ToP of the BoPs

Over the past four decades the global economy has largely experienced prolonged imbalances, with countries running large current account deficits in symbiotic relationships with those running large surpluses. In our recent HindeSight Investor Letter – Top of the BoPs we revisit our long held belief that the current monetary order as defined by a constellation of exchange rate arrangements between the major global currencies, and which maintained these imbalances artificially, has led to excessive global liquidity and credit creation. This in turn drove a litany of asset price bubbles.

The bursting of these asset bubbles has continued in a series these past two decades, each one’s demise leading to more disruptive policy responses which have only succeeded in igniting yet more bubbles, only for those too to fail.

Finally in 2008 we witnessed the finale of decades of credit creation, rising in what appeared to be a crescendo of credit excess and widespread asset booms. We saw this event as the death throes of an unstable monetary regime, only then to see an unprecedented global reaction by policymakers in a coordinated fashion to keep the global system alive. For a moment here today, there are those who dare to believe they have succeeded, with rising equity markets a testimony to a reviving global economy. Nothing could be further from reality.

We stand by our assessment that the disproportionate reaction of central bankers and policymakers alike has merely succeeded in compounding and exacerbating the error of this highly imbalanced monetary system. Recent events in emerging countries are a manifestation of the continuing unravelling of our monetary order.

In another recent HindeSight letter we described how the world is faced with a binary situation of global deflation or hyperinflation. We believe the odds have tilted firmly towards deflation. It would appear the unwinding of the global imbalances that led to the 2008 crisis is continuing unabashed, irrespective of the recent monetary excess used to abate them.

Large current account deficits led to unsustainable debt creation and as a consequence the trade deficit countries were the first to experience a severe financial crisis, but now on the other side of the equation the surplus countries are experiencing their reaction to the crisis. For balance of payments have two components to the equation both the financiers and the borrowers, so by definition changes in savings and investments in one such country has a profound impact on those of another.

The recent instability in emerging market economies and especially China is a direct consequence of these global imbalances which became stymied briefly by global bail-outs only to have been left in a more vulnerable economic position. The deleveraging process which began in 2008 has been a slow burner but is likely now in full swing. The deflationary risks are very high.

Top of the Pops was a legendary British music chart television show which began weekly broadcasts on the BBC in 1964, and finally wound down its music decks in July 2006. The show comprised performances from leading selling music artists and always culminated with an airing of the number one best selling single of the week, after a rundown of the top 30 singles. So popular was the show that it became a major UK export franchise, with its iconic logo emblazoned over TV screens globally.

Like all great cultural institutions the music was both a representation and manifestation of its ages, shaping popular culture and generations alike. No more emblematic of its age were the Punk rock bands of the 70s, both here in the UK and the US; the ‘Sex Pistols’ and ‘The Clash’, the UK vanguard, and across the Atlantic the ‘Television’ and the ‘Ramones’. Hard-edged, shouted vocals amongst a cacophony of relentless drumming, heavy bass and repetitive electric guitar chords, they bore witness to an anti-establishment movement seemingly disenfranchised with the economic misery of the time.

‘Blitzkrieg Bop’ by the Ramones exemplified the mood of the era, its title inspiration coming from the German World War II tactic, blitzkrieg, which literally means ‘lightning war’. Drawing our own inspiration from Blitzkrieg Bop we echo their rally cry ‘Hey! Ho! Let’s go’ as we re-delve into the area of global imbalances which seems to have taken a back-seat in the debate on the continuing crisis these past few years. We will observe those countries with vulnerable balance of payments in our very own version of Top of the Pops, Top of the BoPs (Balance of Payments) if you will, to see which are exhibiting financial and trade stresses.

We have found balance of payment imbalances to be a superb leading indicator of economic stress, both in the emerging and developed markets, by which we could make investment and trading decisions. They are the thermometer by which we can first observe the very real signs of a monetary system in turmoil. In keeping with our musical theme, we wanted to make reference to another iconic UK show, but this time that of BBC radio and not TV; it’s called Desert Island Discs.

Desert Island Discs marginally pre-dates the auspicious events of the Bretton Woods conference of 1944, when allied nations gathered in New Hampshire to formulate the terms of an agreement on how to regulate the international monetary system, after the likely conclusion of World War II. The show began in 1942 and endures today, each week inviting a distinguished guest to envisage that they are a castaway on a desert island; who having chosen eight pieces of music, a book and a luxury item to take with them to the island are then asked to review their life in reference to excerpts of these choices. 

