For those rich in assets, 2013 was a good year. Equity markets, especially in the US, rose substantially. Property markets continued their recovery. Even bonds, which lose value when interest rates rise, did well overall due to spread compression and the generous ‘roll-yield’ associated with steep yield curves. Indeed, declining risk premia and the associated fall in implied volatilities across all major asset classes was the single biggest financial market story of 2013. Why did this occur? Is it sustainable? In this report, I explain why it is not, and how, unseen by the economic mainstream, severe damage is being done to the global economy, in various ways, with the financial market consequences highly likely to be felt in 2014, and in the years to come.
THE PERILS OF FINANCIAL MARKET MANIPULATION IN THEORY AND PRACTICE
Other than a handful of economic officials and ivory-tower academics, few would argue that asset prices are where they are today independent of the unprecedented monetary and fiscal stimulus of recent years. Indeed, many economic officials openly admit that their actions have influenced financial market variables and that this is an important policy goal. Academic economists provide much theoretical although highly questionable support for this view.
Naturally, however, if asset prices are artificially supported by policy, then financial market participants will no doubt be concerned as to what happens when such policy is withdrawn. This is the single, best explanation for the recent, sharp correction in risky asset valuations around the world.
Economic officials, spooked by market developments, are thus now at pains to reassure all that they will only withdraw stimulus in a way that does not destabilise markets. While that sounds nice on paper, there is scant evidence that it can work in practice. Indeed, the entire modern history of economic officials managing financial market expectations has been an abject failure of economic boom and bust. In order to understand why, we need to revisit this history, beginning with the original ‘Maestro’ conductor of the financial orchestra…
BACK TO WHENCE IT ALL BEGAN: THE MAESTRO OF ‘FORWARD (MIS)GUIDANCE’
Alan Greenspan was at the height of his fame in 2003. Having already been the subject of a best-selling book, MAESTRO, by veteran Washington Post journalist (and Watergate sleuth) Bob Woodard, Mr Greenspan became ‘Sir’ Alan in 2002, receiving an honourary Knighthood from Her Majesty, Queen Elizabeth II. But it was in 2003 that Sir Alan claimed his special place in the annals of modern monetary history by introducing what is known today as ‘forward guidance’: explicit attempts to influence asset prices and, thereby, manage the economy to an even greater degree than that allowed by setting the level of interest rates, of bank reserve and other lending requirements, and through banking and financial regulation more generally. Announced to the world on 12 August 2003, for the first time in its history, the Fed included forward guidance (in bold) at the end of its policy statement:
The Federal Open Market Committee decided today to keep its target for the federal funds rate at 1 percent.
The Committee continues to believe that an accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, is providing important ongoing support to economic activity. The evidence accumulated over the intermeeting period shows that spending is firming, although labor market indicators are mixed. Business pricing power and increases in core consumer prices remain muted.
The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.
The minutes of this FOMC meeting were published just over a month later, on 18 September. The decision to include the statement was described thus:
The Committee also decided to include a reference in the announcement to its judgment that under anticipated circumstances policy accommodation could be maintained for a considerable period.
The minutes then documented the discussion which followed:
Several members commented that the nature of the Committee’s communications had evolved substantially over recent meetings and that it might be useful to schedule a separate session to review current practices. They agreed to do so prior to the next scheduled meeting on September 16.
Now, turning to that September meeting, we read in the minutes released later that year that:
The members also reviewed the further use of the reference concerning the maintenance of an accommodative policy stance “for a considerable period” that was included in the press statement issued for the August meeting. Given the uncertainties that characteristically surround the economic outlook and the need for an appropriate policy response to changing economic conditions, the members generally agreed that the Committee should not usually commit itself to a particular policy stance over some pre-established, extended time frame. The course of policy would be determined by the evaluation of the outlook, not the passage of time. The unusual configuration of already low interest rates and reservations about the strength of the expansion had justified the inclusion of the phrase “for a considerable period” in the statement issued in August. While changing circumstances would call for removal of that reference at some point, doing so at this meeting might suggest the members’ views on the economy had changed markedly. Accordingly, the Committee decided to release a statement after this meeting that was virtually identical to that used after the August meeting apart from some minor updating to reflect ongoing economic developments. (Emphasis added.)
In 2004, the Fed expanded on this precedent as it began to prepare financial markets for higher interest rates from the, at the time, unprecedented low of 1%.
January (rates unchanged):
…the Committee believes that it can be patient in removing its policy accommodation.
May (rates unchanged):
…the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.
June (rates raised by 0.25%):
…the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.
This last forward guidance was then left in place as the Fed raised rates in steady 0.25% increments through the remainder of 2004 and into late 2005. Finally, in December that year, having raised interest rates in a long series of 0.25% baby steps to over 4%‑a level that could be considered in a normal range—the Fed changed the forward guidance yet again and concluded its policy statement thus:
The Committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.
In other words, the Fed indicated three things: First, that additional rate rises were probably on the way. Second, that these rises would not exceed 0.25% each. Third, that the FOMC believed that it was now approaching the end of the rate hiking cycle.
So, when looking back on this period as monetary historians, what are we to conclude about the effectiveness of this forward guidance? Did it work?
Well, as we know, 2003-05 were the years in which the US housing market went from strength to steroids. Borrowing costs remained low, especially for long maturities, something that Sir Alan once described as a ‘conundrum’. With the Fed pointing out with forward guidance that rates would rise slowly, in predictable fashion, leveraged mortgages and home equity extraction were all the rage. And with house prices rising so steadily, lending standards were relaxed. Subprime lending exploded. Light-doc or even no-doc mortgages were easy to come by. Interest-only mortgages and the substantial leverage they offered were also increasingly common. Entirely new segments of the population (eg, those without steady jobs or income) were taking out mortagages for which they never would have qualified in normal circumstances. The bubble, as it were, was being blown to colossal proportions.
If the goal of Fed policy was to create a housing and credit bubble, then yes, forward guidance was a huge success. If the goal was to nuture the US economy back towards a path of balanced, sustainable economic growth, it was an abject failure. We learned this the hard way, as we know, in 2008.
2013: THE BIGGEST BUBBLE YET?
Subsequent to the financial fireworks of 2008, central banks around the world have made extensive use of forward guidance in order to influence a broad range of asset prices. What was once regarded as highly unusual has become the apparently necessary norm. Sir Alan set the precedent that time commitments could and, in unusual circumstances, should be used to try and influence interest rates. Now we are living through an aggressive, global campaign to micromanage not only interest rates but financial markets generally.
Following round after round of QE and other forms of generally unprecendented (and, in some cases, probably illegal) monetary and fiscal stimulus in the US and around the world, risky asset markets entered 2013 with substantial positive momentum. Many ascribe this in part to the aggressive reflationary policies—colloquially known as ‘Abenomics’–adopted by Japan following the 2012 election of Prime Minister Shinzo Abe. Others ascribe it to the ECB’s 2012 commitment to do ‘whatever it takes’ to keep the euro-area financial system liquid and intact. What no one can ascribe it to, however, is anything fundamental to the long-term profit outlook for non-financial corporations—the lifeblood of a developed economy. On every important measure, non-financial corporations have seen a deterioration in their long-term profit outlook since 2012:
- Headline revenue growth has been stagnant and below expectations;
- Profit margins have shrunk;
- Inventories have built up;
- Fixed investment has been weak.
There has, however, been a modest improvement in their collective financial condition:
- Liquidity ratios have improved;
- Balance sheet leverage has declined (if only rather modestly);
- Interest costs are low.
These financial factors, however, are insufficient to support higher valuations on their own because the long-term outlook for corporate profits has far more to do with investment rates, revenues and profit margins than with financial conditions, which are artificially and temporarily benign. That said, a generally rising interest rate environment is a clear negative, something that could certainly occur in 2014 given the low starting point for corporate borrowing costs.
