[Editor's Note: The following piece was written exclusively for The Cobden Centre by Axel Kaiser, the Executive Director of think tank Fundacion para el Progresso, based in Santiago. It gives a good outline of how Austrian/free market ideas are developing in South America. Many young people globally are now embracing the ideas of Mises and Hayek, but we are also currently seeing undesirable reactions among many people, who now tragically associate free market ideas with crony capitalism and bailouts for the wealthy in society.]
The Austrian school of economics has gained increasing attention since the 2008 financial crisis and Latin America has not been an exception in this trend. It is mostly young people who have been captivated by the ideas of Hayek, Mises, Rothbard and Huerta de Soto. The most powerful proponents of these ideas in the Spanish-speaking world presently are the Juan de Mariana Institute and the Universidad Rey Juan Carlos in Spain. The first actively participates in the public debate while the second has introduced both a Masters degree and a PhD in Austrian Economics under the leadership of Austrian economist Jesús Huerta de Soto. Many Latin Americans have been trained in the Universidad Rey Juan Carlos and returned to their countries to teach and influence in the public debate.
But there are also several institutions supported by private sponsors that actively promote Austrian economics and classical liberalism in Latin America itself. A remarkable case is Caminos de la Libertad in Mexico. Financed by Ricardo Salinas Pliego, head of the Salinas Group, Caminos de la libertad focuses on educating students in the ideas of liberty. It also organizes the most competitive classical liberal essay contest for scholars in the Spanish-speaking world. Fundación Libertad in Rosario, Argentina is another think tank that advances the Austrian school with great success among young people. Perhaps the most notable case of an institutional effort made to spread classical liberalism and the Austrian school is the Universidad Francisco Marroquín in Guatemala, which was founded entirely on a classical liberal philosophy. Its contributions to the cause of liberty have been considerable in a region dominated by socialist and populist worldviews.
Other important think tanks are CEDICE that does an extraordinary complex work in Venezuela, CREES in the Dominican Republic, IEEP in Ecuador and Fundación para el Progreso in Chile. This last one emerged as a classical liberal reaction against the dramatic rise that socialism and populism experienced over the last years. The Cato Institute has also a special concern with Latin America and permanently finds in these institutions support for organizing the “Cato University”, which brings together students from all over Latin America to learn classical liberalism and fee market economics from leading Latin American scholars.
Despite all these efforts, Latin America at large seems to be moving in the direction of populism and statism. The best and most alarming example is Chile. Long considered a bastion of free market reforms, the country has started a violent departure from the path of progress that followed the last three decades. The hegemony of left-wing and populist ideas has overwhelmed public opinion and caught pro market opinion leaders off guard. If the new statist trend is not stopped on time, the now most prosperous country in the region could follow an Argentinian type of institutional evolution in the next decades that would leave Latin America without a role model on sound economic policy.
Like in Europe and the United States, one of the central causes for the hegemony of statism in Latin America is the fact that most intellectuals and especially university professor are strong supporters of government intervention. This is extremely problematic in countries that are developing and require a wide consensus on policies needed for overcoming poverty. The free market movement in Latin America is still too weak to counterbalance this hegemony and achieve the shift in the intellectual climate of opinion necessary to move towards sound economic policies. It remains to be seen if in the long run the failure of statist ideas will allow once again for change that is desperately needed in the region. It that comes to happen, current pro market think tanks and intellectuals will play a decisive role in shaping the new institutional arrangements and in creating the public support for ensuring their survival.
Axel Kaiser is a Chilean public intellectual, financial columnist and writer dedicated to spreading classical liberalism in Latin America. He is also executive director of the think tank Fundación para el Progreso based in Santiago.
Although it might seem odd for a school of economics to largely ignore the role of money in the economy, this is indeed the case with traditional Keynesian economics. Declaring in 1963 that, “Inflation is, always and everywhere, a monetary phenomenon,” Milton Friedman sought to place money at the centre of economics where he and his fellow Monetarists believed it belonged. Keynesian policies continued to dominate into the 1970s, however, and were blamed by the Monetarists and others for the ‘stagflation’ of that decade—weak growth with rising inflation. Today, stagflation is re-appearing, the inevitable result of the aggressive, neo-Keynesian policy responses to the 2008 global financial crisis. In this report, I discuss the causes, symptoms and financial market consequences of the new stagflation, which could well be worse than the 1970s.
THE GOLDEN AGE OF KEYNESIANISM
During the ‘Roaring 20s’, US economists mostly belonged to various ‘laissez faire’ or ‘liquidationist’ schools of thought, holding that economic downturns were best left to sort themselves out, with a minimal role for official intervention. President Hoover’s Treasury Secretary Andrew Mellon (in)famously represented this view following the 1929 stock market crash when he admonished the government to stay out of private affairs and allow businesses and investors to “Liquidate! Liquidate! Liquidate!”
The severity of the Depression caught much of the laissez faire crowd off guard and thus by 1936, the year John Maynard Keynes published his General Theory, there was a certain open-mindedness around what he had to say, in particular that there was a critical role for the government to play in supporting demand during economic downturns through deficit spending. (There were a handful of prominent economists who did warn that the 1920s boom was likely to turn into a big bust, including Ludwig von Mises.)
While campaigning for president in 1932, Franklin Delano Roosevelt famously painted Herbert Hoover as a lasseiz faire president, when in fact Hoover disagreed with Mellon. As Murray Rothbard and others have demonstrated, Hoover was a highly interventionist president, setting several major precedents on which FDR would subsequently expand. But all is fair in politics and FDR won that election and subsequent elections in landslides.
With the onset of war and the command war economy it engendered, in the early 1940s the economics debate went silent. With the conclusion of war, it promptly restarted. Friedrich von Hayek fired an early, eloquent shot at the Keynesians in 1946 with The Road to Serfdom, his warning of the longer-term consequences of central economic planning.
The Keynesians, however, fired back, and with much new ammunition. Beginning in the early 20th century, several US government agencies, including the Federal Reserve, began to compile vast amounts of economic statistics and to create indices to aggregate macroeconomic data. This was a treasure-trove to Keynesians, who sought quantitative confirmation that their theories were correct. Sure enough, in 1947, a new, definitive Keynesian work appeared, Foundations of Economic Analysis, by Paul Samuelson, that presented statistical ‘proof’ that Keynes was right.
One of Samuelson’s core contentions was that economic officials could and should maintain full employment (ie low unemployment) through the prompt application of targeted stimulus in recessions. As recessions ended, the stimulus should be withdrawn, lest price inflation rise to a harmful level. Thus well-trained economists keeping an eye on the data and remaining promptly reactive in response to changes in key macroeconomic variables could minimise the business cycle and prevent Depression.
For government officials, Samuelson’s work was the Holy Grail. Not only was this a theoretical justification for an active government role in managing the economy, as Keynes had provided; now there was hard data to prove it and a handbook for just how to provide it. A rapid, historic expansion of public sector macroeconomics soon followed, swelling the ranks of Treasury, Commerce, Labor Department and Federal Reserve employees.
CHICAGO AND THE ‘FRESHWATER’ DISSENT
Notwithstanding the establishment of this new economic mainstream and a public sector that wholeheartedly embraced it, there was some dissent, in particular at the so-called ‘freshwater’ universities of the American Midwest: Chicago, Wisconsin, Minnesota and St Louis, among others.
Disagreeing with key Keynesian assumptions and also with Samuelson’s interpretation of historical data, Monetarists mounted an aggressive counterattack in the 1960s, led by Milton Friedman of the Chicago School. Thomas Sargent, co-founder of Rational Expectations Theory, also took part.
The Chicago School disagreed that there was a stable relationship between inflation and employment that could be effectively managed through fiscal policy. Rather, Friedman and his colleagues argued that Keynesians had made a grave error in largely ignoring the role of money in the economy. Together with his colleague Anna Schwarz, Friedman set out to correct this in the monumental Monetary History of the United States, which re-interpreted the Great Depression, among other major events in US economic history, as primarily a monetary- rather than demand-driven phenomenon. Thus inflation, according to Friedman and Schwarz, was “always and everywhere a monetary phenomenon,” rather than a function of fiscal policy or other demand-side developments.