Although not quite existing as long as the show (according to the Telegraph it’s the longest running radio show in the UK), if we at Hinde Capital were to be castaway on a desert island, in our own version of the game Desert Island Economic Discs* – the ten macroeconomic ‘records’ we would take with us as an excerpt to a life, in this case a country, would be: 

1. Current account balance as a % of GDP (and commensurate capital account)
2. Debt as % of GDP (Debt composition as % of GDP)
3. Current account balance as a % of Investment
4. Real Effective Exchange Rate
5. Stock Prices
6. Exports
7. M2/ reserves/ Domestic Credit
8. Output
9. Short-term capital inflows/GDP
10. Real interest rate on bank deposits

The countries which make our Top of the BoPs, are mainly those of the Emerging Markets. These countries are all exhibiting the hallmarks of a classic balance of payments (BoPs) crisis which have built up over many decades.


These large and persistent trade imbalances have been caused by distortions in financial, industrial, and trade policies. These distortions have prevented adjustments for many years, but large imbalances ultimately are unsustainable because the capital flows that finance the trade imbalances can be reversed only with a reversal of trade imbalances. Eventually these imbalances will adjust in spite of policy and institutional constraints, but in this case the adjustment is often violent and can come in the form of a financial crisis.

A country that appears peaceful and stable may encounter unexpected crises. There are structural problems in China’s economy which cause unsteady, unbalanced and uncoordinated and unsustainable development

Premier Wen Jiabao (2007) 

The global crisis is a financial crisis driven primarily by global trade and capital imbalances. This is the macro theme we have pursued these past 7 years. We believe the global crisis is in full swing again and asset prices are in danger of falling globally. Money is less effective at catching the falling knife. 

Emerging market countries are exhibiting the signs of crisis-like price action associated with deteriorating balance of payment balances, even though many have built up significant foreign exchange reserves.

Investors and policymakers do not believe this is the beginning of a major EM contagion crisis. They are lulling themselves into a false sense of security. They see the EM market tremors, and do not fear a re-run of the EM crises of old. They are right. This is not (just) going to be an EM crisis. Recent events portend a far more serious crisis is at hand; the unravelling of our global monetary system.

The crux – the EM tremors are really signifying the demise of the credit bubble that began bursting in 2008. This is not the start of the EM crisis. It is the beginning of the end of a credit bubble collapse that began in 2008.

We have witnessed unprecedented global fiscal and monetary stimulus (QE) which was used to arrest a global credit deflation. This led to the development of a truly global bond bubble. As debt levels rose in the developed countries and monetary stimulus was exported (de facto QE) to EM countries it underpinned growth with excess credit. 

Since 2003 EM countries have seen US$7 trillion of inflows into their countries and a commensurate appreciation in their currencies; ones that they have struggled to control. These are not just strong flows rather they are astronomical in size and have been achieved by this excessively loose and unconventional monetary policy.

The paradox of such inflows strengthening currency rates is that they have succeeded in stultifying EM export-led growth, despite this supply of credit. The commodity exporters amongst them have been left doubly reeling by the confluence of higher exchange rates and lower demand from a stagnating global economy and in particular China. They have all seen their commodity revenues fall precipitously. 

In a re-run of the 1990s the appreciation of the dollar against a rapidly depreciating yen has begun to drag USD Asia higher. This was the trigger for the Asian Tiger currency crisis in 1997. This has been a final nail in the coffin of Sino imperialism, as their export competitiveness is lost too.

In the 1980s it was a hike by the US Fed that triggered the LatAm crisis. Today, the mere whisper of tighter monetary conditions in the US, vis-a-vis a tapering of QE has led to higher bond rates globally. Note tapering is not the same as hiking interest rates.

The consequences of multiple rounds of QE have heightened global risks as it has both exacerbated ‘currency competition’ and hot capital flows into countries seeking desperately for a return both from income and capital growth. This has created major distortions in term rates, equity and bond values, driving them artificially high in price.

These distortions have created risks far greater than the fragilities of EM countries of yesterday years. The system of credit creation has produced unstable growth underpinned with collateral which is both mobile and suspect in its integrity.