John Hussman does an excellent job at summarising just why we should be so concerned about the current level of US stock market valuations in his recent weekly commentary, PUSHING LUCK, which you can find here. And here’s my former colleague Andrew Lapthorne’s recent take on the same subject:
US profits are not growing, companies are over not underinvesting (they may in fact have overinvested), and corporates are carrying more (not less) net debt than they were in 2009. It would appear that many believe the opposite to be true, yet corporate report and accounts data seems to say otherwise.” But hey- stocks are at record highs, right, and the market is never wrong (except when it is), so who cares. Indeed “Thank goodness equities went up in 2013, otherwise it might have been a rather depressing year.
When it comes to having a market view there are typically (at least) two sides to every argument. When it comes down to the state of US quoted sector profits and balance sheets there should be little argument, but even here there is a great debate, and several viewpoints with which we do not entirely agree.
First is the notion that profits growth accelerated in the US last year. Yes, the pro-forma figures from popular providers such as I/B/E/S show EPS growth of around 6-7%, but pro-forma figures are whatever you wish them to be. Reported earnings growth slowed to almost zero in 2013 and EBIT is largely where it stood at the beginning of 2012.
Capital expenditure growth, the great hope for 2014, slowed throughout 2013 as did cash flow growth and sales growth. However, capex as a proportion of sales is at elevated (not depressed) levels. Why would a company step up investment when faced with contracting margins and lacklustre demand? Surely sales and profit growth recoveries lead investment and not the other way around?
US corporates do indeed hold lots of cash, which is currently at record levels, but they also hold record levels of debt. Net debt (so discounting those massive cash piles) is 15% above the levels seen in 2008/09. The idea that corporates are paying down debt is simply not seen in the numbers. What is true is that deleveraging has occurred through the usual mechanism of higher asset prices (no doubt an aim of central bank policy). This is the painless form of deleveraging. It is also the most temporary, for a simple pull-back in equities and rise in volatility will put the problem back on centre stage.
Financial market animal spirits being what they are, however, and encouraged no doubt by economic officials admitting their desire to support valuations, 2013 saw a relentless, prolonged compression of risk premia not only in US equities, but in most asset markets, and implied volatilities trended lower. At the start of 2014, the VIX volatility index had fallen to only 12, a level associated historically with what Sir Alan once called ‘irrational exuberance’ back in 1996.
The dramatic compression in risk premia and associated low implied volatility are but two major warning signs of a dangerously overinflated bubble in risky assets. Another is the resurgent growth of so-called ‘shadow’ banking activities, such as collateralised securities issuance, including the residential mortgage backed securities that helped to fuel the mid-2000s US housing bubble.
As reported recently in the Financial Times, these securities, and the entities investing in them such as Real Estate Investment Trusts (REITs), “enjoy lighter regulation, benefit from tax efficiencies and possess increasingly deep pockets that allow them to make aggressive loans to property developers… Their role in the market is growing—as is that of hedge funds and ‘business development companies’ that provide capital to middle-market companies, and a whole host of other specialty financiers.”
Also noted in the article cited above, regulators’ increasingly heavy hands on commercial banks are having the perverse affect of driving various risky activities into the shadows, obscuring them from regulatory view. There is also concern at the Bank for International Settlements (BIS) and among central bankers generally that the shadowy practice of so-called ‘collateral transformation’ could be a source of financial system fragility in future. Nor is such concern misplaced, as I wrote in a report last year, COLLATERAL TRANSFORMATION: THE LATEST, GREATEST FINANCIAL WEAPON OF MASS DESTRUCTION (link here). Here is a relevant excerpt from that report:
[I]f interbank lending is increasingly collateralised by banks’ highest quality assets, then unsecured creditors, including depositors, are being de facto subordinated in the capital structure and are highly likely to ‘run’ at the first signs of trouble. And if banks are holding similar types of collateral that suddenly fall in value, then they can all become subject to a run at the same time, for the same reason…
An obvious consequence of such collateral transformation is that it increases rather than decreases the linkages in the financial system and thus in effect replaces firm-specific, idiosyncratic risk with systemic risk, exactly the opposite of what the regulators claim they are trying to do by increasing bank regulatory capital ratios.
Financial regulators may believe that they are one step ahead of the next crisis, but then they also believed this in 2007, 2001, 1992, 1980, etc, etc. It would be highly naïve to trust them this time round when there is ample evidence of a global bubble in risky asset valuations quite possibly larger than that of 2007. The fact is the moral hazard associated with financial (mis)regulation and bail-outs only serves to increase the fragility of the system with each fresh application. Indeed, the boom-bust dynamic of the entire post-Bretton-Woods era is far easier to explain and understand as a policy-driven process rather than as a market-driven one. The growing activism of central bankers and other economic officials with each successive boom-bust clearly illustrates the point. (This is also the subject of chapter 3 of my book, THE GOLDEN REVOLUTION.)
MEA CULPA: I WAS WRONG
On two occasions in early 2013 I predicted that equity markets were due a correction or even a crash. I was wrong. There was a brief period over the summer when emerging markets and stocks began to roll over, but it was mild and short-lived. It did, however, demonstrate yet again the central role that Fed forward guidance plays in manipulating asset markets: The selloff was directly associated with the Fed’s initial ‘taper talk’; and the subsequent recovery in risk assets occurred when the Fed backed away from plans to imminently reduce the pace of QE. Later in the year, the Fed followed through with a very modest tapering plan that did not spook asset markets to the degree the initial talk did.
Markets continued to rally subsequent to the formal ‘taper’ announcement late last year, in what I would consider to be a classic ‘buy the rumour, sell the fact’ response. Underlying market momentum was strong and, on the surface at least, economic data appeared to confirm that the economy was growing, if only moderately.
Underneath the surface, however, the data were deteriorating. Specifically, the quality of growth was poor. Most growth was not due to business fixed investment or household income, but rather an extended inventory build. Real final sales, a measure of ‘core’ GDP that strips out inventories, was stagnant at under 2% last year. Meanwhile, the modest improvement in headline labour market data obscured a continuing decline in the work-force participation rate, something that normally only occurs during and in the aftermath of recessions.
More recently, even the headline data have begun to show reason for worry and I’m not the least surprised that the hugely overvalued US stock market has taken notice. Prices have declined sharply, if by a modest amount overall, and the VIX volatility index has spiked to above 20. Bulls will argue that this is but a necessary consolidation before the bull market resumes. They may be right. But their momentum arguments are increasingly removed from valuation reality, as discussed above. Momentum can carry the airplane into thin air, yes, but it can’t prevent the subsequent stall and possible crash. Risk-reward now strongly favours a defensive stance.
HOW TO PLAY IT FROM HERE
For those still overweight equities or risky assets generally, now is a good time to cash in your chips. To the extent that your portfolio guidelines and benchmarks require you to hold equities, then it is time to rotate into defensive, deep-value, income-generating shares. These could include, for example, infrastructure, consumer non-discretionary and well-capitalised mining shares, including gold miners. That may seem an odd combination, but it so happens that even well-capitalised miners are trading at distressed levels at present, offering unusually good value.
Another oddity is that, following a three-year bear market, global commodity prices in general are low. Yes, in the event that equity markets decline sharply, commodity prices are also likely to decline. However, the decline is likely to be relatively modest, in particular for what I consider to be ‘defensive’ commodities: those with little if any correlation to the business cycle. These include grains, other agricultural products and precious metals. Grains prices are currently very depressed following bumper crops and associated excess inventory. Coffee has only just begun to recover from a multi-year bear market. Sugar prices are also depressed. If stagflationary conditions set in during 2014 and beyond—as I expect and explain why in a moment—defensive commodities are the best place to be, as was also the case in the stagflationary 1970s.
