediary* involved. Most private currencies entail the use of trusted third parties. EVE online, for example, an online game founded in 2003 has evidently managed its money supply in a manner that keeps its value relatively stable. It may be possible to code an “elastic money supply” rule in the Bitcoin protocol, but it is not immediately clear to me how this might work. Injecting new money into the system would be easy. The tricky part would be in how to destroy money (having the algorithm debit Bitcoin wallets that are secured by private keys).
Max: You mentioned that you welcome the competition for central banks; if private currencies became widely used, could it chip away at American supremacy, a degree of which is based on the dollar, the so-called “exorbitant privilege”?
David: In my view, America supremacy is not based on the dollar. The status of the dollar simply reflects American supremacy, which is based fundamentally on the structure of that economy (something “real” not “monetary”). The America dollar already faces stiff competition from a variety of alternative candidates, including the Yen, the Euro, and gold. If gold cannot displace the USD, why would we expect Bitcoin to?
The Wall Street Journal, recently, in The Return of the Greenback, observed that “the resurgent dollar has logged its longest winning streak in 17 years, rising against a broad basket of currencies for nine straight weeks.” This has led to, perhaps irrational, exuberance from supply side titans Larry Kudlow and Steve Moore.
Cheapening the dollar is a bad thing, unequivocally. It does not necessarily follow that making the dollar dearer is a good thing. And there is a frequently unnoticed factor at work: the dollar’s status as the world reserve currency. Dr. Jared Bernstein, senior fellow with the Center on Budget and Policy Priorities, and, previously, chief economist to Vice President Biden and executive director of the White House Task Force on the Middle Class, boldly claims that the dollar’s reserve currency status has cost America 6 million jobs. This is a startling, and potentially important, claim.
We live in a world monetary system that makes the U.S. dollar its official reserve currency. About 60% of international central bank reserves are Yankee dollars. Some, both right and left, in America and abroad, consider the reserve currency status of the dollar a bug in the software of our world monetary system. Getting this fixed is, in the opinion of some consequential thinkers, of capital importance for the generation of quality jobs, and equitable prosperity, in America and the world.
The reserve currency status of the dollar, particularly as a potential factor in wage stagnation, has profound political implications. Dispirited voters yearn for leadership that actually understands how to get the economic tide to lift all boats again. Notwithstanding his promotion of some marked policy differences with this columnist, this columnist says three cheers for Dr. Bernstein for squarely pushing the reserve currency question into play.
Dr. Bernstein stirred up a healthy argument in an August New York Times op-ed entitled Dethrone ‘King Dollar.’ Bernstein:
[T]he new research reveals that what was once a privilege is now a burden, undermining job growth, pumping up budget and trade deficits and inflating financial bubbles. To get the American economy on track, the government needs to drop its commitment to maintaining the dollar’s reserve-currency status.
Bernstein draws on an interesting, and thoughtful, paper by economist Kenneth Austin in The Journal of Post Keynesian Economics. Austin dramatically illustrates the explosion of international dollar reserves and explores the possible significance to our economy. Bernstein performs a signal public service by placing this into the policy discourse. Bernstein:
Mr. Austin argues convincingly that the correct metric for estimating the cost in jobs is the dollar value of reserve sales to foreign buyers. By his estimation, that amounted to six million jobs in 2008, and these would tend to be the sort of high-wage manufacturing jobs that are most vulnerable to changes in exports.
Bernstein’s proposal drew a tart riposte at Café Hayek from Don Boudreaux and another from the Heritage Foundation’s Daily Signal by Bryan Riley and William Wilson.
Shortly after Bernstein’s proposed dethroning of ‘King Dollar’ Larry Kudlow and Steve Moore, in their NRO column, joyfully celebrated The Return of King Dollar:
[W]hen the dollar crashed in the 1970s — especially relative to gold — the economy collapsed into a crippling stagflation. From 1999 to 2009, the dollar index dropped by almost 40 percent, with only a brief surge between 2004 and 2006. The economy and wages were sluggish at best.
The relationship between a strong currency and prosperity is lost on the many nations that adhere to the mercantilist model whereby a devalued currency supposedly gives a country a competitive edge by making exports cheaper. …
Kudlow and Moore deserve praise for their opposition to cheapening the dollar. That said, cheering on a “strong” dollar intellectually is akin to calling for a longer inch or a heavier ounce as a recipe to — magically — make us richer.
No. What is needed is a high integrity, meticulously defined, dollar.
A dollar at the mercy of a freelancing Fed, subject to being whipsawed in value, up or down, is a barrier to commerce. Money, by definition, is a medium of exchange, a store of value and — not be overlooked — a unit of account. There are many empirical data tending to show that only by meticulously maintaining the definition of the unit — for example, by defining the dollar by grains of gold and making it legally convertible thereunto — can good job creation, and equitable prosperity, consistently be achieved.
There is a deep, fascinating, historical context. It extends even to the use of the regal metaphor. Therein rests an irony wrapped in a controversy inside some history.
The history? Keynes employed a regal metaphor (applied to gold rather than currency) in his 1930 tract Auri Sacra Fames in which he writes
… gold, originally stationed in heaven with his consort silver, as Sun and Moon, having first doffed his sacred attributes and come to earth as an autocrat, may next descend to the sober status of a constitutional king with a cabinet of Banks….
The irony? Keynes explicitly mistrusted the Fed. Keynes did not wish to endow the U.S. Federal Reserve with the power that, under then-prevailing circumstances which no longer need apply, a return to the gold standard would have entailed. Keynes, in his 1923 essay, Alternative Aims In Monetary Policy:
It would be rash in present circumstances to surrender our freedom of action to the Federal Reserve Board of the United States. We do not yet possess sufficient experience of its capacity to act in times of stress with courage and independence. The Federal Reserve Board is striving to free itself from the pressure of sectional interests; but we are not yet certain that it will wholly succeed. It is still liable to be overwhelmed by the impetuosity of a cheap money campaign.
Keynes expressed wariness of the risk of currency depreciation (better known as inflation). Sure enough, eventually the Federal Reserve indeed became “overwhelmed by the impetuosity of a cheap money campaign.” The Fed cheapened its product — Federal Reserve Notes — by 85% since 1971 (and by about 95% since the Fed’s inception).
A dollar today is worth a 1913 nickel and a 1971 nickel and dime. This gives a whole new meaning to the phrase “nickeled and dimed to death.”
Cheapening of money is very bad for business. It is really, really, terrible for labor. Ron Paul, call your office: Keynes proved quite right to be dubious about the Fed.
Why do so few of the economists who exalt Keynes share his tough-mindedness toward the Fed? Why do so few grasp the irony of their mesmerized adulation of an institution with such a mediocre (and sometimes catastrophic) track record? Many acorns have fallen far from the tree.
One of the factors in play involves one of the standard tropes of mercantilism, to which Kudlow and Moore allude: the intentional depreciation of a national currency to gain unfair trade advantage. This is what classically was called a “beggar-thy-neighbor” policy. The neighbor, in this instance, is America. Forbes Media chairman, and Editor-in-Chief, Steve Forbes, and Forbes.com columnist Nathan Lewis, both gold standard advocates, are zealous critics of mercantilism (as is this columnist).