By the late 1960s the dissent played a central role in escalating policy disputes, due primarily to a prolonged expansion of US fiscal policy. Following Keynesian policy guidance, the government responded to the gentle recession of the early 1960s with fiscal stimulus. However, even after the recession was over, there was a reluctance to tighten policy, for reasons both foreign and domestic. At home, President Johnson promised a ‘Great Society’: a huge expansion of various programmes supposedly intended to help the poor and otherwise disadvantaged groups. Abroad, the Vietnam War had escalated into a major conflict and, combined with other Cold War military commitments, led to a huge expansion of the defence budget.
DE GAULLE AND INTERNATIONAL DISSENT
In the early 1960s a handful of prescient domestic observers had already begun to warn of the increasingly inflationary course of US fiscal and monetary policy (Henry Hazlitt wrote a book about it, What Inflation Is, in 1961.) In the mid-1960s this also became an important international topic. Under the Bretton-Woods system, the US was obliged to back dollars in circulation with gold reserves and to maintain an international gold price of $35/oz. In early 1965, as scepticism mounted that the US was serious about sustaining this arrangement, French President Charles De Gaulle announced to the world that he desired a restructuring of Bretton-Woods to place gold itself, rather than the dollar, at the centre of the international monetary system.
This prominent public dissent against Bretton-Woods unleashed a series of international monetary crises, roughly one each year, culminating in President Nixon’s decision to suspend ‘temporarily’ the dollar’s convertibility into gold in August 1971. (Temporarily? That was 43 years ago this month!)
The breakdown of Bretton-Woods would not be complete until 1973, when the world moved formally to a floating-rate regime unbacked by gold. However, while currencies subsequently ‘floated’ relative to one another, they collectively sank in purchasing power. The price of gold soared, as did the price of crude oil and many other commodities.
Rather than maintain stable prices by slowing the growth rate of the money supply and raising interest rates, the US Federal Reserve fatefully facilitated the dollar’s general devaluation
with negative real interest rates. While it took several years to build, in part because Nixon placed outright price controls on various goods, eventually the associated inflationary pressure leaked into consumer prices more generally, with the CPI rising steadily from the mid-1970s. Growth remained weak, however, as the economy struggled to restructure and rebalance. Thus before the decade was over, a new word had entered the economic lexicon: Stagflation.
STAGFLATION IS A KEYNESIAN PHENOMENON
Keynesians were initially mystified by this dramatic breakdown in the supposedly stable and manageable relationship between growth (or employment) and inflation. Their models said it couldn’t happen, so they looked for an explanation to deflect mounting criticism and soon found one: The economy had been hit by a ‘shock’, namely sharply higher oil prices! Never mind that the sharp rise in oil prices followed the breakdown of Bretton-Woods and devaluation of the dollar: This brazen reversal of cause and effect was too politically convenient to ignore. Politicians could blame OPEC for the stagflation, rather than their own policies. But an objective look at history tells a far different story, that the great stagflation was in fact the culmination of years of Keynesian economic policies. To generalise and to paraphrase Friedman, stagflation is, always and everywhere, a Keynesian phenomenon.
Why should this be so? Consider the relationship between real economic activity and the price level. If the supply of money is perfectly stable, then any negative ‘shock’ to the economy may reduce demand, but that will result in a decline rather than a rise in the general price level. The ‘shock’ might also increase certain prices in relative terms, but amidst stable money it simply cannot increase prices across the board, as is the case in stagflation.
They only way in which the toxic stagflationary mix of both reduced growth and rising prices can occur is if the money supply is flexible. Now this does not imply that a flexible money supply is in of itself a Keynesian policy, but deficit spending is far easier with a flexible money supply that can be increased as desired to finance the associated deficits. Yes, this then crowds out real private capital, with negative long-term consequences for economic health, but as we know, politicians are generally more concerned with the short-term and the next election.
CONTEMPORARY EVIDENCE OF STAGFLATION
Contemporary examples provide support for the reasoning above. It is instructive that two large economies, Japan and France, have been chronically underperforming in recent years, slipping in and out of recession. Both run chronic budget deficits in blatant Keynesian efforts to stimulate demand. In Japan, where the money supply is growing rapidly, inflation has been picking up despite weak growth: stagflation. In France, where the money supply has been quite stable, there is price stability: That is merely stagnation, not stagflation.
The UK, US and Germany have all been growing somewhat faster. Following the large devaluation of sterling in 2008, the UK experienced a multi-year surge in prices amidst weak growth, clearly a stagflationary mix. The US also now appears to be entering stagflation. Growth has been weak on average in recent quarters—outright negative in Q1 this year—yet inflation has now risen to 4% (3m annualised rate). Notwithstanding a surge in labour costs this year, the US Fed has, up to this point, dismissed this rise in CPI as ‘noise’. But then the Fed repeatedly made similar claims as CPI began to rise sharply in the mid-1970s.
In Japan, the UK and US, the stagflation is highly likely to continue as long as the current policy mix remains in place. (For all the fanfare surrounding the US Fed’s ‘tapering’, I don’t consider this terribly meaningful. Rates are still zero.) In France, absent aggressive structural reforms that may be politically impossible, the stagnation is likely to remain in place.
Germany is altogether a different story than the rest of these mature economies. While sharing the same, relatively stable euro money supply as France, the price level in Germany is also stable. However, Germany has been growing at a faster rate than most other developed economies, notwithstanding a smaller deficit. This is compelling evidence that Germany is simply a more competitive, productive economy than either the US or UK. But this is nothing new. The German economy has outperformed both the US and UK in nearly every decade since WWII. (Postwar rebuilding provided huge support in the 1950s and 1960s but those days are long past.)
The persistence of German economic outperformance through the decades clearly demonstrates the fundamental economic superiority of what is arguably the least Keynesian set of policies in the developed world. Indeed, Germans are both famed and blamed for their embrace of sound money and fiscal sustainability. ‘Famed’ because of their astonishing success; ‘blamed’ because of, well, because of their astonishing success relative to economic basket cases elsewhere in Europe and around the world. As I sometimes say in jest to those who ‘blame’ the Germans for the economic malaise elsewhere: “If only the Germans weren’t so dammed productive, we would all be better off!”
INVESTING FOR STAGFLATION
Stagflation is a hostile environment for investors. As discussed above, Keynesian policies require that the public sector siphon off resources from the private sector, thereby reducing the ability of private agents to generate economic profits. So-called ‘financial repression’, a more overt seizure of private resources by the public sector, is by design and intent hostile for investors. Regardless of how you choose to think about it, stagflation reveals previously unseen resource misallocations. As these become apparent, investors adjust financial asset prices accordingly. (Perhaps this is now getting under way. The Dow fell over 300 points yesterday.)
The most recent historical period of prolonged stagflation was the 1970s, although there have been briefer episodes since in various countries. Focusing here on the US, although there was a large stock market decline in 1973-4, the market subsequently recovered these losses and then roughly doubled in value. The bond market, by contrast, held up during the first half of the decade but, as stagnation gradually turned into stagflation, bonds sold off and were sharply outperformed by stocks.
That should be no surprise, as inflation erodes the nominally fixed value of bonds. Stock prices, however, can rise along with the general price level along as corporate revenues and profits also rise. It would seem safe to conclude, therefore, that in the event stagflationary conditions intensify from here, stocks will outperform bonds.
While that might be a safe conclusion, it is not a terribly helpful one. Sure, stocks might be able to outperform bonds in stagflation but, when adjusted for the inflation, in real terms they can still lose value. Indeed, in the 1970s, stock market valuations failed to keep pace with the accelerating inflation. Cash, in other words, was the better ‘investment’ option and, naturally, a far less volatile one.
Best of all, however, would have been to avoid financial assets and cash altogether and instead to accumulate real assets, such as gold and oil. (Legendary investors John Exter and John van Eck did precisely this.) The chart below shows the total returns of all of the above and the relative performance of stocks, bonds and cash appears irrelevant when compared to the soaring prices of gold and oil, both of which rose roughly tenfold.
REAL VS NOMINAL ASSETS IN STAGFLATION
(Jan 1971 = 100)
Source: Bloomberg; Amphora
Some readers might be sceptical that, from their current starting point, gold, oil or other commodity
prices could rise tenfold in price from here. Oil at $100/bbl sounds expensive to those (such as I) who remember the many years when oil fluctuated around $20. Gold at $1,300 also seems expensive compared to the sub-$300 price fetched by UK Chancellor Brown in the early 2000s. In both cases, prices have risen by a factor of 4-5x. Note that this is the rough order of magnitude that gold and oil rose into the mid-1970s. But it was not until the late 1970s that both really took off, leaving financial assets far behind.