In contrast to other defensive commodities, however, livestock prices are unusually expensive, in particular cattle. This is due in large part to extreme weather in North America. So high prices may be justified but their potential to rise further seems constrained at this point, in part due to the potential for substitution effects as cash-poor consumers gradually switch to more affordable protein sources, such as poultry or dairy products, for example.
Turning to precious metals, I remain a long-term gold and silver bull for a variety of reasons. Economic officials may claim their policies are succeeding at reducing deficits and thus future debt burdens but the truth is in fact the exact opposite. Yes, by blowing asset bubbles they can artificially reduce public sector deficits for a time, as much of the tax-base is asset-price-related in some way. But with the inevitable bust in asset prices comes the inevitable bust in tax revenues. And as Arthur Laffer and others have showed, beyond a certain point, inflationary marginal tax bracket creep no longer increases but rather decreases revenues, as a number of high-tax economies figured out during the 1990s and 2000s. Some countries, such as France, are still figuring this out, and increasingly suffering for it.
Faced with intractable future debt burdens, economic officials will continue to favour inflationary over deflationary economic policies. Rates of money creation are likely to remain elevated and populist, price-fixing economic policies purporting to support middle-class incomes—minimum wage increases or socialised health care come to mind—are highly likely to be stagflationary in their future effects. Combined with various forms of so-called ‘financial repression’, limiting the ability of savers to protect themselves from inflation, merely preserving existing wealth will be a challenge. As precious metals can be neither arbitrarily devalued as fiat currencies can, nor defaulted on as with corporate securities, they should now play an unusually important role in every defensive investor’s portfolio.
TOWARD A BRIGHTER FUTURE
These can be depressing times for those of us who don’t trust in the effectiveness of modern, neo-Keynesian economic micromanagement. Indeed, for those who believe that such micromanagement in fact misallocates resources, turning the economy’s capital stock into a deformed, mangled mess over time, it is difficult to remain at all optimistic for the future. However, while a great bust (or Misean ‘crack-up boom’) is an inevitable part of the global financial system reset that lies in the future, perhaps the near future, once that is out of the way there are reasons to be not just optimistic, but highly so.
Consider, for example, the great price deflation that has taken place in recent years across a broad range of technology goods. Cutting-edge research, entrepreneurial spirit and business acumen have completely transformed the ways in which we communicate, do business, transact and entertain, and the prices for such services have plummeted. The positive economic productivity shock provided by the full spectrum of what we call ‘tech’ is as if not more profound than that of mechanised agriculture; railroads; assembly line mass-production; antibiotics; plastics, synthetics and petrochemicals; air travel; intermodal container shipping; you name it.
Most regard our amazing modern capital stock as just a given, something that spontaneously came into existence. But no, it would never have come into existence without the tireless work of countless innovators, most of whom are and will remain essentially unknown, unlike past celebrities such as Thomas Edison, Henry Ford or Steve Jobs.
Just as important, there is a critical role for the state in all of this dynamism, to provide for the rule of law and the enforcement of property rights. Without those robust parameters, spontaneous entrepreurial activity cannot respond efficiently to information and thus will be suboptimal, as George Gilder’s best-selling new book, KNOWLEDGE AND POWER (find it here) convincingly demonstrates. Highlighting the crucial role of information in a capitalist economy, he argues compellingly that a market-based economy is at base a highly efficient if necessarily chaotic information system that cannot possibly be understood by any person or group of persons.
Central economic planning, by contrast, is highly counterproductive as it not only cannot use information efficiently; it distorts the flow of all economic information in countless if largely unseen ways. The more technologically advanced an economy, therefore, the more damaging central planning becomes.
This is one way to understand why the failed Anglo-Saxon financial system and associated economic micromanagement is such a drag on growth everywhere. It is sucking vital resources out of potentially highly dynamic regional and global industries and distorting the flow of information everywhere, to the detriment of job creation and income growth. Sure, shrinking the financial sector would require those workers to be re-trained to some extent to move into new industrial directions, but this sort of ‘creative destruction’ at the micro level is part and parcel of the dynamic nature of real, sustainable, qualitative economic advancement at the macro level. The sooner we bring it on the sooner the exponential economic progress associated with an information economy can resume.
Fortunately, in the coming financial market bust lie the seeds of such renewal. It will soon become painfully obvious to those in power that the financial system is beyond repair and, once they get out of the way, creative destruction will create a new one through the implementation of new technologies imbued with entrepreneurial spirit. Say what you will about Bitcoin, crowdfunding and other recent financial innovations; they provide examples for how new technologies may one day completely displace the archaic, ossified, ‘Too Big To Fail’ financial behemoths of our time.
A FINAL OBSERVATION
Those familiar with my book and following the relevant news flow around gold and central bank reserve policies may have noticed that the de-rating of the dollar and remonetisation of gold continues to take place in the dark background of international economic and monetary relations. (A superficial treatment of the topic was recently published in the Financial Times.) But much as astronomers can observe black holes indirectly, by the distortions they create in nearby space, so the remonetisation of gold can be inferred from keen observation of gold flows and economic policy shifts taking place around the world. The strongest such signals may be emanating from China at present, but there are others: in Germany, Russia and Nigeria, for example. (For a more thorough discussion on this topic, please see Cognitive Dollar Dissonance: Why a Global Rebalancing and Deleveraging Requires the De-Rating of the Dollar and Remonetisation of Gold, The Gold Standard Journal, issue 34, October 2013. The link is here.)
Care to comment on this report? Please send me a note: email@example.com
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 The link to this FOMC statement is here.
 This research from Societe Generale was featured here.
 COMPETITION FOR SHADOW BANKING LURKS IN THE SHADOWS, Financial Times, 17 January 2014. The link is here.
 The most recent of these predictions was made in March. The link to the relevant report, ASSUME THE BRACE POSITION, is here.
 For a more thorough discussion of this episode from last year, please see my previous report, WILL THE FED RE-ARM THE BOND MARKET VIGILANTES? Amphora Report vol. 4 (July 2013). The link is here.
 George Gilder is hardly the first to have made this point, however. Among others, Friedrich von Hayek, Immanuel Kant, Confucius and innumerable quantum physicists have also explored the necessary limits to knowledge, in their various ways. One particularly poignant example is Leonard Read’s famous assay, I, PENCIL.
 The article, by veteran FT columnist Gillian Tett, can be found at the link here.
This article was previously published in The Amphora Report, Vol 5, 07 February 2014.
“The Fed insists on saving us from ‘everyday low prices’ – they call it deflation. I submit that in a world of technological wonder, prices ought to be weakening: it costs less to buy things because it costs less to make them. This benign tendency the Fed resists at every turn. It wants the price level (as it defines it) to rise by two percent a year, plus or minus. In so doing, it creates redundant credit that finds its way into other things. These excess dollars do mischief. On Wall Street we call this mischief a bull market and we’re generally all in favour of it..
“The Fed, in substance if not in name, is [still] engaged in a massive experiment in price control. (They don’t call it that.) But they fix the Fed Funds rate, they manipulate the yield curve.. they talk up the stock market. They have their fingers and their thumbs on the scale of finance. To change the metaphor, we all live to a degree in a valuation ‘hall of mirrors’. Who knows what value is when the Fed fixes the determining interest rate at zero? So I said “experiment in price control” but there is no real suspense about how price control turns out. It turns out, invariably, badly.”
- James Grant, recently interviewed on CNBC.
Consider the following table. It comes by way of iShares by Blackrock (not a fragrance), via Barry Ritholtz and Absolute Return Partners. It shows the recommended positioning of Wall Street’s finest with regard to bond markets and equities. (This exercise may well show that when everyone is thinking the same, nobody is really thinking at all.)