Steve Forbes (with Elizabeth Ames) in their recent book Money: How the Destruction of the Dollar Threatens the Global Economy and What We Can Do About It observes:
The neo-mercantilists of the twentieth century may have thought that floating exchange rates would allow countries to correct perceived imbalances with their rivals and bolster their domestic economies. But the monetary system they created was more volatile than the one they had destroyed, with balance harder than ever to achieve.
The turmoil of the post-Bretton Woods era is what sent European nations scurrying for the shelter of a stable currency, setting the stage for the euro. The explosion of currency trading it has wrought has become a huge source of fees for banks. It has helped produce the market swings and giant windfalls so decried by Occupy Wall Street and others. In this dangerous world, monetary policy is deployed as a frequent weapon, nearly always with destructive consequences.”
Nathan Lewis writes, in his Forbes.com column Keynes and Rothbard Agree: Today’s Economics is Mercantilism:
All of today’s premier economic policies, notably monetary manipulation and floating fiat currencies, attempts to “manage the economy” via government deficit spending, and the never-ending concern over “imbalances” in trade, are straight-up Mercantilism.
We really won’t make much progress in our economic understanding until this is recognized. The entirety of today’s Mercantilist agenda should be discarded; first, at an intellectual level, and then at the level of public policy. Britain did this, and went from an economic backwater overshadowed by tiny Holland, to the birthplace of the Industrial Revolution and the center of the largest empire of the nineteenth century.
Forbes and Lewis are skeptical about the power of manipulating currency to achieve trading advantage. The intramural dispute among gold standard advocates around the current account, however, is of mostly academic significance. The respective camps respectfully agree as to most of the disorders caused by paper money. They agree that the remedy to our “Little Dark Age” of wage stagnation lies in the definition of the dollar by gold.
Businessman/scholar Lewis E. Lehrman, founder and chairman of the Lehrman Institute (whose monetary policy website this columnist professionally edits) too is an outspoken critic of mercantilism. Lehrman is the leader of a group of thinkers influenced by the works of his mentor Jacques Rueff, influential French monetary official, public intellectual (Mont Pelerin society member), and iconic classical gold standard advocate.
As for the unjustly obscure Rueff, keen monetary observer Robert Pringle, author of The Money Trap states in his influential blog of the same name:
[Rueff] would have predicted the Global Financial Crisis and economic catastrophe of the past seven years – and would certainly have attributed it to the absence of an international monetary system worth the name. He would have been equally critical of the flawed construction of the euro.
He saw that the globalizing trading regime was fundamentally at odds with mercantilist monetary and exchange rate policies: one aspired to universality and openness, the other pointed to particularization and separation.
More generally, monetary nationalism, unleashed by the absence of a global standard for money, is inconsistent with a liberal order.
Reserve currency status of the dollar, the more emphatically when the dollar is not defined by and redeemable in a fixed weight of gold, is a form of monetary nationalism inconsistent with a liberal order. And according to Bernstein reserve currency status also is costing millions of jobs.
What are some of the costs of the “exorbitant privilege” as the dollar’s reserve currency status was called by then finance minister of France Valery Giscard d’Estaing? Ought now America to give the exorbitant privilege a gold watch and send it into retirement?
To be continued.
Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/09/29/the-rise-and-fall-and-rise-and-fall-of-king-dollar-part-1/
Just over three weeks ago, in his keynote address to the Global Corporocracy at the so-called ‘Summer Davos’ meeting in Tianjin, Li Keqiang firmly stated that: ‘…we [have] focused more on structural readjustment and other long-term problems, and refrained from being distracted by the slight short-term fluctuations of individual indicators.’
He went on to downplay the fetish for the 7.5% GDP number, saying that ‘…we believe the actual economic growth rate is within the proper range, even if it is slightly higher or lower than the… target.’
As if that were not clear enough, Finance Minister Lou Jiwei rather spoiled Madame Lagarde’s infrastructure orgy at the Sep 20th weekend G20 meeting in Australia when he pointed out that China had already tried the very approach which his Western peers are itching to undertake – and which they hope can be financed by a grab at their citizens’ private pension funds.
Lou pointed out that while the programme may well have provided a short term fillip to ‘growth’, it brought environmental damage, capital misallocation, and dangerously increased indebtedness in its train. As if that were not enough of an ‘ice bucket challenge’ for his audience of panting Keynesians, he reiterated Li’s diagnosis that his government’s macro-economic policy would ‘continue to focus on the general objectives, in particular to maintain employment growth and price stability’ and that [emphasis added], ‘policy adjustments will not change on a single economic indicator’.
However determinedly deaf certain Occidental wise monkeys were to this pronouncement, Lou’s local market traders certainly took the words to heart: rebar, rubber, and iron ore fell 4% to major new lows in the Monday session, while a whole range of metals, petrochemicals, and others dropped 2% or more. If the impending Golden Week holiday may have been enough to discourage any further initiative selling of the metals over the succeeding few days (steel, iron, rubber, and cotton were NOT similarly spared), nevertheless the verdict was clear: the pain would continue.
Li himself seemed to be resolutely sticking to his guns. In the two policy announcements he has made since his big speech, he has continued to tinker with microeconomic reforms (e.g., liberalizing delivery services) and to enact fiscal measures (notably the introduction of a series of accelerated depreciation measures aimed both at alleviating the current tax burden and at encouraging SMEs to undertake a little more capex in future). Nowhere is there any hint that the regime’s nerve has failed or therefore that the spigots are about to be opened once more.
The latest kite to be flown on this account is the speculation raised by the WSJ that PboC chief Zhou Xiaochuan will be ‘retired’ at the upcoming autumn plenum. Though no confirmation of any sort has been forthcoming so far, we have already been subjected to no shortage of punditry as to the whys and wherefores of the supposed move.
Chief among these have been somewhat conflicting conspiracy theories that his expulsion would represent variously a reassertion of its influence by the factions so far largely being steam-rolled by Xi and, in almost exact opposition to this, a move by Xi to ride himself of a turbulent monetary priest who – wait for it – has proved too reluctant to swamp the ailing economy with the massive amounts of liquidity Xi has now decided is necessary in complete contradiction of the programme he and his team have been pursuing!
Though we have no special insight into this matter, it does strike us as unlikely that Zhou is suddenly now regarded as an enemy – this is, after all, the man whose gravitas and reputation for calm confidence was deemed so valuable to the incoming administration that it deliberately bent the rules concerning the mandatory retirement of top officials in order to keep him in his post. It seems far more probable, therefore, that if the personnel change is indeed to be affected – and the fulsome encomium to this ‘wise old sage’ which was carried in all the main outlets over the weekend rather diminishes the prospect – his baton would be passed on to someone of like mind. Several commentators have already noted that this may well be the case if the go-to man tipped to be his successor, Guo Shuqing, actually does get the nod.
Whether the incumbent stays or goes, however, the very fact that the mere rumour of his departure was enough to have the stimulus junkies drooling that their itch for the next fix would soon be assuaged is revealing of the parlous state to which we have all been reduced in our QEternity, Goldilocks world of an utter reliance on the foibles of central bank heads to determine where we should place our next bets, to the exclusion of all other factors.