If anything, a persuasive case can be made that the potential for gold, oil and other commodity prices to outperform stocks and bonds is higher today than it was in the mid-1970s. Monetary policies around the world are generally more expansionary. Government debt burdens and deficits are far larger. If Keynesian policies caused the 1970s stagflation, then the steroid injection of aggressive Keynesian policies post-2008 should eventually result in something even more spectacular.
While overweighting commodities can be an effective, defensive investment strategy for a stagflationary future, it is important to consider how best to implement this. Here at Amphora, we provide investors with an advisory service for constructing commodity portfolios. Most benchmark commodity indices and the ETFs tracking them are not well designed as investment vehicles for a variety of reasons. In particular, they do not provide for efficient diversification and their weightings are not well-specified to a stagflationary environment. With a few tweaks, however, these disadvantages can be remedied, enabling a commodity portfolio to produce the desired results.
CURRENT COMMODITY OPPORTUNITIES
For those inclined to trade commodities actively, and relative to each other, there are an unusual number of opportunities at present. First, grains are now unusually cheap, especially corn. This is understandable given current global weather patterns supportive of high yields, but beyond a certain point producers are fully hedged and/or are considering withholding some production to sell once prices recover. That point is likely now close.
Second, taking a look at tropical products, cotton has resumed the sharp slide that began earlier this year. As is the case with grains, we are likely nearing the point where producer hedging and/or holding out for higher prices will support the price. By contrast, cocoa prices continue their rise and I note that several major chocolate manufacturers have recently increased prices sharply to maintain margins. That is a classic indication that prices are near a peak.
Third, livestock remains expensive. Hog prices have finally begun to correct lower but cattle prices are at record highs. There are major herd supply issues that are not easily resolved in the near-term but consumers are highly price sensitive in the current environment and substitution into pork or poultry products is almost certainly now taking place around the margins. Left to run for awhile, this is likely to place a lid on cattle prices, although I do expect them to remain elevated for a sustained period until herds have had a chance to re-build.
Fourth, following a brief correction lower several weeks ago, palladium prices have risen back near to their previous highs of just under $900/oz. Palladium now appears expensive relative to near-substitute platinum; to precious and base metals generally; and relative to industrial commodities. The primary source of demand, autocatalysts, has remained strong due to auto production, but recent reports of rising unsold dealer inventory in a handful of major countries, including the US, may soon weaken demand. In the event that the fastest growing major auto markets—the BRICS—begin to slow, then a sharp decline in palladium to under $700 is likely.
Finally, a quick word on silver and gold. While both have tremendous potential to rise in a stagflationary environment, it is worth noting that, following a three-year correction, they appear to have found long-term support. Thus I believe there is both near-term and well as longer-term potential and I would once again recommend overweighting both vs industrial commodities.
1Von Mises not only warned of a financial crash and severe economic downturn in 1929; he refused the offer of a prominent position at the largest Austrian bank, Kreditanstalt, around the same time, not wanting to be associated with what he correctly anticipated would soon unfold. A Wall Street Journal article discussing this period in von Mises’ life is linked here.
2A classic revisionist view is that of Murray Rothbard, AMERICAS GREAT DEPRESSION. More recent scholarship by Lee Ohanian has added much additional detail to Rothbard’s work. I briefly touch on this subject in my book and also in a previous Amphora Report, THE RIME OF THE CENTRAL BANKER, linked here.
June’s FMQ components have now been released by the St Louis Fed, and it stands at a record $13.132 trillion. As can be seen in the chart above, it is $5.48 trillion more than an extension of the pre-Lehman crisis exponential growth trend. At this point readers not familiar with the construction of FMQ and its purpose may wish to refer to the original paper, here.
It should be borne in mind that there may be seasonal factors at play, with dips in the growth rate discernable at this time of year in the past. So the slower growth rate of FMQ, up $44bn between April and June when it might have risen $150-200bn, is not necessarily due to tapering of QE3. If tapering was responsible for slowing growth in FMQ, we could expect to see some tightening in short-term interest rates. But as the chart of 3-month T-bill rates shows they have been in a declining trend since last November.
The chart confirms that tapering seems to be having little or no effect on money markets and therefore the growth rate of fiat currency.
Weakness in interest rates is also consistent with poor economic demand. This week the first estimate of Q2 GDP was released which came in at an annualised 4%, substantially above market estimates of 3.1%. This outturn conflicts sharply with the lack of any meaningful demand for money, until one looks at the underlying estimates.
Of this 4% increase, the change in real private inventories added 1.66%. In other words GDP based on goods and services actually sold was only 2.34%. That changes in unsold goods, which is what inventories represent, should be part of final consumption is a dubious proposition, but need not concern us here. According to the technical note accompanying the release, figures for inventories and durable goods (which showed an incredible rise of 14%) are estimated and not hard data, so are subject to future revision. On this basis, the surprise GDP figure is little more than a government econometrician’s guess until the real data is available. Suspicions that these guesses err on the optimistic side are confirmed by the experience of the Q1 GDP figure, which was revised sharply downwards from first estimates when hard data eventually became available.
Whichever way we look at FMQ, it continues to expand at a frightening pace irrespective of the GDP outturn and its flaws. Furthermore, a look at the most recent Fed balance sheet confirms this view, showing that the 1st August figure will be considerably higher, unless there is an offsetting contraction of bank credit.
There is little sign of any such contraction. We can conclude from short-term market interest rates that the US economy is going nowhere fast, contrary to this week’s GDP estimate, and that demand for credit continues to come from essentially financial activities. But given that GDP estimates turn out to be far too optimistic, what if the US economy stalls or even slumps? Won’t that lead to a reversal of FMQ’s growth trend?
This is essentially the argument of the deflationists. In a slump they expect a dash from credit into cash as asset prices tumble. The counterpart of credit is deposits, the major components of FMQ. And without Fed intervention FMQ would rapidly contract. But in the event of a slump the Fed cannot be expected to stand idly by without taking extraordinary measures: in the words of Mario Draghi at the ECB, whatever it takes.
[Editor's note: this piece first appeared on mises.org]
At the time of this writing, Argentina is a few days away from formally defaulting on its debts.How could this happen three times in just twenty-eight years?
Following the 2001 default, Argentina offered a debt swap (a restructuring of debt) to its creditors in 2005. Many bondholders accepted the Argentine offer, but some of them did not. Those who did not accept the debt swap are called the “holdouts.” When Argentina started to pay the new bonds to those who entered the debt swap (the “holdins”), the holdouts took Argentina to court under New York law, the jurisdiction under which the Argentine debt has been issued. After the US Supreme Court refused to hear the Argentine case a few weeks ago, Judge Griesa’s ruling became final.
The ruling requires Argentina to pay 100 percent of its debt to the holdouts at the same time Argentina pays the restructured bonds to the “holdins.” Argentina is not allowed, under Griesa’s ruling, to pay some creditors but not others. The payment date was June 30. Because Argentina missed its payment, it is now under a 30-day grace period. If Argentina does not pay by the end of July it will, again, be formally in default.
This is a complex case that has produced different, if not opposite, interpretations by analysts and policy makers. Some of these interpretations, however, are not well-founded.
How Argentina Became a Bad Debtor
An understanding of the Argentine situation requires historical context.
At the beginning of the 1990s, Argentina implemented the Convertibility Law as a measure to restrain the central bank and put an end to the hyperinflation that took place in the late 1980s. This law set the exchange rate at one peso per US dollar and stated that the central bank could only issue pesos in fixed relation to the amount of US dollars that entered the country. The Convertibility Law was, then, more than just a fixed-exchange rate scheme. It was legislation that made the central bank a currency board where pesos were convertible to dollars at a “one to one” ratio. However, because the central bank had some flexibility to issue pesos with respect to the inflow of US dollars, it is better described as a “heterodox” rather than “orthodox,” currency board.