Investors have nowhere to turn, emerging market countries growth is faltering in response to export disadvantages brought about by rampant G10 currency devaluations. China is finally succumbing to its side of the global imbalance excesses. First it was the deficit nations now it’s the turn of the creditor nations to falter, primarily China.

Trade flow reversals are leading to massive capital outflows out of EMs and the question remains: will the central banks of these countries sell their FX reserves, UST- bonds and euro government bonds (bunds) to finance this surge in outflows?

It is not clear that renewed global central bank liquidity provision will even stabilise a situation we see as growing dire by the day. China is the driver. All eyes on China.


Cyprus – oh the irony!?

Seemingly innocuous events can portend more serious outcomes, though we recognise them only in hindsight. This is the dramatic irony of history. When a single shot in Sarajevo took out a largely unknown European aristocrat, who would have known then that the world would plunge into the First World War.

The Cypriot savers must have thought the authorities were being highly ironic, of the Socratic kind, when they were told they were receiving a bail-out, except it was a “bail-in”. I don’t know the Greek/Turkish for ‘you are having a laugh’, but I bet that’s what they are saying. So what is a bail-in?

A bail-in takes place before a bankruptcy, and involves losses being imposed on bondholders, something that has rarely taken place throughout the GFC and euro crisis. In fact taxpayers (the government) have consistently bailed-out the private sector in full. The Cypriot bank rescue is no exception, except this time there is a bail-in and ironically again not of bondholders but of the depositors first. This is a direct contravention to the usual legal claims on the capital structure.

So there you have it – on Friday 14th March Cyprus became the 5th country to receive an EU bail-out (in), except this one was a bail-in but one with a significant and severe twist of fate. The Cypriot government in Nicosia is scheduled to vote on a EU bail-out plan which calls to extract a “tax” on bank depositors (savers) some €5.8 billion: 6.75 per cent for anyone with less than €100,000 in a Cypriot bank account, 9.9 per cent for anyone with more than that.

This is an unprecedented assault on individual property rights and every individual in the developed world should take notice, and far from stabilising the eurozone, the bail-out likely heightens contagion risk across the EU.

Why bother holding a bank account when your government can expropriate your savings? Far from containing a bank run in Cyprus, it will exacerbate it, absent capital controls, and likely begin significant depositor flights across the European periphery.

These events I believe signify one of the most alarming developments in the Eurozone crisis and the global economy since the financial crisis began.

Cypriot Disputes and Levies

For a sovereign entity so small, Cyprus has had more than its fair share of international controversy and disputes. Cyprus has a long and convoluted history with the British, Turks and Greeks, whose tensions have wreaked havoc across Europe over two World Wars. This weekend marked yet another period of disquiet in the history of this troubled island.

Cyprus is reeling from an oversized and ailing banking system.  Technically bankrupt, domestic banks stand at €126.4 billion in size, or over 7 times the size of the economy.  Without a bail-in, depositors would be wiped out and Cyprus would undergo economic collapse, bringing along with it all the attendant social misery and deprivation of a depression.

Ironically Cyprus is no stranger to levies.  The British extracted taxes in the 19th century to cover the compensation they owed to the Ottoman Sultanate, who had conceded the island to the British.

In 1878, under the Cyprus Convention, the Cyprus became a protectorate of the British in a secret agreement between the United Kingdom and Ottoman Empire. The Greek Cypriots believed the British would eventually help Cyprus unite with mother Greece, just as with the other Ionian Islands. The indigenous Cypriots believed it their natural right to reunite the island with Greece; after all, the very first census showed the population was comprised of 74% Greeks and 24% Turks.

Fast forward half a century and most of us over the age of 40 refer to the Cyprus dispute as that of the conflict between the Republic of Cyprus and Turkey over Turkish-occupied North Cyprus. My knowledge of the origins of the Cyprus dispute is a little sketchy, but as I understand it the dispute originally was born out of the Cypriots’ desire for self-determination away from the British Crown, which had unlawfully declared itself the constitutional ruler after Greece failed to fulfil its WWI obligations to invade Bulgaria; in return, the Republic of Turkey recognized British rule of the island.

Eventually this colonial dispute became an ethnic one between Greek and Turkish islanders and their respective mother countries. In 1974 Turkey invaded Northern Cyprus and declared unilateral independence, as well as itself a sovereign entity – the Turkish Republic of Northern Cyprus – but has never received UN and international recognition. There has been a UN no-go zone buffering North and South ever since.