Giving this crowd some brief hope, the PboC did in fact adjust the repo rate lower and also offered (in its usual, frustratingly opaque manner) a CNY500 billion injection of funds to the five biggest state-owned banks even though this may have been no more than a partial offset to the ongoing lack of foreign exchange accumulation – of especial significance now that the CBRC has clamped down on end-period deposit hunting – and/or a timely assist aimed at preventing the IPO flood from dampening a rekindled enthusiasm for stocks.
The realisation that the country’s current afflictions might not be susceptible of alleviation in the time-honoured Yellen-Draghi fashion seems to be spreading. With the capital market queue for bank refinancing now said to stretch to CNY600 billion and with the count of bad and doubtful loans rising rapidly (if still hugely understated), the lenders seem to have a somewhat different focus than that of showering credit on each and every would-be borrower.
Nor are borrowers beating down their doors, at least according to the results of the central bank’s latest quarterly survey. This has loan demand falling below the lows of 2012, so no wonder the monthly data dump shows the pace of increase in yuan loans on bank books dropping to the lowest levels of the past eight years. No wonder either when, as CASS academician Yu Yongding told an audience at Tsinghua University, a recent NBS survey found that lending rates for the average SME was no less than 25.1% annualized.
The combination of usurious rates and burgeoning liabilities (especially accounts receivable which are up more than 14% yoy) means that financing costs for SOEs are rising at a rate of 16.7% p.a. (as the MOF tells us), while those for joint-stock enterprises are growing 14.4%, and for the usually more profitable HK, Macau & Taiwanese owned-firms at no less than 27.2%, so says the NBS. The Chinese Enterprise Confederation also reported that the top 205 state-owned manufacturing companies’ income margin was a mere 1.8% this past year, while that for their 295 private counterparts was a less than stellar 2.8% (for comparison, over the past 4 ½ years, US manufacturers have returned an average of 10.6¢ pre- and 8.7¢ after-tax on each $1 of sales).
Would you be borrowing more in a decelerating economy if these were your business metrics?
Reflecting all this on the macro side, Want China Times reported that, with several Chinese provinces finding it ‘hard’ to reach their GDP numbers, voices are being raised in favour of a lowering of the goalposts (the message naturally being far more important than the medium in Leninist thinking).
Recall here that the official spin keeps emphasizing both the long-term nature of the shift to the ‘New Normal’ (which one unnamed cynic dared to translate as ‘recession’!) and continually pleads the medium-term difficulties associated with the ‘Three Overlay’ constellation – viz., the problems of changing the emphasis from the quantity to the quality of output; the ‘structural’ shift away from investment and toward consumption as the focus of future development; and the tribulations of eliminating (‘digesting’ in Newspeak) some of the excess capacity and crippling debt levels built up during the ‘stimulus’ the Party unleashed in the attempt to combat the effects of the financial crisis.
Significantly, at the grandly titled ‘2014 Co-prosperity Capital Wealth Summit’ held on Sunday, former NBS chief economist and State Department advisor Yao Jingyuan opined that this baleful cyclical conjunction would last for another three to five years. Simultaneously, Shengsong Cheng of the central bank pointed out – in what may be the first serious attempt at disassociating the regime from its previous expectational anchor – that if China were to grow at no more than 6.7% p.a. over the remainder of the decade, the desideratum of doubling the size of the economy over the whole of that ten year stretch would still have been achieved. It would also seriously embarrass many of the Sinomaniacs’ determinedly bullish projections.
As Want China Times also wrote, besides the growing shortfalls in Jiangsu, Shandong, Shanxi, Heilongjiang, Hunan, and Guangdong provinces, Shenzhen is labouring under the burden of a fall in two-way trade volumes of 28% over the first seven months of the year in addition to a 60% plunge in newly constructed real estate.
As 21st Century Herald has pointed out, the upshot has been that many local governments are trimming outlays, dipping into reserves, and even indulging in asset fire-sales in order to stem the fiscal haemorrhage. Even then, in order to meet revenue goals, resort has been made to a neat, fraudulent round-robin whereby local businesses borrow the money with which to pay fictional taxes and then recoup the outlay in the form of phony subsidies, rebates, and contracts. An official at one northern city admitted that up to 15% of his authority’s budget consisted of such shenanigans but that in certain county governments the padding amounted to 30% of the total. No wonder the expansion of bank balance sheets is having so little effect on genuine activity.
Further to the regional tale of woe, the local stats bureau made it known that even mighty Shanghai’s industries saw an actual drop in the value of output of 2.5% yoy in August, figures which represent a truly stunning reversal from June’s +7.1 gain and the first half’s overall increase of +4.4%.
Meanwhile, the CISA reported that implied steel consumption has failed to grow so far this year for the first time in the new millennium. No surprise then that rumours continue to swirl about the possible CNY10’s of billions involved in the potential bankruptcy of Sinosteel. Likewise, Reuters reported that ‘sources at the country’s major oil companies have predicted that China’s diesel consumption is set to post its first decline in more than a decade.’ How much of even that is real demand is another moot point given that SAFE has just announced the identification of $10 billion in fake cross-border transactions in a scandal which has progressively widened out from the initial Qindao port incident to encompass no less than 24 separate provinces and cities thus far.
Globally, the impact is being felt in the bellwether chemical industry. As the American Chemistry Council noted, there was a ‘worrying’ slide in operating rates during what is typically the seasonally strong second quarter. Things have not improved much since. Q2. The ACC showed Germany dropping from 4.8% growth in February to a fall of 3.5% in August. India crashed from +12.9% in January to +3.4% in August. Japan fell from +9.2% in March to just +0.8% in August. Mexico went from 1% growth in April to -2.8% and Russia slowed from +4.2% in January to -10.4% last month.
Only one major country managed to maintain a relatively strong growth level. You may not be surprised to learn that this stalwart was China, where output peaked at +11.1% in April, was still a strong +8.8% four months later. Why the anomaly? No real mystery: the country has swung from being a net importer of bulk chemicals to being a net exporter, much as it has in refined oil products and also in some metals. No-one dare utter the word, ‘dumping’!
All of this is a sharp contrast to the first stages of Chinese expansion when the country purchased large quantities of raw and semi-processed items – without much regard to their cost – either to employ them in building out its own industries and infrastructure (as Mr Lou pointed out) or to incorporate – along with a range of other bought-in, more sophisticated components – into finished-goods exports bound for Western consumers who were borrowing a goodly portion of the necessary invoice amounts.
Nowadays, many of those foreign customers are either unwilling or unable add any more to their slate, while the prevailing quest for China’s factory owners is to find some way of more profitably utilising some of the vast overcapacity they have built up in the interim.
One consequence is that, even allowing for possible distortions in the data, it is clear that things are running no where near as hot as they once were. Taking the five years to the peak of the last cycle, Chinese industrial corporations enjoyed compound annual revenue growth of over 25% and profit growth of 37%. Fast forward and since the end of 2012, earnings growth and – perhaps even more tellingly – revenues are up by a much lesser 10% or so. Not a basis on which to be too gung-ho on further capital outlays, nor one in which double-digit rises in wage costs can continue to be blithely accommodated.