Still, under this scheme, Argentina could not monetize its deficit as it did in the 1980s under the government of Ricardo Alfonsín. It was the monetization of debt that produced the high inflation that ended in hyperinflation. Due to the Convertibility Law during the 1990s, Carlos Menem’s government could not finance the fiscal deficit with newly created money. So, rather than reduce the deficit, Menem changed the way it was financed from a money-issuance scheme to a foreign-debt scheme. The foreign debt was in US dollars and this allowed the central bank to issue the corresponding pesos.
The debt issued during the 1990s took place in an Argentina that had already defaulted on its debt six times since its independence from Spain in 1816 (arguably, one-third of Argentine history has taken place in a state of default), while Argentina also exhibited questionable institutional protection of contracts and property rights. With domestic savings destroyed after years of high inflation in the 1980s (and previous decades), Argentina had to turn to international funds to finance its deficit. And because of the lack of creditworthiness, Argentina had to “import” legal credibility by issuing its bonds under New York jurisdiction. Should there be a dispute with creditors, Argentina stated it would accept the ruling of New York courts.
Many opponents of the ruling today claim that Argentina’s creditors have conspired to take away Argentine sovereignty, but the responsibility lies with the Argentine government itself, which has established a long record of unreliability in paying its debts.
The Road to the Latest Default
These New York-issued bonds of the 1990s had two other important features besides being issued under New York legal jurisdiction. The incorporation of theparipassu clause and the absence of the collective action clause. The paripassuclause holds that Argentina agrees to treat all creditors on equal terms (especially regarding payments of coupons and capital). The collective action clause states that in the case of a debt restructuring, if a certain percentage of creditors accept the debt swap, then creditors who turn down the offer (the “holdouts”) automatically must accept the new bonds. However, when Argentina defaulted on its bonds at the end of 2001, it did so with bonds that included theparipassu clause but which did not require collective action by creditors.
Under the contract that Argentina itself offered to its creditors, which did not include the collective action clause, any creditor is entitled to receive 100 percent of the bonus even if 99.9 percent of the creditors decided to enter a debt swap. And this is precisely what happened with the 2001 default. When Argentina offered new bonds to its creditors following the default, the “holdouts” let Argentina know that under the contract of Argentine bonds, they still have the right to receive 100 percent of the bonds under “equality of conditions” (paripassu) with those who accepted the restructuring. That is, Argentina cannot pay the “holdins” without paying the “holdouts” according to the terms of the debt.
The governments of Nestor Kirchner and Cristina Kirchner, however, in another sign of their contempt for institutions, decided to ignore the holdouts to the point of erasing them as creditors in their official reports (one of the reasons for which the level of debt on GDP looks lower in official statistics than is truly the case).
It could be said that Judge Griesa had to do little more than read the contract that Argentina offered its creditors. In spite of this, much has been said in Argentina (and abroad) about how Judge Griesa’s ruling damages the legal security of sovereign bonds and debt restructuring.
The problem is not Judge Griesa’s ruling. The problem is that Argentina had decided to once again prefer deficits and unrestrained government spending to paying its obligations. Griesa’s ruling suggests that a default cannot be used as a political tool to ignore contracts at politician’s convenience. In fact, countries with emerging economies should thank Judge Griesa’s ruling since this allows them to borrow at lower rates given that many of these countries are either unable or unwilling to offer credible legal protection to their own creditors. A ruling favorable to Argentina’s government would have allowed a government to violate its own contracts, making it even harder for poor countries to access capital.
We can simplify the case to an analogy on a smaller scale. Try to explain to your bank that since it was you who squandered your earnings for more than a decade,you have the right to not pay the mortgage with which you purchased your home. When the bank takes you to court for not paying your mortgage, explain to the judge that you are a poor victim of evil money vultures and that you have the right to ignore creditors because you couldn’t be bothered with changing your unsustainable spending habits. When the judge rules against you, try to explain to the world in international newspapers how the decision of the judge is an injustice that endangers the international banking market (as the Argentine government has been doing recently). Try now to justify the position of the Argentine government.
[Editor's note: this piece was first published at Zero Hedge, which has had several excellent articles tracking the effusions of the PBOC and their effect on credit markets]
Shortly after we exposed the real liquidity crisis facing Chinese banks recently (when no repo occurred and money market rates surged), China (very quietly) announced CNY 1 trillion of ‘Pledged Supplementary Lending’ (PSL) by the PBOC to China Development Bank. This first use of the facility “smacks of quantitative easing” according to StanChart’s Stephen Green, noting it is “deliberate and significant expansion of the PBOC’s balance sheet via creating bank reserves/cash” and likens the exercise to the UK’s Funding For Lending scheme. BofA is less convinced of the PBOC’s quantitative loosening, suggesting it is more like a targeted line of credit (focused on lowering the costs of funding) and arguing with a record “asset” creation by Chinese banks in Q1 does China really need standalone QE?
China still has a liquidity crisis without the help of the PBOC… (when last week the PBOC did not inject liquidty via repo, money market rates spiked to six-month highs…)
And so the PBOC decided to unleash PSL (via BofA)
The China Business News (CBN, 18 June), suggests that the PBoC has been preparing a new monetary policy tool named “Pledged Supplementary Lending” (PSL) as a new facility to provide base money and to guide medium-term interest rates. Within the big picture of interest rate liberalization, the central banks may wish to have a series of policy instruments at hand, guaranteeing the smooth transition of the monetary policy making framework from quantity tools towards price tools.
PSL: a new tool for base money creation
Since end-1990s, China’s major source of base money expansion was through PBoC’s purchase of FX exchanges, but money created from FX inflows outpaced money demand of the economy. To sterilize excess inflows, the PBoC imposed quite high required reserve ratio (RRR) for banks at 17.5-20.0% currently, and issued its own bills to banks to lock up cash. With FX inflows most likely to slow after CNY/USD stopped its one-way appreciation and China’s current account surplus narrowed, there could be less need for sterilization. The PBoC may instead need to expand its monetary base with sources other than FX inflows, and PSL could become an important tool in this regard.
…and a tool for impacting medium-term policy rate
Moreover, we interpret the introduction of the PSL as echoing the remarks by PBoC Governor Zhou Xiaochuan in a Finance Forum this May that “the policy tool could be a short-term policy rate or a range of it, possibly plus a medium-term interest rate”. The PBoC is likely to gradually set short-term interbank rates as new benchmark rates while using a new policy scheme similar to the rate corridor operating frameworks currently used in dozens of other economies. A medium-term policy rate could be desirable for helping the transmission of short-term policy rate to longer tenors so that the PBoC could manage financing costs for the real economy.
Key features of PSL
Through PSL, the PBoC could provide liquidity with maturity of 3-month to a few years to commercial banks for credit expansion. In some way, it could be similar to relending, and it’s reported that the PBoC has recently provided relending to several policy and commercial banks to support credit to certain areas, such as public infrastructure, social housing, rural sector and smaller enterprises.
However, PSL could be designed more sophisticatedly and serve a much bigger monetary role compared to relending.
First, no collateral is required for relending so there is credit risk associated with it. By contrast, PSL most likely will require certain types of eligible collaterals from banks.
Second, the information disclosure for relending is quite discretionary, and the market may not know the timing, amount and interest rates of relending. If the PBoC wishes to use PSL to guide medium-term market rate, the PBoC perhaps need to set up proper mechanism to disclose PSL operations.
Third, relending nowadays is mostly used by the PBoC to support specific sectors or used as emergency funding facility to certain banks. PSL could be a standing liquidity facility, at least for a considerable period of time during China’s interest rate liberalization.
Some think China’s PSL Is QE (via Market News International reports),
Standard Chartered economist Stephen Green says in a note that reports of the CNY1 trillion in Pledged Supplementary Lending (PSL) that the People’s Bank of China recently conducted in the market smacks of quantitative easing. He notes that the funds which have been relent to China Development Bank are “deliberate and significant expansion of the PBOC’s balance sheet via creating bank reserves/cash” and likens the exercise to the UK’s Funding For Lending scheme. CDB’s balance sheet reflects the transfer of funds, even if the PBOC’s doesn’t.
The CNY1 trillion reported — no details confirmed by the PBOC yet — will wind up in the broader economy and boost demand and “sends a signal that the PBOC is in the mood for quantitative loosening,” Green writes
The impact will depend on whether the details are correct and if all the funds have been transferred already, or if it’s just a jumped up credit facility that CDB will be allowed to tap in stages.