As far as the sell side was concerned, brash individualism and bold contrarianism died some time during 2013. By the start of 2014, all that remained on Wall Street was the hive mind of the Borg – a rather bland consensus that bonds were bad and equities were good. Astonishing that stockbrokers might possibly nurse such bias. So January’s primary trends (bonds rallying, and equities tanking), if sustained, may serve to remind us all that unsolicited sell side research, being to all intents and purposes free, is worth precisely what folk pay for it.
If the last investor is already loaded up to the gills on stocks, where is the greater fool to whom those stocks can then be sold? January may have given us an answer. Pimco’s Bill Gross comes to a similar conclusion in his latest investment outlook, from which the following is taken:
..be “careful.” Bull markets are either caused by or accompanied by credit expansion. With credit growth slowing due in part to lower government deficits, and QE now tapering which will slow velocity, the U.S. and other similarly credit-based economies may find that future growth is not as robust as the IMF and other model-driven forecasters might assume. Perhaps the whisper word of “deflation” at Davos these past few weeks was a reflection of that. If so, high quality bonds will continue to be well bid and risk assets may lose some lustre.
Astonishing, too, that the world’s largest bond manager might possibly nurse such bias in favour of “high quality bonds”. Especially when they’re not (high quality, that is) – there just happen to be oodles of them. But the fact remains that investors seem to have been spooked by the final arrival of Fed tapering, and those in emerging markets doubly so. But since we’re all trapped in what James Grant calls that valuation ‘hall of mirrors’, courtesy of central banks endlessly tinkering with asset prices via the most aggressive monetary stimulus in world history, it’s not remotely easy trying to foresee the outlook for either bonds, or stocks, or anything else. Rather than just abandon the field and sit disgruntled on the sidelines in cash, our response is to seek solace in the most compelling examples of deep value we can find, both in the credit market and in stocks.
Tim Lee of Pi Economics also sees evidence of a growing deflation shock. His chart below shows that a proxy for global broad money growth (a simple weighted average of money growth rates for the US, the Eurozone, the UK and Japan) peaked in 2011 and now appears to be rolling over.
Tim now expects major equity markets to continue to decline as the crisis in the ‘Fragile Five’ economies accelerates. “At some stage the dollar will then begin to appreciate more broadly and Eurozone yield spreads will begin to blow out. Treasury yields will, of course, continue to decline.” If this comes to pass, Wall Street will have managed to get its asset allocation advice for 2014 precisely wrong on both counts. Developed equities will fall, while fixed income (notably US Treasuries) will rally further.
Macro hypothesizing is all very well, but it at least partly assumes that the hypothesizer is benchmarked and in our case, we’re not. We don’t currently have significant exposure to developed world equities since we see much more compelling value (in classic Graham & Dodd terms) in certain pockets of the Asian markets. And we currently have no exposure to US Treasuries because we can access higher real yields with objectively superior credit quality elsewhere. That is, of course, a raging anomaly, but we never said markets were entirely or even necessarily remotely rational.
We always thought that markets (in both the debt and equity spheres) were overly complacent about the risks associated with Fed tapering. Last year, for example, the Fed printed and bought $500 billion-worth of US Treasuries – and the Treasury market still went down. The idea that the Treasury market would shrug off the determined departure of its biggest buyer in 2014 always seemed nonsensical. Now, however, there is increasing reason to fear deflationary forces at work throughout most of the developed markets other than Japan, so the price dynamic for Treasuries has changed markedly. Similarly for developed world equities, where the gyrations of January indicate – to us – a market that is coming to the slow realisation that it has already stepped over the cliff edge. Unfortunately many investors, with central banks having slashed deposit rates to de minimis levels, have gone ‘all-in’ with regard to risk assets in the desperate pursuit of yield. Be careful what you wish for. It is quite clear that central banks will do literally anything within their power to attempt to avert deflation – to ensure that “it cannot happen here”. That does not mean they will succeed – but they may end up destroying fiat currencies in the process (one of the reasons we have consistently held gold).
Tim Lee believes it is “quite obvious” what the Fed will ultimately do:
They will expand their balance sheet dramatically further by doing QE in outright risk assets – junk debt, equities, etc. They will swap money for risk assets, not money for safe assets.
The problem is that this would be a very big step; a further violation of the ‘rules’ of central banking. And we have a new Fed chairman, who has only just taken office. It is likely that things will have to get very bad before that very big step can be taken.
Six years into this crisis, and in the words of Lily Tomlin, things are going to get a lot worse before they get worse. From our perspective as asset managers, it comes down to a simple mantra: continually question precisely what you own, and why you own it.
This article was previously published at The price of everything.
No two buzzwords define the present crisis more than “contagion” and “robustness” in the world of economists and policy wonks. The current interrelated nature of the financial system has bred a fragile situation where the success of the greater economy supposedly hinges on its individual components, such as banks that are too big to fail. To combat this fragility, economists have increasingly sought to build robust institutions. Such institutions will remain strong in the face of adverse effects if an individual component of the economy fails — be it subprime mortgages, sovereign debt, deposit-taking institutions or investment banks. This approach to the crisis stresses that if we cannot battle contagion, we had better construct strong institutions to weather future storms.
Nassim Taleb takes great issue with this approach in his new book Antifragile. His view is that constructing such so-called robust institutions is not sufficient as they continually fight yesterday’s battles. Instead the focus should be in building “antifragile” institutions. Although often confused with robustness or resilience, an antifragile institution is not only unharmed by adverse events, but is actually strengthened by them. Building antifragile institutions will not only strengthen the global economic arena, but also have wide-ranging social applications.
Taleb’s latest work builds on two of his previous books, Fooled by Randomness(2001) and The Black Swan (2007). The common theme underlying all three is that there are events which are fundamentally unknowable — true uncertainties — in distinction to merely risky outcomes. Since we cannot know in advance what these events are, or what their effects will be, we should not exert too much effort in constructing contingency plans.
It is at this point that my first quibble with the book arises, and one I had with its predecessor The Black Swan. Taleb bifurcates between two definitions of uncertain events. On the one hand he invokes random or fundamentally unknowable events. Readers of this journal will be sympathetic to this definition of uncertainty, bearing close resemblance to Mises’s own use of “case probabilities” (1949, pp. 110–113), or Shackle’s (1949) use of “non-seriable, non-divisible” events. On the other hand, it is also clear that Taleb also thinks of uncertain events as merely rare events. These are events located on the fat or long tails on a probability distribution. Even though he thinks that these represent true uncertainty, there is no doubt that he is referring to fundamentally probabilistic events.
This quibble aside, one can apply much of the remaining work cognizant that Taleb’s terminology differs from that of the Austrian economists, and also that the domain of his theory is slightly different than he thinks.
Something is “antifragile” if it gets stronger from a negative event. What are some examples? Taleb applies the prefix of his book liberally to outline what choices we should be pursuing. Indeed, the body of the book gives a long list of antifragile actions that, at least on one level, boil down to doing the exact opposite of what you think you should be doing.
Authors should be shocked to learn that there is almost no news that can harm a writer’s credibility, and that any publicity is good publicity (pp. 51–52). Corporations and governments that try to “reinstill confidence” should not be trusted because they would do so only if they were ultimately doomed (p. 53). Children shouldn’t be on antidepressants as this removes a source of learning from the life experience and thus make individuals less capable of dealing with unwanted events later in life (p. 61). The sinking of the Titanic was a positive disaster as it put shipbuilders on their toes, and possibly avoided an even larger accident later (p. 72). The general theme is that those who make errors are stronger than those who don’t — reliability, or antifragility — only comes when something is regularly tested by an unwanted event.