At the largest of scales, evidence of this change can also be found. During the whole of the two decades before Crash, world trade volumes rose at 7.2% a year, compounded: since the start of 2011, that pace has slowed to a tardy 2.0%, meaning that now, some six years on from the Snowball Earth episode, we are only at three quarters of the level we would have attained had the crisis not intervened. And, as we know, all this is closely related in a complex web of cause-and-effect to the rate global money growth. That latter is facing its own challenges given that the ongoing steep rise in the dollar reduces the effective global heft of the monies being emitted by just about everyone other than the Chinese themselves with their similarly-soaring currency.
In passing, economic turmoil may be one thing with which the leadership has to contend, but the upsurge of violence in Xinjiang – where up to 50 people were reported killed during a bomb attack on two Luntai police stations – and the rather more peaceful, if no less weighty, street protests in HK – with their uncomfortable echoes of East European ‘Colour’ revolutions – are another matter entirely.
All told, the Chinese CCP and its new leaders have some sizeable challenges to overcome in the months ahead.
If there is one concept that illustrates the difference between a top-down macro-economic approach and the reality of everyday life it is the velocity of circulation of money. Compare the following statements:
“The collapse in velocity is testament to the substantial misallocation of capital brought about by the easy money regimes of the past 20 years.” Broker’s research note issued September 2014; and
“The mathematical economists refuse to start from the various individuals’ demand for and supply of money. They introduce instead the spurious notion of velocity of circulation according to the pattern of mechanics.” Ludwig von Mises, Human Action.
This article’s objective is not to disagree with the broker’s conclusion; rather it is to examine the basis upon which it is made.
The idea of velocity of circulation referred to arose from the quantity theory of money, which links changes in the quantity of money to changes in the general level of prices. This is set out in the equation of exchange. The basic elements are money, velocity and total spending, or GDP. The following is the simplest of a number of ways it has been expressed:
Amount of Money x Velocity of Circulation = Total Spending (or GDP)
Assuming we can quantify both money and total spending, we end up with velocity. But this does not tell us why velocity might vary: all we know is that it must vary in order to balance the equation. You could equally state that two completely unrelated quantities can be put into a mathematical equation, so long as a variable is included whose only function is to always make the equation balance. In other words the equation of exchange actually tells us nothing per se.
This gives analysts a problem, not resolved by the modern reliance on statistics and computer models. The dubious gift to us from statisticians is their so-called progress made in quantifying the economy, so much so that at the London School of Economics a machine called MONIAC (monetary national income analogue computer) used fluid mechanics to model the UK’s economy. This and other more recent computer models give unwarranted credence to the idea that the economy can be modelled, derivations such as velocity explained, and valid conclusions drawn.
Von Mises’s criticism is based on the philosopher’s logic that economics is a social and not a physical science. Therefore, mathematical relationships must be strictly confined to accounting and not be confused with economics, or as he put it human action. Unfortunately we now have the concept of velocity so ingrained in our thinking that this vital point usually escapes us. Indeed, the same is true of GDP, or the right hand side of the equation of exchange.
GDP is only an accounting identity: no more than that. It ranks gin with golf-balls by reducing them both to a monetary value. Statisticians select what’s included so it is biased in favour of consumer goods and against capital investment. Crucially it does not tell us about an ever-changing economy comprised of successes, failures, and hard-to-predict human needs and wants, which taken all together is economic progress. And because it is biased in its composition and says nothing about progress the value of this statistic is grossly exaggerated.
The only apparent certainty in the equation of exchange is the quantity of money, assuming it is all recorded. No one seems to allow for unrecorded money such as shadow banking, but we shall let that pass. If the money is sound, as it was when the quantity theory of money was devised, one could assume that an increase in its quantity would tend to raise prices. This was experienced following Spain’s importation of gold and silver from the new world in the sixteenth century, and following the gold mining booms in California and South Africa. But relating an increase in the quantity of gold to prices in general is at best a summary of a number of various factors that drive the price relationship between money and goods.
Today we no longer have sound money, whose purchasing power was regulated by human preferences across national boundaries. Instead we have fiat currencies whose purchasing power is formalised in foreign exchanges. When the Icelandic krona on 8th October 2008 halved in value, it had nothing to do with changes in the quantity of money or Iceland’s GDP. Yet if we try to interpret velocity in this case, we will find ourselves pleading a special case to explain its substantial increase as domestic prices absorbed the shock imparted through the foreign exchanges.
Iceland’s currency collapse is not an isolated event. The purchasing power of a fiat currency varies constantly, even to the point of losing it altogether. The truth of the matter is the utility of a fiat currency is entirely dependent on the subjective opinions of individuals expressed through markets, and has nothing to do with a mechanical quantity relationship. In this respect, merely the potential for unlimited currency issuance or a change in perceptions of the issuer’s financial stability, as Iceland discovered, can be enough to destabilise it.
According to the equation of exchange, this is not how things should work. The order of events is first you have an increase in the quantity of money and then prices rise, because monetarist logic states that prices rise as a result of the extra money being spent, not as a result of money yet to be spent. With a mechanical theory there can be no room for subjectivity.
It is therefore nonsense to conclude that velocity is a vital signal of some sort. Monetarism is at the very least still work-in-progress until monetarists finally discover velocity is no more than a factor to make their equation balance. The broker’s analyst quoted above would have been better to confine his statement to the easy money regimes of the past 20 years being responsible for the substantial misallocation of capital, and leaving out the bit about velocity entirely.
A small slip perhaps on the way to a sensible conclusion; but it is indicative of the false mechanisation of human behaviour by modern macro-economists. However it should also be noted that is impossible to square the concept of velocity of circulation with one simple fact of everyday life: we earn our salaries once and we dispose of it. That’s a constant velocity of roughly one.
The U.S. financial system faces a major, growing, and much under-appreciated threat from the Federal Reserve’s risk modeling agenda—the “Fed stress tests.” These were intended to make the financial system safe but instead create the potential for a new systemic financial crisis.
The principal purpose of these models is to determine banks’ regulatory capital requirements—the capital “buffers” to be set aside so banks can withstand adverse events and remain solvent.
Risk models are subject to a number of major weaknesses. They are usually based on poor assumptions and inadequate data, are vulnerable to gaming and often blind to major risks. They have difficulty handling market instability and tend to generate risk forecasts that fall as true risks build up. Most of all, they are based on the naïve belief that markets are mathematizable. The Fed’s regulatory stress tests are subject to all these problems and more. They:
- ignore well-established weaknesses in risk modeling and violate the core principles of good stress testing;
- are overly prescriptive and suppress innovation and diversity in bank risk management; in so doing, they expose the whole financial system to the weaknesses in the Fed’s models and greatly increase systemic risk;
- impose a huge and growing regulatory burden;
- are undermined by political factors;
- fail to address major risks identified by independent experts; and
- fail to embody lessons to be learned from the failures of other regulatory stress tests.
The solution to these problems is legislation to prohibit risk modeling by financial regulators and establish a simple, conservative capital standard for banks based on reliable capital ratios instead of unreliable models. The idea that the Fed, with no credible track record at forecasting, can be entrusted with the task of telling banks how to forecast their own financial risks, displacing banks’ own risk systems in the process, is the ultimate in fatal conceits. Unless Congress intervenes, the United States is heading for a new systemic banking crisis.