But BofA believes it is more likely a targeted rate cut tool (via BofA)
The investment community and media are assessing the possible form and consequence of the first case of Pledged Supplementary Lending (PSL) by PBoC to China Development Bank (CDB). The planned total amount of RMB1.0tn of PSL is more like a line of credit rather than a direct Quantitative Easing (QE). The new facility can be understood as a “targeted rate cut” rather than QE. We reckon that only some amount has been withdrawn by CDB so far. Despite its initial focus on shantytown redevelopment, we believe the lending could boost the overall liquidity and offer extra help to interbank market. Depending on its timespan of depletion, the actual impact on growth could be limited but sufficient to help deliver the growth target.
Relending/PSL to CDB yet to be confirmed
The reported debut of PSL was not a straightforward one. The initial news report by China Business News gave no clues on many of the details of the deal expect for the total amount and purpose of the lending. With the limited information, we believe the lending arrangement is most likely a credit line offered by PBoC to CDB. The total amount of RMB1.0tn was not likely being used already even for a strong June money and credit data. According to PBoC balance sheet, its claims to other financial institutions increased by RMB150bn in April and May. If the full amount has been withdrawn by CDB, it is equivalent to say PBoC conducted RMB850bn net injection via CDB in June, since CDB has to park the massive deposits in commercial banks. We assess the amount could be too big for the market as the interbank rates were still rising to the mid-year regulatory assessment. The PBoC could disclose the June balance after first week of August, we expect some increase of PBoC’s claims on banks, but would be much less than RMB850bn.
Difference with expected one
In our introductory PSL report, we argue that the operation has its root in policy reform of major central banks. However, we do not wish to compare literally with these existing instruments, namely ECB’s TLTRO or BoE’s FLS. Admittedly, the PBoC has its discretion to design the tailor-made currency arrangement due to the special nature of policy need. However, the opaque operation of PSL will eventually prove it a temporary arrangement and perhaps not serving as an example for other PSLs for its initial policy design to be achieved. According to Governor Zhou, the PSL is supposed to provide a reference to medium-term interest rate, which is missing in today’s case.
The focus is lowering cost of funding
We have been arguing that relending is a Chinese version of QE. Although relending is granted to certain banks, but there is no restriction on how banks use the funding. However, we believe PSL is more than that. The purpose of CDB’s PSL has been narrowed down to shantytown redevelopment, an area usually demands fiscal budget or subsidy in the past. Funding cost is the key to this arrangement.
Indeed, the PBoC has been working hard to reduce the cost of funding in the economy since massive easing is not an option under the increasing leverage of the economy. A currency-depreciation easing has been initiated by PBoC to bring down the interbank rate. Since then the central bank carefully manages the OMO in order to prevent liquidity squeeze from happening. On 24 July, State Council and CBRC have introduced workable measures to reduce funding cost of small and micro-enterprises.
Impact of the lending
PSL is not a direct QE, but there could be some side effect by this targeted lending. PSL to CDB means the funding demand and provision come hand-inhand. Targeted credit easing by nature is a requirement by targeted areas demanding policy support, which could be SMEs, infrastructure or social housing. In this regard, it is not surprising to see more PSL to support infrastructure financing. In addition to the direct impact on those targeted areas, we expect the overall funding cost could benefit from liquidity spillover.
Since the news about PSL with CDB last Monday, we have seen a rally in the Shanghai Composite Index. However we believe multiple factors may have contributed to the rebound in the stock market including: (1) better than expected macro data in 2Q/June and HSBC PMI surprising on the upside leading to improved sentiment; (2) The State Council and the CBRC have introduced measures to reduce funding cost of small and micro-enterprises; (3) More property easing with the removal of home purchase restrictions in several cities. PSL could have contributed to the improved sentiment on expectation of further easing.
Since as we noted previously, China’s massive bank asset creation (dwarfing the US) hardly looks like it needs QE…
As Bank Assets exploded in Q1…
dramatically outpacing the US…
Unless something really bad is going on that needs an even bigger bucket of liquidity.
* * *
So whatever way you look at it, the PBOC thinks China needs more credit (through one channel or another) to keep the ponzi alive. Anyone still harboring any belief in reform, rotation to consumerism is sadly mistaken. One day of illiquidity appears to have been enough to prove that they need to keep the pipes wide open. The question is where that hot money flows as they clamp down (or not) on external funding channels.
Notably CNY has strengthened recently as the PSL appears to have encouraged flows back into China.
* * *
The plot thickened a little this evening as China news reports:
- *CBRC ALLOWS CHINA DEV. BANK TO START HOUSING FINANCE BUSINESS
- *CHINA APPROVES CDB’S HOME FINANCE DEPT TO START BUSINESS: NEWS
Thus it appears the PSL is a QE/funding channel directly aimed at supporting housing. CNY 1 trillion to start and maybe China is trying to create a “Fannie-Mae” for China.
Governments and central banks have made little or no progress in recovering from the Lehman crisis six years ago. The problem is not helped by dependence on statistics which are downright misleading. This is particularly true of real GDP, comprised of nominal GDP deflated by an estimate of price inflation. First, we must discuss the inflation adjustment.
The idea that there is such a thing as a valid measure of price inflation is only true in an econometrician’s imagination. An index which might be theoretically valid at a single point in time is only subsequently valid in the wholly artificial construction of an unchanging, or “evenly rotating economy”: in other words an economy where everyone who is employed remains in the same employment producing at the same rate, retains the same proportion of cash liquidity, and buys exactly the same things in the same quantities. Furthermore business inventory quantities must also be static. All human choice must be excluded for this condition. Only then can any differences in prices be identified as due to changes in the quantity of money and credit. Besides this fiction, an accurate index cannot then be constructed, because not every economic transaction is reported. Furthermore biases are built into the index, for example to overweight consumer spending relative to capital investment, and to incorporate government activity which is provided to users free of cost or subsidised. Buying art, stockmarket investments or a house are as much economic transactions as buying a loaf of bread, but these activities and many like them are specifically excluded. Worse still, adjustments are often made to conceal price increases in index constituents under one pretext or another.
Economic activities are also only selectively included in GDP, which is supposed to be the total of a country’s transactions over a period of time expressed as a money total. A perfect GDP number would include all economic transactions, and in this case would capture the changes in consumer preferences excluded from a static price index. But there is no way of identifying them to tell the difference between changes due to economic progress and changes due to monetary inflation.
To illustrate this point further, let’s assume that in a nation’s economy there is no change in the quantity of money earned, held in cash, borrowed or repaid between two dates. This being the case, what will be the change in GDP? The answer is obviously zero. People can make and buy different products and offer and pay for different services at different prices, but if the total amount of money spent is unchanged there can be no change in GDP. Instead of measuring economic growth, a meaningless term, it only measures the quantity of money spent. To summarise so far, governments are using a price index, for which there is no sound theoretical basis, to deflate a money quantity mistakenly believed to represent economic progress. In our haste to dispense with the reality of markets we have substituted half-baked ideas utilising dodgy numbers. The error goes wholly unrecognised by the majority of economists, market commentators and of course the political classes.
It also explains some of the disconnection between monetary and price inflation. Price inflation in this context refers to the increase in prices due to demand enabled by extra money and credit. As already stated, newly issued money today is spent on assets and financial speculation, excluded from both GDP and its deflator.
It stands to reason that actions based on wrong assumptions will not achieve the intended result. The assumption is that money-printing and credit expansion are not having an inflationary effect, because the statistics say so. But as we have seen, the statistics are selective, focusing on current consumption. Objective enquiry about wider consequences is deterred, and nowhere is this truer than when seeking an understanding of the wider effects of monetary inflation. This leads us to the second error: we ignore the fact that monetary inflation is a transfer of wealth from the public to the creators of new money and credit.
The transfer of wealth through monetary inflation is initially selective, before being distributed more generally. The issuers of new currency and credit are governments and the banks, both of which reap the maximum benefit of utilising them before any prices rise. But the ultimate losers are the majority of the population: by the time new money ends up in wider circulation prices have already risen to reflect its existence.