The theory has merit. Consider this lesson applied to central bank policies. In the wake of the dot-com bust a concerted effort by the world’s central banks flooded the global financial system with liquidity. The liquidation of assets that should have happened never did, and as a result lenders and borrowers didn’t learn their lesson on prudential money management. The seeds were sown for the larger crisis starting in 2007–2008 because a simple lesson was not learned when the financial system’s problems were still in relative infancy.
There is much to learn from this book and much to be wary of. At the end of the day, Taleb reckons the best test of an anti-fragile institution is Mother Nature mixed with a healthy dose of time. In chapter 21 he criticizes the prevailing orthodoxy of “neomania,” the mistaken belief that newer is better. Those institutions that have existed the longest are, in all likelihood, those that will continue to exist into the future. As an example, imagine that the year is 1988 and answer the following: which structure will last the longest, the Berlin Wall or the Great Pyramid of Giza.
In this test, as in much of the book, Taleb asks too much and too little. He asks too much because those institutions with the most longevity were once upon a time also the ones with the least. There must be a better test than longevity, as it only pushes the problem back in time to identify the source of antifragility. It cannot be turtles all the way down.
An applied example relevant to the present financial crisis would involve looking for those institutions that have been strengthened by current affairs. The crisis has taken its toll on many aspects of the financial services industry, but some general types of products have proven surprising resilient, or antifragile. Governments with prudent fiscal policies — e.g., Germany, Switzerland and Singapore — have fared well and indeed been strengthened as finances deteriorate in more profligate countries. Investment funds capitalizing on what were once unorthodox strategies, such as gold and other precious metal holdings, have out-performed more traditional investments as the financial crisis worsens. Readers of this journal will also notice that their stock in Austrian economics has increased in value over the past decade. Question begging and failed policies developed through more mainstream theories have led many former outsiders to the ranks of Austrian economists. An unwanted event caused an offsetting positive outcome in all these scenarios. That is what being antifragile is about.
Taleb asks too little by not exploring the true sources of antifragility. He comes close, alluding in many places that market-based institutions better combat the false security that planned institutions create. Explaining and elaborating on this link would do much to take the fundamental merits of antifragility to the next level. It would be, however, fodder for another book.
This article was previously published at Mises.org.
In countries such as Turkey and Argentina a tighter stance implemented by central banks has set in motion an economic bust. In Turkey the central bank has raised the one week repo rate to 10 percent from 4.5 percent while in Argentina the 3-month Treasury bill rate climbed to 25.89 percent from 16 percent in early January. In Argentina an increase in rates took place once the central bank aggressively curbed its monetary pumping, while in Turkey the central bank raised its policy rate.
What prompted the tighter stance? The main reason was the sharp decline in the exchange rate of domestic currencies against the US dollar. The Turkish lira fell to 2.39 per US dollar from 1.76 liras in January last year — a depreciation of almost 36 percent. The price of the US dollar in terms of the Argentina peso jumped to 8 pesos from 5 pesos in January last year — an increase of 60 percent. Note that in the black market the price of the US dollar stood at 12.5 pesos.
The catalyst for the currency depreciation in both economies has been strong increases in the money supply on account of the loose monetary policies of the respective central banks. In Turkey the yearly rate of growth of AMS stood at 30 percent in August this year while in Argentina the yearly rate of growth stood at 40 percent. The underlying currency rate of exchange is set in motion by the relative increases in the money supply. This means that if Turkey and Argentina allow their money supply rate of growth to exceed the rate of growth of the US money supply, both Turkey’s and Argentina’s currency will weaken against the US dollar.
Observe that in Turkey and Argentina the strong increase in the money supply rate of growth was accompanied by strong increases in so called real GDP. In Turkey by Q1 2010 the yearly rate of growth stood at 12.6 percent while in Argentina in Q2 2010 the rate of growth stood at 11.8 percent. Given that GDP reflects changes in the money supply rate of growth we suggest that the growth in GDP mirrors the build-up of bubble activities. The stronger the GDP the stronger the pace of bubble formation is. Obviously then a tighter monetary stance is going to undermine the rate of growth of money supply and thus weaken the support for various bubble activities. It is this that sets in motion an economic bust. We suggest that a similar scenario is awaiting other economies that have been generating a strong real GDP rate of growth by means of monetary pumping.
This article was previously published at Mises.org.
Thanks to the Fed’s tapering, a wider public is becoming aware of currency instability in diverse economies, from Turkey to Argentina, and India to Indonesia. Indeed, on Tuesday night Turkey raised overnight interest rates by a whopping 4.5% to 12% in an attempt to stop a run on the lira.
Turkey has her own political problems, perhaps strong enough to knock the stuffing out of her currency on their own, and Argentina seems to be permanently fighting off hyperinflation. But it is a mistake to think that the idiosyncrasies of each currency are solely the cause of their downfall. The fact that these countries’ currency problems are all happening at the same time tells us the common factor is currency itself.
Over the last decade it has been fashionable to invest increasing quantities of money in these economies. Financial flows have also been instrumental in accelerating the growth of local domestic credit. Money flows are now in the process of reverting back to base and the chart below of the Indian rupee is a good example in which this effect on a currency can be observed.
Between 2002 and 2008 the rupee rose against the dollar (i.e. fewer to the dollar) reflecting inward investment, and after the Lehman Crisis it started to fall as the money-tide reversed. Since then the rupee has lost almost 40% of its value. It is also clear from this chart that the primary trend for the rupee has been firmly down for some time.
The same is true of most other emerging market currencies: before the Lehman Crisis investment flows into them fuelled both economic growth and the expansion of bank credit. Since Lehman, these flows have reversed mostly offset by yet more expansion of domestic credit.
Over much of the last century US dollar cash and deposits expanded on the back of a gold standard; in the same way today’s emerging markets have expanded on the back of a dollar standard. Therefore, the redemption of these currencies into the US dollar mirrors pre-WW1 bank runs, except on a global scale. And In every bank run a bank pretends there is no problem until it is too late.
Central banks cannot escape the fact that currencies depend entirely on confidence. Markets are now painfully reminding us of this truism, following the Fed’s second tapering announcement. A whisper in New York becomes a storm in Delhi, Ankara, Sao Paulo, Buenos Aires and Pretoria.
It is an important point. In the same way that under a gold standard a central bank had to have sufficient gold stocks to maintain confidence in its currency, an emerging market central bank has to have sufficient dollar reserves on hand. And this is why from a monetary perspective a desperate central bank is compelled to increase interest rates when Keynesian text books tell us such a move is certain to drive these economies into a deflationary slump.
The screw is now tightening. Having added unprecedented amounts of liquidity into its own economy through quantitative easing, the Fed is now reducing the pace of its expansion of narrow money. Unfortunately this is bad news for emerging market countries, who will surely conclude that international monetary co-operation has broken down.
This article was previously published at GoldMoney.com.
I’ve recently written for Save Our Savers attempting to square the massive expansion of Britain’s monetary base since March 2009 with the fact that inflation has now been within the Bank of England’s target range of 2% (+/- 1%) since June 2012. Here I’d like to expand a little.
Since March 2009 Britain’s monetary base, also known as narrow money or M0, has increased by 321%. We can see that the majority of this is in the form of increased bank reserves, up 642% since March 2009
Source:The Bank of England, series Notes in circulation – RPWB55A, and Reserve Balances – RPWB56A
This is just what we’d expect to see following the Bank of England’s Quantitative Easing, where the Bank creates new money and uses it to purchase bonds from banks – that new money becomes bank reserves. Those banks have sat on that money (not using it as a basis for new credit creation and feeding into M4) which is why, while narrow (M0) money has exploded, broad (M4) money has barely budged, increasing by just 7.4% since March 2009.