[Editor's Note: the full document published by the Cato Institute can be found here]
“Sir, So Ed Miliband “forgot” to mention the deficit. This from a man who was a key member of the team that ran up a massive structural debt pile when the UK should have been enjoying a cyclical surplus. He was part of a Labour administration that took the UK economy to the brink of effective bankruptcy. Yet less than five years on, as we still struggle to deal with the toxic mess that he and his colleagues left behind, he “forgot” to mention it. This surely ranks alongside “the dog ate my homework” for feeble and unbelievable excuses for non-performance of basic required tasks.”
“Politicians and diapers have one thing in common. They should both be changed regularly, and for the same reason.”
It should be striking that government bonds, in nominal terms, have never been this expensive in history, even as there have never been so many of them. The laws of supply and demand would seem to have been repealed. How could this state of affairs have come about ? We think the answer is three-fold:
The bond market is clearly not perfectly efficient.
Bond yields are being manipulated by central banks through a deliberate policy of financial repression (and QE, of course).
Many bond fund managers may be unaware, or unconcerned, that the benchmarks against which they choose to be assessed are illogical and irrational.
What might substantiate our third claim ? It would be the festering intellectual plague that bedevils the fund management world known as indexation. Bond indices allocate their largest weights to the most indebted issuers. This is the precise opposite of what any rational bond investor would do – namely, to overweight their portfolio according to those issuers with the highest credit quality (or perhaps, all things being equal, with the highest yields). But bond indices do exactly the opposite. They force any manager witless enough to have fallen victim to them to load up on the most heavily indebted issuers, which currently also happen to offer amongst the puniest nominal yields. As evidence for the prosecution we cite the US Treasury bond market, the world’s largest. The US national debt currently stands at $17.7 trillion. With a ‘T’. Benchmark 10 year Treasuries currently offer a yield to maturity of 2.5%. US consumer price inflation currently stands at 1.7%. (We offer no opinion as to whether US CPI is a fair reflection of US inflation.) On the basis that US “inflation” doesn’t change meaningfully over the next 10 years, US bond investors are going to earn an annualised return just a smidgen above zero percent.
How do US Treasury yields stack up against the longer term trend in interest rates ? The following data are from @Macro_Tourist:
10 year US Treasury yields since 1791
The chart shows the direction of travel for US market rates since independence, given that the Continental Congress defaulted on its debts.
Now it may well be that US Treasury yields have further to fall. As SocGen’s Albert Edwards puts it,
“Our ‘Ice Age’ thesis has long called for sub-1% bond yields and I see this extending to the US and UK in due course.”
As things stand, the trend is with the polar bears. The German bond market has already broken down through the 1% level (10 year Bunds at the time of writing currently trade at 0.98%).
Deutsche Bank Research – specifically Jim Reid, Nick Burns and Seb Barker – recently published an extensive examination of global debt markets (“Bonds: the final bubble frontier ?” – hat tip to Arnaud Gandon of Heptagon Capital). Deutsche’s strategists ask whether bonds constitute the culminating financial bubble after almost two decades of them:
“After the Asian / Russian / LTCM crises of the late 1990s we entered a supercycle of very aggressive policy responses to major global problems. In turn this helped encourage the 2000 equity bubble, the 2007 housing / financial / debt bubble, the 2010-2012 Euro Sovereign crisis and arguably some recent signs of a China credit bubble (a theme we discussed in our 2014 Default Study). At no point have the imbalances been allowed a full free market conclusion. Aggressive intervention has merely pushed the bubble elsewhere. With no obvious areas left to inflate in the private sector, these bubbles have now arguably moved into government and central bank balance sheets with unparalleled intervention and low growth allowing it to coincide with ultra-low bond yields.” [Emphasis ours.]
The French statesman George Clemenceau once commented that war is too important to be left to generals. At this stage in the game one might be tempted to add that monetary policy is far too important to be left to politicians and central bankers. We get by with free markets in all other walks of economic and financial life – why let the price of money itself be dictated by a handful of State-appointed bureaucrats ? We were once told by a fund manager (a Japanese equity manager, to be precise – rare breed that that is now), around the turn of the millennium, that Japan would be the dress rehearsal, and that the rest of the world would be the main event. Again, the volume of the mood music is rising in SocGen’s favour.
We nurse no particular view in relation to how the government bond bubble (for it surely is) plays out – whether yields grind relentlessly lower for some time yet, or whether they burst spectacularly on the back of the overdue return of bond market vigilantes or some other mystical manifestation of long-delayed economic common sense. But Warren Buffett himself once said that,
“If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”
The central bank bond market poker game has been in train for a good deal longer than half an hour, and the stakes have never been higher. Sometimes, if you simply can’t fathom the new rules of the game, it’s surely better not to play. So we’re not in the business of chasing US Treasury yields, or Gilt yields, or Bund yields, ever lower – we’ll keep our bond exposure limited to only the highest quality credits yielding the highest possible return. Even then, if Fed tapering does finally dissipate in favour of Fed hiking – stranger things have happened, though we can’t think of any off the top of our head – it will make sense at the appropriate time to eliminate conventional debt instruments from client portfolios almost entirely.
But indexation madness is not limited to the world of bonds. Its malign, unthinking mental slavery has fixed itself upon the equity markets, too. Equity indices, as is widely acknowledged, allocate their largest weights to the largest and most expensive stocks. What’s extraordinary is that even as stock markets have powered ahead, index trackers have enjoyed their highest ever inflows. The latest IMA data show that more UK retail money was put into tracker funds in July than in any other month since records began. We accept the ‘low cost’ aspect of tracker funds and ETFs; we take serious issue with the idea of buying stock markets close to or at their all-time high and being in for any downside ride on a 1:1 basis.
But there is a middle way between the Scylla of bonds at all-time low yields and the Charybdis of stocks at all-time high prices. Value. Seth Klarman of the Baupost Group once wrote as follows:
“Stock market efficiency is an elegant hypothesis that bears quite limited resemblance to the real world. For over half a century, disciples of Benjamin Graham, the intellectual father of value investing, have prospered buying bargains that efficient market theory says should not exist. They take advantage of the short-term, relative performance orientation of other investors. They employ an absolute (not relative) valuation compass, patiently exploiting mispricings while avoiding overpaying for what is popular and trendy. Many are willing to concentrate their exposures, knowing that their few best ideas are better than their hundredth best, and confident in their ability to tell which is which.
“Value investors thrive not by incurring high risk (as financial theory would suggest), but by deliberately avoiding or hedging the risks they identify. While efficient market theorists tell you to calculate the beta of a stock to determine its riskiness, most value investors have never calculated a beta. Efficient market theory advocates moving a portfolio of holdings closer to the efficient frontier. Most value investors have no idea what this is or how they might accomplish such a move. This is because financial market theory may be elegant, but it is not particularly useful in formulating a successful investment strategy.