Everywhere, monetary inflation transfers real wealth from ordinary people on fixed salaries or with savings. In the US for example, since the Lehman crisis money on deposit has increased from $5.4 trillion to $12.9 trillion. This gives us an idea of how much the original deposits are being devalued through monetary inflation, a continuing effect gradually revealed through those original deposits’ diminishing purchasing-power. The scale of wealth transfer from the public to both the government and the commercial banks, which is in addition to visible taxes, is strangling economic activity.
The supposed stimulation of an economy by monetary means relies on sloppy analysis and the ignorance of the losers. Unfortunately, it is process once embarked on that is difficult to stop without exposing the true weakness of government finances and the fragility of the banking system. Governments with the burden of public welfare costs are in a debt trap from which they lack the resolve to escape. The transformation of an economy from no monetary discipline into one based on sound-money principals is widely thought by central bankers to risk creating a major banking crisis. The crisis will indeed come, but it will probably have its origins in the inability of individuals, robbed of the purchasing power of their fixed salaries and savings, to pay the prices demanded from them by businesses. This is called a slump, an old-fashioned term for the simultaneous contraction of production and demand. Not even zero or negative interest rates will save the banks from this increasingly certain event, for a very simple reason: by continuing the transfer of wealth from individuals through monetary inflation, the cure will finally kill the patient.
There is a growing certainty in the global economic outlook that is deeply alarming. The welfare-driven nations continue to impoverish their people by debauching their currencies. As Japan’s desperate monetary expansion now shows, far from improving her economic outlook, she is moving into a deepening slump, for which this article provides the explanation. Unfortunately we are all on the path to the same destructive process.
[Editor's note: the following piece was originally published by World Dollar at zerohedge.com]
In 2003, Jörg Guido Hülsmann, a senior fellow of the Mises Institute, published the essay “Has Fractional-Reserve Banking Really Passed the Market Test?” in a Winter edition of The Independent Review. The key conclusion drawn was that it is the obfuscation of the difference between fractional-reserve IOUs and genuine money titles which preserves the the practice of fractional-reserve banking.
It is the belief of this author that this essay has not received the acclaim that it so richly deserves. Indeed, its implications for the future of money and banking are monumentous. If those who advance the Austrian School of economics, the Mises Institute and Zero Hedge most prominently among them, were to grant its ideas a great renaissance, the worldwide return to sound money may happen far sooner than most could have believed possible.
J.G. Hülsmann explains why “in a free market with proper product differentiation, fractional-reserve banking would play virtually no monetary role” (p.403). The incisive reason given is that genuine money titles are valued at par with money proper, while fractional-reserve IOUs + RP (Redemption Promise) would be valued below par, due to default risk.
Here is the deductive argument being made:
1. Debt (IOUs + RP) is promised money.
2. A promise has the risk of not being kept (default risk).
3. Therefore, promised money, debt (IOUs + RP), is less valuable than genuine money titles (/money proper).
J.G. Hülsmann goes on to explain why the mispricing of fractional-reserve debt (IOUs + RP) persists. The reasons given include the outlawing of genuine money titles and deceptive language (“deposits”). This author would like to add one more reason, namely the myth that the government could actually “guarantee” deposits in the event of a systemic run. Systemic runs mean, by definition, most if not all money proper exiting the fractional reserve banking system, meaning the money proper with which the “guarantees” could be fulfilled doesn’t exist, short of unprecedented levels of new money printing and financial repression. This point is acknowledged on p.22 of the otherwise unexceptional “The Chicago Plan Revisited” by Jaromir Benes and Michael Kumhof.
The history of fractional reserve banking is, then, defined by informational inefficiency. Market participants have failed to reflect the price differential between fractional reserve debt (IOUs + RP) and genuine money titles.
Let us now extend the deductive argument:
4. Therefore, an arbitrage opportunity exists. All holders of Debt (IOUs + RP) have an economic incentive to make the redemption request for genuine money titles (/money proper).
Mervyn King, ex-governor of the Bank of England, once claimed that it is irrational to start a bank run, but rational to participate in one once it has started. While the second part of the claim is correct, the first is not. It is irrational not to start a bank run, due to the arbitrage opportunity that exists.
This, of course, holds the assumption that the market will become informationally efficient, and will therefore capitalise on the mispricing. But the holding of this assumption is only credible if this idea is spread. We live in a time with an unprecedented level of competing voices wanting to be heard, the unfortunate consequence of which is that we drown out the voices that are truly exceptional. It is no exaggeration to say that “Has Fractional-Reserve Banking Really Passed the Market Test?” may prove to be the most revolutionary essay in the history of monetary economics and banking, if only it receives the level of appraisal and promotion it deserves.
On this matter, the reasons given for the persistence of the mispricing of fractional-reserve debt (IOUs + RP) are unsustainable in the long run. The lack of legal protection for genuine money titles is no more than a technicality, for there is nothing in practice that can sustainably prevent the existence of full reserve banks. Awareness that “deposits” are not actually money being held for safekeeping is a matter of educating the public, as is awareness that government’s deposit “guarantees” are not actually credible in the event of a systemic run.
If we assume, then, that fractional-reserve banking will come to its logical ending, there is good reason to believe that the shock will herald the endgame for fiat money. It is in fact the case that all fiat money is the liability of the central bank, which also carries the risk of non-repayment (default risk). This, again, means an arbitrage opportunity for market participants to withdraw the fiat money from the fiat money banking system. This confirms that the original basis for fiat money is destroyed, for its repayment to the central bank is not credible.
Finally, at long last, we have a worldwide return to sound money. Will there be a new 21st century Gold Standard? Will we recourse to cryptocurrencies such as Bitcoin? Will we see the rise of the Equal Opportunity Standard, with everyone in the world being issued once with an equal amount of World dollars? Or will there be another innovation to come? What we must defend, as proud advocates of freedom, is that the free market will decide. That governments finally learn to stop their oppressive, damaging interference with the monetary system.
[Editor's Note: this piece, by Brendan Brown, was first published at mises.org]
First the good news. The House Financial Services Committee has held a hearing on “Legislation to Reform the Federal Reserve on its 100-year Anniversary.” The hearing focused on a bill introduced by Scott Garrett and Bill Huizenga which would require the Fed to provide Congress with a clear rule to describe the course of monetary policy. Now for the bad news. The rule is to be an equation showing how the Fed would adjust interest rates in response to changes in certain economic variables. And the star witness before the committee proposing his own version of such a rule is renowned neo-Keynesian economist, ex-Bush official Professor John B. Taylor.
Inputs into the so-called “Taylor Rule” involve key magnitudes such as “the neutral rate of interest” and “the natural rate of unemployment” as well as the “targeted rate of inflation.” One might have hoped that the Republicans by now would have realized that monetary reform should involve first and foremost jettisoning neo-Keynesian economics. Even the most talented Fed official cannot know the neutral level of interest rates (whether for short, medium, or long maturities) or the natural level of unemployment. And as to inflation targets, these should be scrapped in any monetary reform and replaced by the aim of monetary stability broadly defined to include absence of asset price inflation and a very long-run stable anchor to goods and services prices.
First, Set Interest Rates Free
An essential component of monetary reform should be setting interest rates free. This means no more official pegging or guidance of short-term interest rates and no attempt to manipulate in various ways long-term interest rates. Markets can do a better job of discovering the neutral rates of interest (across different maturities) and positioning market rates at any time relative to these so as to guide the economy along an equilibrium path than any set of well-informed and even well-meaning Fed officials. This is all on the big assumption that the reformers can design a monetary system around a suitable firmly placed pivot.
Under the gold standard the pivot was a fixed price for gold alongside the widespread use of gold coins. And so the amount of high-powered money in the world grew in line with the above ground stock of yellow metal, which occurred at a glacial, but flexible pace. The demand for high-powered money was itself a fairly stable function of income and wealth. And so the system was well-anchored. Yes, there were imperfections, including the advent of fractional-reserve banking which meant that the demand for high-powered money became less stable. Yet given the absence of deposit insurance and too-big-to-fail and only limited lender of last resort roles banks could be counted upon to have a strong demand for reserves (mainly in the form of gold) to back their deposits. Moreover the obligation to convert customers’ deposits into gold coin on request buttressed this demand for high powered money from the banks.