Another irony of the day was that in return for the British protectorate the Ottoman Empire received military support against Russia in Asia. As I will cover later, Russia has been integral to the demise and now the future well-being of Cyprus. Another legacy dispute that has compounded the Cypriot collapse was their adherence to Enosis. This refers to ‘the union’ – incorporation of the island of Cyprus into Greece. Observance of this tradition led the Cypriot banks to misguidedly purchase vast amounts of Greek sovereign debt before and during the euro crisis. Cyprus became a casualty of the Greek’s very own bailout restructuring. Oh the irony again.

Creditor Structure

Bank depositors by now will have realised that bank deposit guarantees are not worth the paper they are written on and the legal precedent to label this confiscation of assets as a ‘stability levy’ or tax has no doubt been framed as such so as to circumvent EU deposit guarantee law, which this levy clearly violates. This is stealing – period.

Every saver in Italy, Spain, Portugal – but not limited to these countries, as it potentially applies to any saver in northern Europe and the UK – is at risk of a confiscation of their hard-earned money.  We will likely see depositor flight from the periphery to the supposedly more robust surplus countries, principally Germany. This is despite the very large outstanding Target2 balances owed Germany by the periphery, but don’t expect the man in the street to be aware of this fact.  This is unfortunate as some progress was being made in the reduction of Target2 imbalances as deposits in the periphery showed renewed signs of growth.

The Troika has run roughshod over the rule of law. By calling for a universal bail-in of depositors (the most secure rung of the bank capital ladder) before extracting money from shareholders, junior and subordinated bondholders, the EU bureaucrats and IMF have unilaterally ripped up the legal framework for property rights. This is a truly worrying and frightening progression – actually regression – in economic freedom.

At Hinde Capital, we have no issue with uninsured depositors contributing to the bail-out of a banking system, even as unpalatable and clearly undesirable as this would seem.

Unfortunately bank depositors (savers) have long been under the misguided impression that they are potentially immune from a bank collapse, with the State providing a safety net in the form of deposit guarantees up to a declared sum.  I would argue that individuals, partly due to government propaganda in the good times, have long since forgotten – or indeed have never understood – that once you deposit your money into a bank, you give up your right to ownership, i.e. it’s a LOAN! An asset which is lent out multiple times according to the agreed practice under fractional reserve banking clearly has a risk of no return, albeit a seemingly a low risk when confidence and trust in the economic system is high.

In truth, the correct order of claims on the creditor structure in this ‘bankruptcy’ proceeding has been largely ignored as the Cypriot banks have such a small sliver of equity and debt, and have an unusually large depositor base.  It is the involvement of the depositor base that turns this whole debacle into a plot of immense political intrigue and, indeed, even conspiracy.

Cyprus-sia ‘Tax’ Haven

It has been long known that Cyprus has held a vast sum of deposits from Russian lenders, and because of that Russia has been its biggest direct foreign investor. Low corporate tax rates, sub 10%, were the attraction, with Russians transferring their money into companies based in Cyprus. Some of this was then reinvested back in Russia.  According to Der Spiegel:

An internal study by the German foreign intelligence agency, the Bundesnachrichtendienst (BND), says banks in Cyprus hold $26 billion (€20.33 billion) in deposits by Russian investors. According to the BND, most of this money has been illegally moved abroad to evade Russian tax authorities. By Cypriot standards it’s a tremendous sum given that the island’s entire annual GDP amounts to €17 billion.

The Cypriot government on Monday denied the money-laundering accusation. A government spokesman said SPIEGEL was trying to besmirch the reputation Cyprus has as an international investment location. The country had effective money-laundering rules and adhered to EU law, the spokesman said.

Indeed, Russians aren’t the only ones who sought the refuge of this once tax safe-haven, and consequently other European countries were not keen to be seen to be using their own tax payers’ money to afford a bail-out for ‘tax dodgers’ and money laundered in Cypriot banks by Russian KGB, mafia and their own citizens. So you could call the tax on uninsured depositors actually a levy on money laundering – call it a 10% haircut for washing your dirty linen. I bet any good money launderer worth his salt would take that cut.