Source:The Bank of England, series Notes in circulation (RPWB55A) and Reserve Balances (RPWB56A) (M0), and Monthly amounts outstanding of M4 (monetary financial institutions’ sterling M4 liabilities to private sector) (in sterling millions) seasonally adjusted (LPMAUYN) (M4)
This relative restraint in M4 growth explains the relative restraint in inflation. There is no great mystery as to why banks which have just seen their assets tank and ravage their balance sheets should want to hold more reserves. The key question is what happens next.
The chart above shows the ratio of M0 to M4 since May 2006; how many pounds of broad money each pound of narrow money is supporting. From 25:1 between May 2006 and March 2009, it slumped via successive bouts of Quantitative Easing to about 6:1 since September 2012.
Now, on the one hand banks might stick to this new, lower ratio. Chastened by their experiences with mortgage backed assets they might desire a permanently lower reserve to asset ratio and all QE will have been is a vast recapitalisation of banks.
On the other hand, as ‘recovery’ kicks in they might start to increase their reserve to asset ratio. They might not scale the giddy heights of 25:1 again, but they will be multiplying out from a monetary base which has tripled in size. Britain’s monetary base is now £362 billion and M4 is about six times that, £2.2 trillion. But if renewed confidence in the banking sector saw banks return to higher ratios, the resulting M4 figures would be as follows:
Here, we are told, the Bank of England will be able to ‘drain’ this liquidity from the system. It would do this by reversing QE; selling bonds to banks and effectively destroying the base money it receives in return. But a massive increase in the supply of bonds relative to the demand for them will lower their price. This is the same as raising their yield and this is the same as raising a key interest rate.
It is worth pondering for a moment the scale of bond sales and consequent rise in interest rates which might be necessary to drain this base money from the financial system. We must hope either that the economy can stand it or that banks keep holding these reserves.
“We know Carney is blagging us, he knows we know but he has to keep a straight face and essentially say – look chaps no fundamental reason to keep rates at zero – in fact none whatsoever – but I need a couple of years to offload all our Gilts back onto you chumps.”
- Analysis of UK central bank policy from an anonymous but well-respected City source.
So farewell then, forward guidance. We barely knew you. We were never fans of this policy and said as much. Here, for example, is what we wrote in ‘The Spectator’ last October:
The financial crisis of 2007-8 was caused in large part by unsustainable property markets in the US, the UK and elsewhere. Credulous borrowers took on too much debt and credulous bankers encouraged them. The sudden abatement of that frenzy meant that governments had to step in to bail out otherwise insolvent banks. In the process, government finances disintegrated, hence the uneasy half-steps toward austerity undertaken throughout the indebted West. Yet central bankers now seem to believe the best medicine for a financial meltdown triggered by a housing bubble is a new housing bubble. George Osborne’s sudden urge to tinker with his own Help to Buy scheme is an indication of Downing Street’s nervousness about this trend.
But there is only so far central banks can go in the cause of economic stimulus. Traditionally, cutting base rates has always provided a ‘coup de whisky’ for jaded markets. So when base rates are stuck around zero, unorthodox stimulus is required. The Bank of England has provided it, in the form of its quantitative easing programme. For QE, read printing money. We’ve had £375 billion so far and not a whole lot of obvious economic recovery to show for it, other than in the property markets of Mayfair, Chelsea and Belgravia.
Five years on from the collapse of Lehman Brothers, which threatened a second Great Depression, our central bankers are treated as gods. Since there is no counterfactual, we will never know what might have happened if western governments had pursued free market policies and allowed a few bankrupt banks to fail (or be wholly nationalised, rather than perpetuate the illusion of a healthy financial sector). What’s clear is that central bank stimulus has entered hitherto uncharted territory: historically unprecedented base rates; trillions of dollars, pounds and yen conjured up to reconstruct bank balance sheets and support monstrous government borrowing; hyper-aggressive reflationary tendencies that have driven millions of investors into high-risk assets. If economic health could be measured in property values alone, the stimulus has been a success. In terms of maintaining sound currencies or encouraging a climate of confident business investment, central bank stimulus has been a disaster.
It’s time to ask whose interests the central banks really serve. While they pay lip service to the interests of embattled savers, it is clear that their primary function today is to act as lenders and stimulators of last resort to a venal banking system — Danegeld, if you prefer, paid by savers through artificially low deposit rates and channelled to a narrow financial elite. But it will be a pyrrhic victory for Carney and his peers if our banks have been ‘saved’ at the expense of everybody else.
The base rate — the fundamental reference rate for the price of money — is under the control of the Bank of England’s monetary policy committee. What the Bank of England cannot entirely control, however, is the gilt market, which dictates how cheaply or expensively the UK government can borrow money over various terms. Alarmingly for Carney, gilt investors have already voted with their feet. His much heralded ‘forward guidance’ — flashy central bank jargon for keeping interest rates on hold until there is tangible evidence of economic recovery in falling unemployment numbers — has been revealed as farce by rising gilt yields. The market, in other words, does not believe the governor’s pledge. In vowing to keep back the tide, Mark Carney is acting like a latter-day Cnut.
Longstanding readers will also appreciate that we feel toward central bankers the way lamp-posts would feel toward dogs – if they were capable of feeling anything at all. It’s a sad thought that there is apparently nobody better qualified than Mark Carney from within this sceptered isle’s native population of 63 million – but then we must accept that there are only so many Goldman Sachs alumni out there, let alone those that must squeak by on a housing allowance of just £250,000. If it were down to us, we would replace more or less the entire executive staff of the Bank of England (and the Fed, and the ECB..) with an old sock. With a nod to the democratic impulse, we could perhaps be allowed to vote for our favourite old sock from a roster of different socks, as opposed to suffer the economic indignity of unelected bureaucrats manipulating interest rates, and much else besides, in the cause of bailing out their buddies at otherwise insolvent banks (and governments).
But there’s the world as we might like it, and there’s the world as is. In the world as is, a popular January pastime for economists, fund managers and financial analysts is to issue unsolicited predictions about how the balance of the year will shape up, investment-wise. We have to assume that these are always self-interested and conflicted: Chinese equity managers will mysteriously forecast extraordinarily strong economic growth in China (and no blow-up of the shadow banking system); Gilt investors will mysteriously foresee strong performance from UK government bonds despite the fact that real yields are non-existent and Mark Carney is caught between a rock and a hard place (see above) when it comes to exiting from now unnecessary monetary stimulus; etc. etc. ad infinitum for all the different asset classes and their respective managers.
Well, we don’t see the point. What’s more interesting to those of us not sufficiently self-important to be wining and dining at Davos this year (Matt Damon? Really?) is to get an assessment of consensus expectations from the City, and then consider those. Helpfully, this is exactly what Espirito Santo’s Marcus Ashworth has done. Here is his Top Ten summary of ‘Street consensus’ for 2014:
- Equities to continue to grind higher, an up year but not as strong as 2013. Despite the fact that earnings are anaemic and buy-backs are the only response.
- Bonds might be doing a bit better now, led by credit, but bond yields must go up substantially at some point this year.
- Dollar to go higher, Yen lower, Euro to crack at some point surely.
- Nikkei to put in another banner year, ahead of the pack as Yen weakens.
- Oil lower as US supply alters the world dynamic, Iran and others become less pressing with supply snafus dissipating.
- China to struggle to keep growth pace up, Government forced to prevent bankruptcies.
- Gold to wallow as risk on makes it ever less of a hedge fund toy but gold bugs will continue to fret about the Bundesbank’s gold and China buying it all.
- Bank of England to be the first to raise rates but not before the ECB takes them negative. Fed will be all tapered out by the summer, November latest.
- Credit [i.e. corporate debt] is about as tight as it can possibly get, in the trough, only a muppet would buy it down here.