“If academics espousing the efficient market theory had no influence, their flawed views would make little difference. But, in fact, their thinking is mainstream and millions of investors make their decisions based on the supposition that owning stocks, regardless of valuation and analysis, is safe and reasonable. Academics train hundreds of thousands of students each year, many of whom go to Wall Street and corporate suites espousing these beliefs. Because so many have been taught that outperforming the market is impossible and that stocks are always fairly and efficiently priced, investors have increasingly adopted strategies that eventually will prove both riskier and far less rewarding than they are currently able to comprehend.”
That sounds about right to us. Conventional investing, both in stocks and bonds on an indexed or benchmarked basis, “will prove both riskier and far less rewarding” than many investors are currently able to comprehend.
The US Federal Reserve can keep stimulating the US economy because inflation is posing little threat, Federal Reserve Bank of Minneapolis President Kocherlakota said. “I am expecting an inflation rate to run below 2% for the next four years, through 2018”, he said. “That means there is more room for monetary policy to be helpful in terms of … boosting demand without running up against generating too much inflation”.
The yearly rate of growth of the consumer price index (CPI) stood at 1.7% in August against 2% in July and the official target of 2%. According to our estimate the yearly rate of growth of the CPI could close at 1.4% by December. By December next year we forecast the yearly rate of growth of 0.6%.
It seems that the Minneapolis Fed President holds that by boosting the demand for goods and services by means of an additional monetary pumping it is possible to strengthen the economic growth. He believes that by means of strengthening the demand for goods and services the production of goods and services will follow suit. But why should it be so?
If by means of monetary pumping one could strengthen the economic growth then it would imply that by means of monetary pumping it is possible to create real wealth and generate an everlasting economic prosperity.
This would also mean that world wide poverty should have been erased a long time ago, after all most countries today have central banks that possess the skills of how to pump money. Yet world poverty remains intact.
Despite the massive monetary pumping since 2008 and the policy interest rate of around zero Fed policy makers seem to be unhappy with the so-called economic recovery. Note that the Fed’s balance sheet, which stood at $0.86 trillion in January 2007 jumped to $4.4 trillion by September this year – a monetary pumping of almost $4 trillion.
We suggest that there is no such thing as an independent category called demand. Before an individual can exercise demand for goods and services he/she must produce some other useful goods and services. Once these goods and services are produced individuals can exercise their demand for the goods they desire. This is achieved by exchanging things that were produced for money, which in turn can be exchanged for goods that are desired. Note that money serves here as the medium of the exchange – it produces absolutely nothing. It permits the exchange of something for something. Any policy that results in monetary pumping leads to an exchange of nothing for something. This amounts to a weakening of the pool of real wealth – and hence to reduced prospects for the expansion of this pool.
What is required to boost the economic growth – the production of real wealth – is to remove all the factors that undermine the wealth generation process. One of the major negative factors that undermine the real wealth generation is loose monetary policy of the central bank, which boosts demand without the prior production of wealth. (Once the loopholes for the money creation out of “thin air” are closed off the diversion of wealth from wealth generators towards non-productive bubble activities is arrested. This leaves more real funding in the hands of wealth generators – permitting them to strengthen the process of wealth generation i.e. permitting them to grow the economy).
Now, the artificial boosting of the demand by means of monetary pumping leads to the depletion of the pool of real wealth. It amounts to adding more individuals that take from the pool of real wealth without adding anything in return –an economic impoverishment.
The longer the reckless loose policy of the Fed stays in force the harder it gets for wealth generators to generate real wealth and prevent the pool of real wealth from shrinking.
Finally, the fact that the yearly rate of growth of the CPI is declining doesn’t mean that the Fed’s monetary pumping is going to be harmless. Regardless of price inflation monetary pumping results in an exchange of nothing for something i.e. an economic impoverishment.
“We look to Scotland for all our ideas of civilisation.” –Voltaire
In the face of nearly universal warnings from other nations, including England, the Scots have taken a pause from their legendary bravery to vote against full independence from the United Kingdom. Yet given the evident financial and monetary failures of most major developed economies in recent years, not only the UK, the Scots should take full advantage of the greater autonomy already promised by Westminster. In this report, I present a plan, inspired by the ‘Scottish Enlightenment’ of the 18th century, that would enable the Scots, probably in less than six years, to become the most prosperous Anglosphere region in the world. It won’t be easy, but then the easy isn’t for the brave.
who needs independence anyway?
The Scots may have shied away from decisive action on this particular occasion, but to paraphrase Shakespeare, “Independence is the undiscovered country.” Like death, it can be rather intimidating. But then the Scots, including their cousins the Scots-Irish, once settled the New World in vast numbers—an act of supreme bravery if ever there was—and played a critical role in the formation of the United States. This role included providing the bulk of the militia that would fight and eventually vanquish the formidable British army and their Hessian mercenaries.
There was another critical role played by the Scots in the 18th century, however, a rather more civilised one to be sure. This was the intellectual movement known as the ‘Scottish Enlightenment’, to which belonged prominent philosophers such as David Hume and the father of so-called ‘classical’ economics, Adam Smith. These ideas, in particular that of Scottish ‘Common Sense Realism’, would provide much of the basis for the original, Jeffersonian political culture of the United States, as documented by Alexis de Tocqueville, among others.
The US founding documents, including the Declaration of Independence—drafted by Jefferson—and the Constitution, are replete with Enlightenment concepts, including those of Natural Law; the centrality of commerce in society; private property rights; individual responsibility and the essential but limited role of government. Associated documents such as the Federalist Papers elaborate on the official documents, making the Enlightenment associations more obvious.
While not a term used in any of the above, the concept of ‘lasseiz faire’ economics, associated with Adam Smith’s famous ‘invisible hand’ of the marketplace, in time became a commonplace explanation for the astonishing prosperity of the young United States. Indeed, notwithstanding notable exceptions, such as the two Banks of the United States and a handful of national infrastructure projects, the US government remained but a tiny part of the national economy prior to the exigencies brought about by the Civil War. Even thereafter, the US government remained small in comparison with that of most European countries. Indeed, the US government had almost zero debt and financed itself almost entirely though excise taxes (eg customs duties) until the creation of the Federal Reserve and introduction of the federal income tax in 1913.
THE ORIGINAL SCOTTISH SUCCESS STORY
It is perhaps no coincidence that, given the prominence of Scots in early American commerce, culture and politics, and the English dejection at losing the Colonies, Scotland would emerge as the most important trading partner of the US in the early 19th century. Glasgow soon became the world’s largest shipyard and due to associated local advances in engineering and science, it has as strong a claim as any city in the world to being the heart of the industrial revolution that would eventually sweep the globe. This was no doubt assisted by the ‘Scottish Diaspora’ of engineers, scientists, skilled tradesmen and businessmen of all stripes.
This astonishing success can be repeated again with sufficient home rule autonomy, as has already been promised by Westminster. Scotland need only reach back into its own past for guidance in order to secure a prosperous future and, quite possibly, overtake not only England but the entire Anglosphere world. The most important ingredients for success can be broken down into six essential elements.
SIX SCOTTISH ELEMENTS FOR SUCCESS WITHIN SIX YEARS
The Scots’ legendary bravery is equalled by legendary parsimony, the first essential element of success. There is no growth without investment and no sustainable investment without savings. It stands to reason that you aren’t a parsimonious society if you carry around a massive, accumulating national debt. Debt service is also a drag on future growth. Thus if the Scots want to prosper long-term, they are going to need to pay down their share of the UK national debt.