Conspiracy Talk

The question is why have the small savers been penalised? This is the point in the plan which makes the EU bureaucrats look so dysfunctional or at best dishonest – I meant to phrase it that way round. By penalising small depositors, mostly local Cypriots, they, as I have stated, undermined the universally agreed EU depositor guarantee that currently stands at €100,000. The talk is that the Cypriot government took a line of credit of some €2.5 billion from Russia in 2011, and having utilised it fully, wanted to appease the ‘motherland’.  So they have agreed not to levy the full tax on deposits above €100,000. By doing this they hope for further assistance from Russia. I suspect they will offer support as Russian banks have loaned in excess of $40 billion to Cypriot companies of Russian origin (according to financial reports).

The Private Sector Initiative (PSI) on depositors is a victory for the ‘northern league’ of Europe, for now at least.  With a German election year in full swing, Merkel needed to satiate German taxpayers by no longer exposing their euros to the profligacy of the periphery. Yes, a victory in round one for Merkel and the CDU, but ‘ding ding’, here comes round two: I bet the Cypriots pull a few punches by pushing back on the levy on small depositors. ‘Ding, ding’ – round 3 – I say Merkel gets knocked off her feet as depositors flee the periphery and then (eventually) Mario has to step in and decide whether to cite ‘irreversibility’ status as a clause to stem a banking sector collapse in Europe, and provide unlimited monetary support, but without the conditionality clause of austerity. I say ‘eventually’ as Mario had repeatedly slapped the EU finance ministers, and Schauble particularly, for advocating a haircut on bank deposits. So he could really make Germany sweat by holding back on a re-load of its big bazookas’ – long-term LTROs and OMTs.

In the interim the national central bank (NCB), in this case Cyprus is no doubt utilising the ELA (Emergency Liquidity Assistance) to supply the Cypriot banks with sufficient funds to remain liquid in the event of insolvency and failure.  This is at the risk of the NCB concerned and outside the ECB’s refinancing operational framework.  It is completely opaque and in truth it will appear as a Target 2 ledger or on the ECB asset side as ‘Other assets’.

For now the Cypriot banks are on holiday, forcibly closed for business until at least Thursday at time of writing, so depositors cannot withdraw their money. Likewise, ATMs have been deactivated and electronic wire transfers suspended. They will be opened once the Cypriot parliament has ratified (or not) the deposit levy and other terms of the bail-in. It could well be that the terms change to protect small savers as they should have been all along. Either way, the psychological damage has been exacted across European populations.

Contagion Risk

Those who think there is little risk of a levy being imposed on other periphery members are missing the point. The seeds of doubt have been planted. As a saver facing zero yields on deposits and a potential haircut, why keep your savings in a bank? Sure it is convenient for electronic transactions, but individuals can adapt easily. As one of my more amusing colleagues put it, “mattresses now hold a 10 per cent premium”.

Talk of ‘exceptional’ circumstances and a ‘one-off’ are true but only because Germany and the Troika would never succeed in enforcing such illegal measures on Italy and Spain without risking social unrest and a collapse of the euro. The Cypriots have more leverage than they realise. The Russians don’t need a failure as it could mean Russian bank risk. Moreover, Target 2 imbalances likely ensure that the ECB would not cut off the ELA and risk a euro currency break-up.


What this should reaffirm to you all is how the handling of the crisis has only succeeded in heightening the risks associated with this current monetary order.  The excessive amounts of debt have continued to grow and are clearly not sustainable. Policymakers have resorted to draconian methods of expropriating private sector assets (households, pension funds and corporates) either by excessive explicit ‘taxation’ and/or stealth taxation administered by a policy of negative real rates to help reduce the fixed real burden of debts.

It also reinforces our long-held views that when push comes to shove policymakers (the State) will escalate oppressive tactics against their electorate in a bid to maintain their status quo and that of their fiat currency system.