- Emerging markets are so, like, 2013; current account deficits and currency weakness will force slow money back to the major markets. Europe the new (only) alpha source?
Of course, one response to apparently consensus positions is to take the other side of the trade. But contrarianism for contrarianism’s sake is also a dangerous game. More to the point, while any of us can state a market forecast with a degree of confidence, nobody really knows. From our own perspective, Marcus’ Top Ten feels intuitively correct – these seem to us to represent a fair reflection of many investors’ hopes / fears / biases / portfolios. So what could be the shockers?
- Equities don’t necessarily grind higher for FY2014 as a whole, but mean revert on the basis of some exogenous shock that no-one saw coming; or for that matter in response to one of the many problems that are already well flagged.
- Bond yields “go Japanese” to low levels well below consensus.
- Fears / flows over (Fed) tapering cause currency markets to go mental.
- Japanese stocks disappoint.
- Some or other Middle Eastern black comedy in the making goes full Strangelove.
- China fails to crash. (Or Renminbi fails to appreciate.)
- Gold goes sharply higher in response to 3.
- Gilt yields collapse as economic growth is revealed to be a fantasy conjured up by a central London property bubble.
- Credit spreads remain tight (they are clearly poor value).
- Emerging markets outperform.
So far, so entertaining. A harmless enough diversion. Mostly irrelevant to us, since we spend more time avoiding obvious flashpoints than flirting with them. We’re positioned in
- Creditworthy sovereign and quasi-sovereign bonds, with a growing allocation to floating rate exposure.
- Deep value equities, concentrated in Asia and Japan (with currency selectively hedged).
- Systematic trend-followers, which are nothing if not consistently uncorrelated to stocks and bonds.
- Real assets, notably the monetary metals, gold and silver. This was obviously a pain trade last year, but for us it wasn’t a trade at all, rather a conscious decision not to play in paper currency conflagrations-to-come.
It strikes us, in the light of Mr Carney’s awkward gyrations over forward guidance, and anticipating a less than smooth tapering process from Janet Yellen at the Fed, that 2014 will be the year in which the central banking emperors’ new clothes are revealed to be from Primark rather than Prada.
 Mixed metaphors, of a sort. We know that the emperor’s new clothes consisted of his birthday suit and nothing else. Perhaps we should have said, after Warren Buffett, that 2014 will be the year when we get to see, from a universe comprising governments and investors, just who’s been swimming naked.
This article was previously published at The price of everything.
A paper currency system contains the seeds of its own destruction. The temptation for the monopolist money producer to increase the money supply is almost irresistible. In such a system with a constantly increasing money supply and, as a consequence, constantly increasing prices, it does not make much sense to save in cash to purchase assets later. A better strategy, given this senario, is to go into debt to purchase assets and pay back the debts later with a devalued currency. Moreover, it makes sense to purchase assets that can later be pledged as collateral to obtain further bank loans. A paper money system leads to excessive debt.
This is especially true of players that can expect that they will be bailed out with newly produced money such as big businesses, banks, and the government.
We are now in a situation that looks like a dead end for the paper money system. After the last cycle, governments have bailed out malinvestments in the private sector and boosted their public welfare spending. Deficits and debts skyrocketed. Central banks printed money to buy public debts (or accept them as collateral in loans to the banking system) in unprecedented amounts. Interest rates were cut close to zero. Deficits remain large. No substantial real growth is in sight. At the same time banking systems and other financial players sit on large piles of public debt. A public default would immediately trigger the bankruptcy of the banking sector. Raising interest rates to more realistic levels or selling the assets purchased by the central bank would put into jeopardy the solvency of the banking sector, highly indebted companies, and the government. It looks like even the slowing down of money printing (now called “QE tapering”) could trigger a bankruptcy spiral. A drastic reduction of government spending and deficits does not seem very likely either, given the incentives for politicians in democracies.
So will money printing be a constant with interest rates close to zero until people lose their confidence in the paper currencies? Can the paper money system be maintained or will we necessarily get a hyperinflation sooner or later?
There are at least seven possibilities:
1. Inflate. Governments and central banks can simply proceed on the path of inflation and print all the money necessary to bail out the banking system, governments, and other over-indebted agents. This will further increase moral hazard. This option ultimately leads into hyperinflation, thereby eradicating debts. Debtors profit, savers lose. The paper wealth that people have saved over their life time will not be able to assure such a high standard of living as envisioned.
2. Default on Entitlements. Governments can improve their financial positions by simply not fulfilling their promises. Governments may, for instance, drastically cut public pensions, social security and unemployment benefits to eliminate deficits and pay down accumulated debts. Many entitlements, that people have planned upon, will prove to be worthless.
3. Repudiate Debt. Governments can also default outright on their debts. This leads to losses for banks and insurance companies that have invested the savings of their clients in government bonds. The people see the value of their mutual funds, investment funds, and insurance plummet thereby revealing the already-occurred losses. The default of the government could lead to the collapse of the banking system. The bankruptcy spiral of overindebted agents would be an economic Armageddon. Therefore, politicians until now have done everything to prevent this option from happening.
4. Financial Repression. Another way to get out of the debt trap is financial repression. Financial repression is a way of channeling more funds to the government thereby facilitating public debt liquidation. Financial repression may consist of legislation making investment alternatives less attractive or more directly in regulation inducing investors to buy government bonds. Together with real growth and spending cuts, financial repression may work to actually reduce government debt loads.
5. Pay Off Debt. The problem of overindebtedness can also be solved through fiscal measures. The idea is to eliminate debts of governments and recapitalize banks through taxation. By reducing overindebtedness, the need for the central bank to keep interest low and to continue printing money is alleviated. The currency could be put on a sounder base again. To achieve this purpose, the government expropriates wealth on a massive scale to pay back government debts. The government simply increases existing tax rates or may employ one-time confiscatory expropriations of wealth. It uses these receipts to pay down its debts and recapitalize banks. Indeed the IMF has recently proposed a one-time 10-percent wealth tax in Europe in order to reduce the high levels of public debts. Large scale cuts in spending could also be employed to pay off debts. After WWII, the US managed to reduce its debt-to-GDP ratio from 130 percent in 1946 to 80 percent in 1952. However, it seems unlikely that such a debt reduction through spending cuts could work again. This time the US does not stand at the end of a successful war. Government spending was cut in half from $118 billion in 1945 to $58 billion in 1947, mostly through cuts in military spending. Similar spending cuts today do not seem likely without leading to massive political resistance and bankruptcies of overindebted agents depending on government spending.
6. Currency Reform. There is the option of a full-fledged currency reform including a (partial) default on government debt. This option is also very attractive if one wants to eliminate overindebtedness without engaging in a strong price inflation. It is like pressing the reset button and continuing with a paper money regime. Such a reform worked in Germany after the WWII (after the last war financial repression was not an option) when the old paper money, the Reichsmark, was substituted by a new paper money, the Deutsche Mark. In this case, savers who hold large amounts of the old currency are heavily expropriated, but debt loads for many people will decline.
7. Bail-in. There could be a bail-in amounting to a half-way currency reform. In a bail-in, such as occurred in Cyprus, bank creditors (savers) are converted into bank shareholders. Bank debts decrease and equity increases. The money supply is reduced. A bail-in recapitalizes the banking system, and eliminates bad debts at the same time. Equity may increase so much, that a partial default on government bonds would not threaten the stability of the banking system. Savers will suffer losses. For instance, people that invested in life insurances that in turn bought bank liabilities or government bonds will assume losses. As a result the overindebtedness of banks and governments is reduced.