More Steps Toward Proper Reform
As a matter of practical politics the Republican Congressmen may well conclude that an imminent return to gold is unfeasible. But they could consider in the light of these considerations how best to re-secure the pivot to the US monetary system by creating high-powered money for which demand would be stable and the rate of increase in supply flexibly very low. The steps toward this end would include:
· Abolishing the payment of interest on bank reserves.
· Strict curtailment of lender of last resort function.
· Long-term abolition of deposit insurance.
· Fed withdrawal from creating liquidity in debt markets (no more eligible bills, repo-transactions, etc.).
· Issuance of large-denomination notes (adding to the demand for currency, a key component of high-powered money).
· A legal attack on monopoly power in the credit card business which results often in payers of cash not enjoying a discount.
In this suitably reformed system there would be a huge demand for high-powered money (whether in the form of currency or reserves held by the banks) highly distinct in function from any alternative assets. This demand would not depend on legislating artificially high reserve requirements which bank lobbyists would surely whittle down over time. That was the Achilles heel of the briefly successful monetarist experiment in Germany during the 1970s and early 1980s, as the bankers were finally able to bring political pressure toward lowering reserve requirements such that monetary base no longer was a secure pivot to the monetary system. Accordingly, the Bundesbank gradually shifted to explicit pegging of short-term interest rates albeit subject to a medium-term target for wider money supply growth.
Turning back to the US, even with the reforms suggested, there would still be the difficult question of how to determine the growth in supply of high-powered money. Without a gold connection there has to be some degree of discretionary control in this process, albeit constrained by a quantitative guide (such as an average 1 to 1.5-percent rate of expansion per annum, similar to the expansion rate of above ground gold over the past century) and ultimately constitutionally-embedded legal restrictions.
High-powered money as defined by such a monetary reform would be a far cry from the present situation where the size of the Federal Reserve balance sheet has been recording explosive growth for many years and where the main form of high-powered money, excess reserves, pays interest at above the market rate to the banks. The Republicans in their pursuance of monetary reform would do well to propose some initial steps which would prepare the way for bolder change at a later date with the aim of creating a stable supply and demand for high-powered money.
A key step would be the immediate suspension of interest payments on reserves (which only started in 2008) coupled with a rapid timetable for disposing of the Fed’s massive portfolio of long-term fixed-rate bonds. The Bernanke Fed, and now the Yellen Fed, has used this portfolio as a means of manipulating long-term interest rates (with this depending on an emperor’s new clothes effect whereby markets attach unquestioning importance to the Fed’s massive holdings in forming their expectations of bond prices) and of scaring investors into real assets so adding to the strength of their asset price inflation virus injections.
One suggestion for a rapid timetable would be the Treasury and Fed entering into a deal in which the long-term fixed-rate T-bonds held by the Fed would be converted into long-term floating rate debt and into short- or medium-term T-bills. This would mean less accounting profit under the present structure of yields for the Fed and a lower cost of borrowing for the Treasury. But who really cares about such bookkeeping between the federal government and its monetary agency? In turn the Treasury would announce a long-term timetable for raising the ratio of long-maturity fixed to floating rate debt in the overall total outstanding.
Rome was not made in a day. And the Republicans are certainly not in a position to legislate radical monetary reform. But that is no excuse for a careless decision by the would-be reformers to veer into a cul-de-sac under the misleading directions of Professor Taylor.
“By sacrificing quality an investor can obtain a higher income return from his bonds. Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds. While, taken as a whole, they may work out somewhat better in terms of overall return than the first-quality issues, they expose the owner to too many individual risks of untoward developments, ranging from disquieting price declines to actual default.”
They call them ‘junk bonds’ for a reason. They now constitute an offence against linguistic decency: ‘high yield’ no longer even is. Consider the chart below:
BofA Merrill Lynch High Yield Master II Index (spread vs US Treasuries)
(Source: BofA Merrill Lynch, St. Louis Federal Reserve)
(The index in question is a benchmark for the broad high yield bond market.) Not for nothing did the Financial Times report at the weekend that “Retail investors are getting increasingly nervous about high-yield bonds”.
They should also be getting increasingly nervous about government bonds. Consider, first, this chart:
(Source: Thomson Reuters, Credit Suisse)
In the entire history of the UK Gilt market, yields have never been as low. This suggests that Gilt buyers at current levels are unlikely to enjoy an entirely blissful investment experience.
Just to round up this analysis of bond investor hyper-exuberance, consider this last chart, which puts interest rates (in this case, the UK base rate) in their historical context:
UK base rates, 1700 to 2014
(Source: The Bank of England, Church House)
(*The Bank Rate has comprised variously the Bank Rate, Minimum Lending Rate, Minimum Band 1 Dealing Rate, Repo Rate and Official Bank Rate.)
There is one (inverse) correlation in investment markets that is pretty much iron-clad. If interest rates go up, bond prices go down. This is entirely logical, since the coupon payments on bonds are typically fixed. If interest rates rise, that stream of fixed coupon payments loses its relative attractiveness. The bond price must therefore fall to compensate fixed coupon investors. So now ask yourself a question: in what direction are interest rates likely to go next ? Your answer may have some bearing on your preferred asset allocation.
Bond investors may be acting rationally inasmuch as they believe that central banks will keep interest rates “lower for longer”. But even more rational investors are now starting, loudly, to question the wisdom of central banks’ maintenance of emergency monetary stimulus measures, at least five years after the Global Financial Crisis flared up. Speaking at the ‘Delivering Alpha’ conference covered by CNBC, respected hedge fund manager Stanley Druckenmiller commented as follows:
“As a macro investor, my job for 30 years was to anticipate changes in the economic trends that were not expected by others – and therefore not yet reflected in securities prices. I certainly made my share of mistakes over the years, but I was fortunate enough to make outsized gains a number of times when we had different views from various central banks. Since most investors like betting with the central bank, these occasions provided our most outsized returns – and the subsequent price adjustments were quite extreme. Today’s Fed policy is as puzzling to me as during any of those periods and, frankly, rivals 2003 in the late-stages to early-2004, as the most baffling of a number of instances I have in mind. We at Duquesne [Capital Management] were mystified back at that time why the funds rate was one percent with the ‘considerable period’ attached to it, given the vigorous economic growth statistics available at the time. I recall walking in one day and showing my partners a bunch of charts of economics statistics of that day and asking them to take the following quiz: Suppose you had been on Mars the last five years and had just come back to planet Earth. I showed them five charts and I said, ‘If you had to guess, where would you guess the Federal funds rate was?’ Without exception, everyone guessed way north of one percent, as opposed to the policy at the time which was a verbal guarantee that they would stay at one percent for a ‘considerable period of time.’ So we were confident the Fed was making a mistake, but we were much less confident in how it would manifest itself. However, our assessment by mid-2005 that the Fed was fueling an unsustainable housing Bubble, with dire repercussions for the greater economy, allowed our investors to profit handsomely as the financial crisis unfolded. Maybe we got lucky. But the leadership of the Federal Reserve did not foresee the coming consequences as late as mid-2007. And, surprisingly, many Fed officials still do not acknowledge any connection between loose monetary policy and subsequent events..”
“I hope we can all agree that these once-in-a-century emergency measures are no longer necessary five years into an economic and balance sheet recovery. There is a heated debate as to what a ‘neutral’ Fed funds rate would be. We should be debating why we haven’t moved more meaningfully towards a neutral funds rate. If for no other reason, so the Fed will have additional weapons available if the outlook darkens again. Many Fed officials and other economists defend their current policies by claiming the economy is better than it would have been without their ongoing stimulus. No one knows for sure, but I believe that is logical and correct. However, I also believe if you’d asked the same question in 2006 – that the economy was better in 2004 to 2006 than it would have been without the monetary stimulus that preceded it. But was the economy better in total from 2003 to 2010 – without the monetary stimulus that preceded it? The same applies today. To economists and Fed officials who continually cite that we are better off than we would have been without zero rate policies for long, I ask ‘Why is that the relevant policy time frame?’ Five years after the crisis, and with growing signs of economic normalization, it seems time to let go of myopic goals. Given the charts I just showed and looking at economic history, today’s Fed policy seems not only unnecessary but fraught with unappreciated risk. When Ben Bernanke and his colleagues instituted QE1 in 2009, financial conditions in the real economy were in a dysfunctional meltdown. The policy was brilliantly conceived and a no-brainer from a risk/reward perspective. But the current policy makes no sense from a risk/reward perspective. Five years into an economic and balance sheet recovery, extraordinary money measures are likely running into sharply diminishing returns. On the other hand, history shows potential long-term costs can be quite severe. I don’t know whether we’re going to end with a mal-investment bust due to a misallocation of resources; whether it’s inflation; or whether the outcome will actually be benign. I really don’t. Neither does the Fed.”