Of most importance is the adherence to retrospective changes of law and different rules for different people and countries. Insolvencies are generally well-defined in law. The first is to equity, then subordinated debt, then deposits and senior bonds together.  The creditor structure has been up-ended and more than merely tweaked over the last few years.  I suspect with levels of ignorance high amongst populations they haven’t quite woken up to the reality that the state is not in fact here for your protection as it once was and that we all need to take on self-reliance and a heightened sense of responsibility for ourselves. Some notable rule changes of late are subtle but growing in number:

  1. The ECB, holders of Athens-law and foreign law Greek debt all received different treatment
  2. The Dutch didn’t restructure SNS Reaal paper, they confiscated it
  3. The Irish banned lawsuits against the ultimate wind-down of Anglo Irish
  4. Portuguese private pensions were confiscated

The list is long but you get the idea.  Rule-changes are getting ‘regressively’ more creative and sinister. As a friend pointed out to me, this as if the “football referee has gone from being a quasi-neutral arbiter, to pulling off his black shirt to reveal a Manchester United one underneath and awarding himself a series of penalties.”

The bail-out should have been a legal bail-in whereby equity is wiped out, and all bank debt is written down. Then unsecured (uninsured) depositors i.e. above €100,000 should have taken a double digit hit. By doing this EU finance ministers and lawmakers would have been respecting the creditor hierarchy and honouring the rule of law. The retrospective change of law is what should alarm us all. The insidious and subtle nature of this encroachment on our civil rights sets an ominous precedent and those who glibly mock libertarians for their ‘rants’ are no doubt those same people who thought PIIGS really do fly.

The bail-in announcement for the Cypriot banks late Friday night was one of those events when we all look back and think that was the beginning of the end of the real global financial crisis. Every investor in Europe should be left with no illusion. The political elite will enact whatever it deems fit to protect the euro and their own positions of power.

It is clear that markets and investors underestimate the reality that debt restructurings are necessary but won’t necessarily be enacted, which leaves only more private sector wealth transfers (confiscation) and likely circumvention of the underlying problem of sovereign insolvency by central bank deficit financing.

So much for EMU solidarity…comrades.


Central Bank Revolution I: market monetarism misdiagnosis (M3)

To begin to understand how central banks intend to reignite economic growth we have to understand that central bankers believe that changes in the quantity of money affect the price level, and for a short time, the level of economic activity, ie output.

By examining a classic monetary equation which became the foundation of Milton Friedman’s monetarism and central bank monetary policy we can see why there is potential for much more money printing.


M= money supply

V = velocity of money/ circulation

P = prices of goods and services/ price level

T = quantity of goods and services/ transactions or output 

Irving Fisher termed this the quantity theory of money, and is often credited with this economic identity, but it was in fact the mathematician and astronomer Simon Newcomb who introduced this simple relationship; the equation of exchange, when he ventured into a new field of expertise with his book Principles of Political Economy (1885). Fisher’s belief is upheld by central bankers today: 

we find nothing to interfere with the truth of the quantity theory that variations in money (M) produce normally proportional changes in prices

MV=PT simply put means the amount of money spent (MV) is always equal to the price of all things bought (PT) in an economy over any given period of time. If MV is the quantity of money (M) multiplied by the number of times that money is used during any given period (V); and if PT represents the price (P) of each product multiplied by the quantity purchased or volume traded (T) then this must equal the value of everything produced and sold in an economy during a given period of time.

If we look again at the definition of nominal GDP – the sum of all the goods and services produced, counted in their quantity (the ‘real GDP’), and then multiplied by their prices (the ‘price index’ or ‘deflator’). Clearly this is the same as PT. Therefore MV = PT = Nominal GDP. 

Market Monetarism Misdiagnosis (M3)

A new strain of monetarism called market monetarism argues that because velocity is unpredictable, the Fed should manipulate the money supply so as to offset fluctuations in velocity and maintain a fixed rate of growth in the level of aggregate demand. Successfully doing so, they maintain, would considerably mitigate demand-side macroeconomic fluctuations.

The two decades prior to the financial crisis of 2008 was known by economists as ‘the Great Moderation’, an acknowledgement of a period of low inflation and relatively stable growth, with only two relatively mild recessions.

Furthermore, this stable period was attributed to the success of the Federal Reserve Bank (and many of the other world’s central banks) adopting an inflation target. They decided on a preferred inflation rate and steered the economy towards it, adjusting interest rates lower when inflation fell below target and higher when inflation exceeded the target.

Then in 2008 the severest recession since the Great Depression undermined economists’ faith in the ability of central banks to respond to crises as they were seemingly unable to prevent this major crisis. The search for alternative ways to conduct monetary policy began.

Inflation targeting was supposed to make the demand-side fiscal policy less relevant or even obsolete, as after all, both monetary and fiscal policy affect the same variable, total nominal spending (aggregate demand).