Any of the seven options, or combinations of two or more options, may lie ahead. In any case they will reveal the losses incurred in and end the wealth illusion. Basically, taxpayers, savers, or currency users are exploited to reduce debts and put the currency on a more stable basis. A one-time wealth tax, a currency reform or a bail-in are not very popular policy options as they make losses brutally apparent at once. The first option of inflation is much more popular with governments as it hides the costs of the bail out of overindebted agents. However, there is the danger that the inflation at some point gets out of control. And the monopolist money producer does not want to spoil his privilege by a monetary meltdown. Before it gets to the point of a runaway inflation, governments will increasingly ponder the other options as these alternatives could enable a reset of the system.
This article was previously published at Mises.org.
A number of readers and bloggers have recently suggested there must be collusion between America and China over the transfer of physical gold from Western capital markets. They assume that governments know what they are doing, so there is a bigger game afoot of which we are unaware.
The truth is that China and Western capital markets view gold very differently. You will hardly find anyone in the London Bullion Market who regards gold as money; and for them if gold is no longer money Chinese demand for it is not a monetary issue. Instead it threatens the bullion banks’ business that a useful financial asset, capable of earning many times its physical value in fees, commissions, turns and interest, is being leeched out of the market by Chinese aunties.
It is clear that nearly all Western central bankers share this view, believing that gold will never play a monetary role again. We also know that Marxist-educated government advisers in China have been sheltered from the Keynesians’ antipathy against gold and instead have been brought up on Marx’s belief that Western capitalism will eventually destroy itself. It therefore follows they believe that western paper currencies will probably be destroyed as well.
Otherwise we can only speculate, but the following conclusions about why the Chinese are accumulating gold seem to make most sense:
- There is a fundamental view in China that gold is ultimately money, so it is always worth accumulating by selling potentially worthless foreign currency.
- Encouraging her citizens to accumulate gold achieves two objectives: if they have real wealth to protect it makes them potentially less rebellious in difficult times; and secondly private buying of gold reduces the trade surplus, which in turn reduces the accumulation of foreign currency reserves.
- Gold is generally accepted as superior money throughout Asia, which is China’s long-term regional interest.
- The Chinese Government (and/or the Communist Party) is buying gold for itself. Assumptions it will use gold to beef up the renminbi makes little practical sense, beyond perhaps some window-dressing for currency credibility. Instead she appears to be accumulating gold for unstated strategic reasons.
- Keeping the West short of gold gives China huge leverage in today’s cold currency war, and even more if the currency war heats up.
The idea that America is colluding with China in the gold market must therefore be nonsense. The truth has everything to do with different philosophies about gold.
Advanced western economies have survived without using gold as money for a considerable time. Currency and credit inflation have created a modern finance industry wholly dependent on fiat paper and everyone in mainstream finance is conditioned to believe in the profitable world of fiat currencies. They are therefore predisposed to dismiss gold as never being money again.
That is why the West is less worried about losing physical gold than it should be, and China is glad of the opportunity to buy it. And she can be expected to continue to do so whatever the price, because she knows that in the final analysis gold is the only true money.
This article was previously published at GoldMoney.com.
Minimum wages are a popular topic. Barack Obama proposes a nearly 40% increase from $7.25 per hour to $10.10 and David Cameron has faced calls from some of his own backbenchers to raise Britain’s minimum wage of £6.31 per hour for over 21s. What are the economics?
A wage is the price of labour. At a given price/wage (W1) a certain amount of labour will be purchased (L1). We can show that with the following chart
Many argue that we can make people better off by either setting minimum wages or raising those that there already are. But what are the effects of this? Put another way, what is the effect of raising the price of labour? We can show that with the following chart
As with anything, if you raise its price the quantity of it demanded falls (caveats discussed below); there is less employment, in other words. As economists Paul Krugman and Robin Wells put it, “when the minimum wage is above the equilibrium wage rate, some people who are willing to work – that is, sell labor – cannot find buyers – that is, employers –willing to give them jobs.” (Krugman and Wells 2008) Indeed, most supporters of higher minimum wages tacitly accept this. When you ask them “If raising minimum wages makes people better off, why not raise them to £/$50 per hour?” they generally reply “Don’t be so silly”. Well, indeed. A minimum wage that high would be unaffordable for many employers and unemployment would increase.
But by acknowledging that at a higher price a lower quantity of labour will be demanded they are acknowledging that the demand curve for labour slopes downwards as shown in the following chart
But if the labour demand curve slopes downwards between £/$50 per hour and the current minimum wage why would anyone assume that it doesn’t continue to slope downwards below the minimum wage? In other words, might we not see an increase in employment if we reduced the minimum wage (in real or nominal terms) or eliminated it? At that point the conversation often moves to whether people should be able to hire/work at those lower wages, a question outside the scope of economics.
Now for those caveats. I recently asked some friends whether they would continue to buy the same amount of something if its price went up 25%. One answered “Well, cigarettes pretty much have (over a comparatively short time), and I pretty much have continued to buy them. But I admit that my sickness at having to pay that much for my brand has now driven me to tobacco during the week and the odd cigar at the weekend now (rather than the fiver per day for a pack of Embassy)”
What my friend Miguel has identified here is the notion of elasticity, the change in the quantity of something demanded resulting from a change in its price. If the quantity of something demanded varies greatly with changes in price then demand is ‘elastic’, if the quantity demanded changes very little (or not at all) with changes in price it is, like Miguel’s cigarettes, ‘inelastic’. We can show an inelastic demand for labour with the following chart
Here, with the steep curve given by the inelastic demand for labour, a large rise in the wage from W1 to W2 gives a comparatively small drop in employment, from L1 to L2.
But is labour demand inelastic? One of the factors determining elasticity is the availability of substitutes. If nothing else can fulfil the role of the good which is rising in price you will have to pay more (up to a point) but if something else will do well enough you will switch to buying that instead. And there is a substitute for labour; capital, the price of which is falling thanks to technological innovations just as people campaign to raise the price of labour. In a supermarket lately you might have used a machine to scan your own shopping. Those machines are direct substitutes for the labour of checkout staff. Or, as a meme humorously put it recently,
Another friend replied “Depends on the price to start with, the income of the person and their lifestyle. If Nigella Lawson was on a fixed rate water bill and it went up 25% then I think we can be pretty certain she would buy and consume the same amount.”
Indeed, as Tom says, rises in prices are felt differently by different people – and companies. Raising the price of labour by 40% might not have much of an effect on a big business operating on wide profit margins but it would be crippling for a smaller business with its much thinner margins. It’s curious that many supporters of ‘Buy Local’ also support minimum wage policies which give big businesses a crushing competitive advantage over smaller businesses.
So much for the theory, what about the practice? An extensive review of studies into the effects of minimum wages carried out in 2006 by economists David Neumark and William Wascher (Neumark and Wascher 2006) found that
the oft-stated assertion that recent research fails to support the traditional view that the minimum wage reduces the employment of low-wage workers is clearly incorrect. A sizable majority of the studies surveyed in this monograph give a relatively consistent (although not always statistically significant) indication of negative employment effects of minimum wages. In addition, among the papers we view as providing the most credible evidence, almost all point to negative employment effects, both for the United States as well as for many other countries. Two other important conclusions emerge from our review. First, we see very few – if any – studies that provide convincing evidence of positive employment effects of minimum wages, especially from those studies that focus on the broader groups (rather than a narrow industry) for which the competitive model predicts disemployment effects. Second, the studies that focus on the least-skilled groups provide relatively overwhelming evidence of stronger disemployment effects for these groups.
Neumark and Wascher updated and expanded this study in their 2009 book Minimum Wages (Neumark and Wascher 2009), concluding that
minimum wages do not achieve the main goals set forth by their supporters. They reduce employment opportunities for less-skilled workers and tend to reduce their earnings; they are not an effective means of reducing poverty; and they appear to have adverse longer-term effects on wages and earnings, in part by reducing the acquisition of human capital.
A fitting conclusion here also.