Of course, this is easier said than done. It is also highly preferable to pay down debt out of a growing rather than stagnating income. Thus the key to successful debt reduction is strong growth, which to be sustainable requires strong private investment, the next essential element.
Although parsimonious with respect to consumption, the Scots were once great investors. As mentioned above, Glasgow and the Scottish Lowlands generally have as strong or stronger a claim than the English Midlands as the heart of the industrial revolution, the most rapid accumulation of productive capital in recorded human history. But how could the Scots best facilitate investment today?
There are several policies that would quickly create an investment boom. Most important, Scotland should do better than celtic rival Ireland, with a low corporate tax rate, and abolish the corporate income tax altogether. Yes, you read that right: The effective corporate income tax in many countries now approaches zero anyway, due to all manner of creative cross-border accounting. But while it might be creative, international tax arbitrage accounting is also expensive. Corporations the world over would far prefer to put clever employees to work on real productive activities, if possible, rather than on elaborate accounting schemes requiring constant updating, a dead-weight loss for their customers who pay higher prices as a result.
For those concerned about the tax revenue implications of a zero corporate tax rate, don’t be. What is not paid by corporations in tax is eventually paid out in profits (dividends). Those can be taxed instead, as ordinary income like anything else, thereby simplifying the local personal income tax, which ideally should be a flat amount, say 20%, prepared on a single sheet of paper once a year. So not only will corporations want to relocate to and invest in Scotland; skilled workers will be attracted by the only ‘One-Rate, One-Page’ personal income tax in the entire Anglosphere. Already resident Scots will benefit most from the associated general expansion of the domestic labour market.
Another tax policy that would both attract global investment and simplify things would be to tax capital gains at the same flat rate as on ordinary income. Capital gains are really nothing more than deferred investment income anyway, so by leaving the interim income untaxed, a huge incentive to save is created, thereby providing for the domestic savings required to fund the high investment rates enabling strong and sustainable growth.
As for other taxes, there is much more that Scotland could do to attract investment and support healthy, sustainable growth. Willie Walsh, CEO of BA, has suggested the Scots might sharply reduce duties on airfares. This would have the effect of re-routing much transcontinental air traffic, including profitable connecting flights, from congested London area airports to Scotland.
Developing human capital, at which the Scots excelled in the 19th century, is the third element. Consider which industries are most likely to relocate to Scotland: Those requiring neither natural resources nor extensive industrial infrastructure, that is, those comprised primarily of human capital. Although financial services comes to mind, there is tremendous overcapacity in this area in England and Ireland, including in unproductive yet risky activities, so that is better left to the English and Irish for now. Better would be to concentrate on health care, for example, an industry faced with soaring costs and stifling regulation in much of the world.
Scotland could, inside of six years, become the world’s premier desination for so-called ‘healthcare tourism’. Scotland lies directly under some of the world’s busiest airline routes, an ideal location. Medical professionals from all over the world would be attracted by the zero tax rates on their small businesses and low tax rates on paid-out profits, passing much of the savings along to their patients. In turn, patients from all over the world would travel to Scotland, attracted by the low cost and high quality of healthcare. To further lower costs, the Scots could leverage off their strong legal traditions to reduce opaque malpractice liability disputes to a minimum, thereby making certain that the healthcare industry remains centred around doctors, nurses and patients, rather than lawyers, regulators and bureaucrats, as has become the case in the US, for example.
By attracting much global healthcare talent, Scotland could easily become the leading global location for medical research, development, training and education. Healthcare could thus provide the 21st century equivalent of Scottish shipbuilding in the 19th: A central industry that, in turn, facilitated the development of many other associated industries.
No doubt, in addition to Healthcare and Air Transport, at a minimum a handful of other industries would take advantage of sensible Scottish tax policies. Software firms, nearly devoid of anything other than human capital, would almost certainly respond. Film makers and artists of all stripes would be enticed by the low tax rates on their creative productions. Accountancy and business services firms would follow all of the above.
A fourth essential element to success is to implement Scottish Enlightenment principles for sound banking. This is of utmost importance due to the potential monetary and financial instability of the UK and much of the broader Anglosphere.
As a first step, Scotland should forbid any bank from conducting business in Scotland if they receive any direct financial assistance from the Bank of England or from the UK government. In turn, Scotland should make clear to Westminster that Scottish residents will not contribute to any taxpayer bail out of any UK financial institution. No ‘lender of last resort’ function will exist for financial activities in Scotland, unless such action, if formally requested by a bank, is approved by the Scots in a referendum. (Taxpayers are always on the hook for bailouts one way or the other; why not make this explicit?) The Scots deserve to make any bank bailout decision for themselves, should they deem it necessary or desirable, rather than leave it to an unelected bureaucracy easily captured by the financial industry, as appears to be the case with the Bank of England and the US Federal Reserve.
How then will banks operating in Scotland be perceived as safe and credible institutions? Well, the old-fashioned Scottish way: They will capitalise themselves sufficiently so that investors and depositors will consider their investments and deposits to be secure under all reasonable scenarios. Yes, this implies a high cost of capital and low financial leverage, which in turn imply that bank profitability will be very low. But the Scottish future should not belong to economic financialisation, rather in real, productive activities. Finance should serve the economy, not the other way around.
The fifth element reaches particularly deep into Scottish history: Self-Reliance. Peoples that inhabit relatively inhospitable or infertile lands tend to establish cultures with self-reliance at the core. No, this does not make them culturally backward, but it does tend to contribute to a distrust of foreign or central authority. The Scots, while brave, were frequently disunited in their opposition to English rule, something that had unfortunate consequences for many, not just William Wallace.
While disunity may not be effective in the face of foreign invasion and occupation, there are few who argue that modern governance structures in most developed economies, including the EU, have not become inefficiently over-centralised in recent decades. The Scottish independence movement is not merely a local phenomenon. There are peoples throughout the EU seeking greater local autonomy. The Belgian Flemings have been at it for years. The elder Catalonians have memories of the Spanish Civil War. Various regional organisations in northern Italy have pressed for degrees of independence from Rome. And anti-EU sentiment, in general, has been on the rise over the past decade, even before so-called ‘austerity’ set in post-2008.
Local government tends to be more responsive and accountable to the citizenry, in particular a culturally self-reliant one not tolerant of abuses. More efficiency and effectiveness in government is the result. Decentralisation and self-reliance, together with the adoption of modern communications technologies will make it possible for Scotland, in a short time, to serve as a governance model for others to emulate.
Finally, there is the sixth element: the collective cultural traditions of Scottish Presbyterianism. There are few religions in the world that hold not only faith, but hard work, thrift and charity in such high regard as that of traditional Presbyterianism. Yes, as with most all Europeans, the Scots have become more secular in recent decades. But the same could be said of the Germans, who nevertheless cling to their own, solid Protestant work ethic and associated legal and moral anti-corruption traditions.