No more charts. If these three don’t get the message across, nothing will.
The bond environment, ranging from high yield nonsense to government nonsense, is now fraught, littered with uncertainty and unexploded ammunition, and waiting nervously for the inevitable rate hike to come (or bracing for a perhaps messy inflationary outbreak if it doesn’t). There are clearly superior choices on a risk-reward basis; we think Ben Graham-style value stocks are the logical and compelling alternative.
[Editor's Note: We will keep our readers apprised of developments in the exchange between Paul Krugman and The Cobden Centre regular Ralph Benko.]
Professor Paul Krugman, in his New York Times blog last week, says my most recent column, about him, is “funny and scary.” Last week’s column here inferred that Prof. Krugman is leaving Princeton in quiet disgrace. It drew pretty wide attention.
It also drew over 150 comments. Many commentators merrily berated me. (Comes with the territory.) The column, quite flatteringly, even drew a riposte from Prof. Krugman himself, in hisTimes blog, entitled Fantasies of Personal Destruction:
A correspondent directs me to a piece in Forbes about yours truly that is both funny and scary.
Yep, scurrying away with my tail between my legs, I am, disgraced for policy views shared only by crazy people like the IMF’s chief economist (pdf).
One thing I’ve noticed, though, is how many people on the right are drawn to power fantasies in which liberals aren’t just proved wrong and driven from office, but personally destroyed. Does anyone else remember this bit from the O’Reilly scandal?
“Look at Al Franken, one day he’s going to get a knock on his door and life as he’s known it will change forever,” O’Reilly said. “That day will happen, trust me. . . . Ailes knows very powerful people and this goes all the way to the top.”
And people wonder why I don’t treat all of this as a gentlemanly conversation.
English: Paul Krugman at the 2010 Brooklyn Book Festival. (Photo credit: Wikipedia)
Prof. Krugman’s prestige, and the immense influence provided him by the New York Times, gives his opinions enormous political weight. What he writes has impact in liberal, and Democratic, quarters. Yet he by no means is infallible.
The critique this columnist offered drew on commentaries by figures of real stature. One of these is Niall Ferguson, economic historian, Harvard professor (and Senior Research Fellow of Jesus College, Oxford University, and Senior Fellow at the Hoover Institution, Stanford University). The other commentary came from Paul Volcker who made a disparaging comment fairly interpreted as aimed at Prof. Krugman.
What’s really odd about Prof. Krugman’s Fantasies of Personal Destruction is its abrupt segue into likening my critique to a statement made by someone this columnist never met to someone this columnist never met. What could have motivated this non sequitur?
Perhaps some psychological force is at work? Prof. Krugman, echoing a clever critique by Keynes, himself has invoked Freud as key to understanding proponents of the gold standard. Freud,speculating on subconscious associations between excrement and money, referenced the Babylonian doctrine that “gold is the feces of Hell.” Thus, implies Prof. Krugman, proponents of a gold standard are stuck in an infantile “anal-retentiveness.”
Keynes, perhaps not getting it quite right, alludes to Freud in Auri Sacra Fames(September 1930):
Dr. Freud relates that there are peculiar reasons deep in our subconsciousness why gold in particular should satisfy strong instincts and serve as a symbol.
It presumably is this to which Prof. Krugman obscurely alludes in a blog entitled The She-Devil of Constitution Avenue:
I’ve been saying for a long time that we aren’t having a rational argument over economic policy, that the inflationista position is driven by politics and psychology rather than anything the other side would recognize as analysis. But this really proves it beyond a shadow of a doubt; if you really want to understand what’s going on here, the Austrian you need to read isn’t Friedrich Hayek or Ludwig von Mises, it’s Sigmund Freud.”
Put aside the demonstrable fact of Prof. Krugman’s consistently sloppy conflation of gold investors and gold standard proponents. Put aside his failure to engage with the arguments of the many gold standard proponents not predicting imminent virulent inflation. (Such as this writer.)
Eruditely ridiculing gold proponents as, well, full of s*** is clever. It likely will tickle those readers who find monkeys flinging poo at each other hilarious. Ridicule is much easier, and cheaper, than grappling with scholarly analyses such as that from the Bank of England which provided, in 2011, Financial Stability Paper No. 13, a genuinely interesting critique of the real world performance of fiduciary currency.
That paper is a rigorous analysis of the empirical performance of the fiduciary Federal Reserve Note standard in comparison to the Bretton Woods gold-exchange standard and the classical gold standard. It does not, at least not explicitly, advocate for either predecessor standard. It simply assesses that the Federal Reserve Note standard in practice has proved substantially worse than its predecessors (and calls for the exploration of a rule-based system). A thoughtful response by Prof. Krugman to this paper would be far more interesting, and edifying, than sly scatological insults.
One of the wittier of the commentators to last week’s column accused me of impudence. Guilty as charged. This writer confesses to having committed, in broad daylight, an act of lèse-majesté against the Great and Imperious Krugman. My critics are right to point out that this columnist is a minor figure. Still, do consider: the counsels of integrity to Pinocchio by the tiny Talking Cricket proved, in the end, well founded. One, also, could wish that more of Prof. Krugman’s defenders would tender more persuasive arguments (say, fact-based) than their many variants of “How dare you!”
In responding to my column Prof. Krugman states that “many people on the right are drawn to power fantasies in which liberals aren’t just proved wrong and driven from office, but personally destroyed.” Given Prof. Krugman’s vilification of his adversaries this could be dismissed as rich with irony. Yet there may be more to say.
Prof. Krugman has introduced the great Sigmund Freud into the conversation. Thus it might be fair to say that his consistently rude denigration of his adversaries appears to be what Freud called “projection” (“in which humans defend themselves against unpleasant impulses by denying their existence in themselves, while attributing them to others“).
Consider Prof. Krugman’s public admission that he does not regularly read that which he presumes to criticize. Prof. Krugman states forthrightly:
Some have asked if there aren’t conservative sites I read regularly. Well, no.
Carefully reading one’s opponents’ arguments is not a requisite in life. Yet critiquing arguments one has not thoroughly assimilated is lazy, louche, intellectually slovenly, and — one might fairly infer — unacceptably beneath the standards of, say, Princeton University.
Prof. Krugman dismisses me as “funny and scary.” My several columns pointing out the errors of fact and unsupportable interpretations in his op-eds had been — and surely again will fall — beneath his notice. Still, inaccurately presenting that which one is criticizing is just bad journalism. Readers should be able to rely on editors to assure that a columnist is shooting straight.
As many of my commentators correctly point out I do not command (nor do I presume to deserve) the elite social status of Prof. Krugman. Yet had Prof. Krugman taken even a moment to aim before he fired he could have discovered a right winger who has offered many respectful words, and, when warranted, praise for Barack Obama,Hillary Clinton, Elizabeth Warren, George Soros, MoveOn.org, and Occupy Wall Street (among others with whom he has disagreements). There’s no agenda of “personal destruction.”
If Prof. Krugman had dug a little deeper he might have discovered that my columns routinely are informed by The New York Review of Books, the New Yorker, theAtlantic Monthly, and, yes, the New York Times, all of which I read regularly, usually with pleasure. He would discover that my use of them is not, by and large, to ridicule but to learn and, when in disagreement, to present their claims fairly and dispute them honestly.
Scary stuff? Prof. Krugman, if you find the words of this extremely minor pixel-stained wretch “scary” … what does that say? Perhaps speaking truth to power is scary … to those with power? Yet let me speak a little truth to the powerful, and indispensable,New York Times.
The Nobel Prize in Economics is one of the greatest laurels bestowed in that field. Should Prof. Krugman be permitted to rest on this laurel? Joseph Pulitzer’s directive still applies: “Put it before them… above all, accurately….”
It is not the purpose of this column to see Paul Krugman driven from his virtual office within the paragovernmental New York Times. This columnist makes only a modest call for the Times to assign an editor to fact check his work and help him refrain from reckless disregard for the truth.