The charitable tradition is misinterpreted by some to support a unique form of Scottish socialism, but this contradicts the core Presbyterian concept of man’s direct relationship with God. Presbyterianism holds that to work hard, to be thrifty, to be charitable, is to do God’s work and thus all three can be understood as forms of worship in their own right. However, genuine faith in God, genuine worship, cannot somehow be coerced by a central authority. It must be left to the individual, through their direct relationship to God, to find enlightenment, albeit with the strong support and influence of the local community. To put it somewhat humorously, a Presbyterian minister might say to a Scottish socialist: “Jesus told YOU to help the poor, not to create some centralised government bureaucracy to coerce others into doing so on your behalf!”
Nowhere in the developed world today is private charity taken so seriously as in the United States. Notwithstanding certain wayward cultural traits of modern America, active private charity remains an integral part of the society. This is without doubt a legacy of Presbyterian cultural tradition: Limited government yes, but with limited government comes far greater private and personal responsibility to help the poor or otherwise needy in the community.
So in the home-ruled Scotland of the future, in which self-reliance reasserts itself and government becomes more limited as per Scottish tradition, so the vacuum can be filled by private charitable initiative. This will serve to assist those who struggle to wean themselves off a shrinking public sector safety net, notwithstanding the strong labour market associated with high rates of domestic and foreign investment.
Yes, some Scots might be intimidated by this ambitious six-year plan, notwithstanding its firm rooting in Scottish cultural traditions, the Scottish Enlightenment, and the Scottish industrial revolution. But I’m hopeful that bravery will carry the day, with or without full, formal independence from the UK.
Today’s financial markets are built on the sand of unsound currencies. Consequently brokers, banks and investors are wedded to monetary inflation and have lost both the desire and ability to understand gold and properly value it.
Furthermore governments and central banks in welfare-driven states see markets themselves as the biggest threat to their successful management of the economy, a threat that needs to be tamed. This is the backdrop to the outlook for the price of gold today and of the forces an investor in gold is pitted against.
At the heart of market control is the substitution of unsound currency for sound money, which historically has been gold. Increasing the quantity of currency and encouraging banks to increase credit out of thin air is the principal means by which central banks operate. No matter that adulterating the currency impoverishes the majority of the population: central banks are working from the Keynesian and monetarist manual of how to manage markets.
In this environment an investor risks all he possesses if he insists on fighting the system; and nowhere is this truer than with gold. Gold is not about conventional investing in this world of fiat currencies, it is about insurance against the financial system collapsing under the weight of its own delusions. Regarded as an insurance premium against this risk, gold is common sense; and there are times when it is worth increasing your insurance. In taking that decision, an individual must be able to evaluate three things: the relative quantities of currency to gold, the likelihood of a systemic crisis and the true cost of insuring against it. We shall consider each of these in turn.
The relationship of currency to gold
Not only has the quantity of global currency and bank credit expanded dramatically since the Lehman crisis, it is clear that this is a trend that cannot now be reversed without triggering financial chaos. In other words we are already committed to monetary hyperinflation. Just look at the chart of the quantity of US dollar fiat money and note its dramatic growth since the Lehman crisis in 2008.
Meanwhile, the quantity of above-ground stocks of gold is growing at less than 2% annually. Gold is therefore getting cheaper relative to the dollar by the day. [Note: FMQ is the sum of all fiat money created both on the Fed’s balance sheet and in the commercial banks. [See here for a full description]
Increasing likelihood of a systemic crisis
Ask yourself a question: how much would interest rates have to rise before a systemic crisis is triggered? The clue to the answer is illustrated in the chart below which shows how lower interest rate peaks have triggered successive recessions (blue shaded areas are official recessions).
The reason is simple: it is the accumulating burden of debt. The sum of US federal and private sector debt stands at about$30 trillion, so a one per cent rise in interest rates and bond yields will simplistically cost $300bn annually. The increase in interest rates during the 2004-07 credit boom added annual interest rate costs of a little over double that, precipitating the Lehman crisis the following year. And while the US this time might possibly weather a two to three per cent rise in improving economic conditions, much less would be required to tip other G8 economies into financial and economic chaos.
The real cost of insurance
By this we mean the real price of gold, adjusted by the rapid expansion of fiat currency. One approach is to adjust the nominal price by the ratio of US dollars in circulation to US gold reserves. This raises two problems: which measure of money supply should be used, and given the Fed has never been audited, are the official gold reserves as reported to be trusted?
The best option is to adjust the gold price by the growth in the quantity of fiat money (FMQ) relative to the growth in above-ground stocks of gold. FMQ is constructed so as to capture the reversal of gold’s demonetisation. This is shown in the chart below of both the adjusted and nominal dollar price of gold.
Taken from the month before the Lehman collapse, the real price of gold adjusted in this way is $550 today, based on a nominal price of $1220. So in real terms, gold has fallen 40% from its pre-Lehman level of $920, and has roughly halved from its adjusted high in 2011.
So to summarise:
• We already have monetary hyperinflation, defined as an accelerating debasement of the dollar. And so for that matter all other currencies that are referenced to it are on a similar course, a condition which is unlikely to be halted except by a final systemic and currency crisis.
• Attempts to stabilise the purchasing power of currencies by raising interest rates will very quickly develop into financial and economic chaos.
• The insurance cost of owning gold is anomalously low, being considerably less than at the time of the Lehman crisis, which was the first inkling of systemic risk for many people.
So how is the global economy playing out?
If the economy starts to grow again a small rise in interest rates would collapse bond markets and bankrupt over-indebted businesses and over-geared banks. Alternatively a contracting economy will increase the debt burden in real terms, again threatening its implosion. So the last thing central banks will welcome is change in the global economic outlook.
Falling commodity prices and a flight from other currencies into the dollar appear to be signalling the greater risk is that we are sliding into a global slump. Even though large financial speculators appear to be driving commodity and energy prices lower, the fact remains that the global economy is being undermined by diminishing affordability for goods and services. In other words, the debt burden is already too large for the private sector to bear, despite a prolonged period of zero official interest rates.
A slump was halted when prices collapsed after Lehman went bust; that time it was the creation of unlimited money and credit by the Fed that saved the day. Preventing a slump is the central banker’s raison d’être. It is why Ben Bernanke wrote about distributing money by helicopter as the final solution. It is why we have had zero interest rates for six years.
In 2008 gold and oil prices fell heavily until it became clear that monetary stimulus would prevail. Equities also fell with the S&P 500 Index down 60% from its October 2007 high, but this index was already 24% down by the time Lehman failed.
The precedent for unlimited creation of cash and credit has been set and is undisputed. The markets are buoyed up by a sea of post-Lehman liquidity, are not discounting any trouble, and are ignoring the signals from commodity prices. If the economic downturn shows any further signs of accelerating the adjustment is likely to be brutal, involving a complete and sudden reassessment of financial risk.
This time gold has been in a bear market ahead of the event. This time the consensus is that insurance against financial and systemic risk is wholly unnecessary. This time China, Russia and the rest of Asia are buying out physical bullion liquidated by western investors.
We are being regularly advised by analysts working at investment banks to sell gold. But bear in mind that the investment industry is driven by trend-chasing recommendations, because that is what investors demand. Expecting analysts to value gold properly is as unlikely as farmers telling turkeys the truth about Thanksgiving.