However the slump in nominal spending has had demonstrative effects as both public and private sector debt burdens have risen. Since both households and governments ability to service their debt depends upon their nominal incomes and revenues, a new monetary solution is being advocated that in encompasses the impact of fiscal policy. The solution that has risen to prominence is Nominal GDP level Targeting (NGDPLT).

NGDPLT was the hottest idea in monetary blogs over the last few years but has now migrated from the academic cloudscape to implementation. Central bank monetary policy setting across the G7 is adopting de facto or actual NGDPLT.

It was the Danish economist Lars Christensen of Danske Bank who coined the phrase ‘Market Monetarist’ in his working paper Market Monetarism – The Second Monetarist Counter-revolution. In it he refers to this economic school as the first to be born out of the blogosphere and in the abstract he defines the school as such:

Market Monetarism shares many of the views of traditional monetarism but unlike traditional monetarism Market Monetarism is sceptical about the usefulness of monetary aggregates as policy instruments and as an indicator for the monetary policy stance. Instead, Market Monetarists recommend using market pricing to evaluate the stance of monetary policy and as a policy instrument. Contrary to traditional monetarists — who recommend a rule for money supply growth – Market Monetarists recommend targeting the Nominal GDP (NGDP) level. The view of the leading Market Monetarists is that the Great Recession was not caused by a banking crisis but rather by excessively tight monetary policy. This is the so-called Monetary Disorder view of the Great Recession.

Proponents of NGDPLT believe it is better than inflation targeting, which to date has been used explicitly or implicitly by most central banks as a means of stabilising inflation and growth. Critics of inflation targeting centres on the belief that such a target provides too little flexibility to stabilise growth and/or employment in the event of an external economic shock.

The lead protagonist is arguably Scott Sumner, Professor of economics at Bentley University who adopted the motif of Market Monetarism having written extensively in his blog The Money Illusion to promote NGDPLT.

Sumner outlines nominal income or NGDPLT for the US in an article Re-targeting the Fed in National Affairs, Issue Fall 2011, and applies it to the UK in The Case for NGDP Targeting – Lessons from the Great Recession in a publication by the Adam Smith Institute in 2011.

NGDP and NGDPLT explained

Nominal GDP (NGDP) is the sum of all the goods and services produced, counted in their quantity (the ‘real GDP’), and then multiplied by their prices (the ‘price index’ or ‘deflator’). So NGDP combines a ‘real’ variable – one that measures something being actually produced and a ‘nominal’ variable, one which considers prices and not actual production.

Simply put NGDP is the sum or value of all spending in the economy, measured in US dollars, in the case of the US or Sterling, in the case of the UK etc; as you and I use them. It is the GDP figure that has not been adjusted for inflation. For example if nominal GDP is 8% and inflation has been 4%, the real GDP has increased 4% (NGDP minus inflation).

NGDP Level targeting is where a central bank determines a path along which NGDP would grow, and uses its monetary policy tools to affect that end; either conventional or unconventional if at the zero bound.

In practice the central bank, say the Fed, would adopt an annual rate of nominal income growth of 4 to 5%, and commit to return to that trend line when spending falls short or overshoots. So if the target is 5% and NGDP comes in at only 4% one year, they would aim for 6% the next year.

In most developed countries inflation has been preferred at 2% and long term growth potential at 2 to 3% and monetary policy would react, as it does now, easing when NGDP growth was expected to be too slow and tighten when it was too fast. So if NGDP fell below the target growth rate in any one year then the central bank would seek to make up for that in subsequent years.

What one will see is that in any one year the components of NGDP will vary. If trend target growth is a 5% NGDP, in years where real GDP is 1% then the central bank will alter monetary policy to achieve 4% inflation or such inflation that is required over a number years to regain this trend path of 5%. This as we discuss later is one the main criticisms of NGDPLT – that excessive growth in money supply could lead to higher inflation than is stable for long term sustainable output (employment).

Advocates of NGDPLT believe its overriding virtue is that it can address the dual concerns of macroeconomic policy by combining both employment and inflation into a single metric. It provides a way to address both inflation and output (employment) stability, without placing the central bank in the confusing situation of having to aim at two separate targets which require opposite action to achieve them.

A Flaw in Nominal GDP Level Targeting

In our latest HindeSight Investor Letter – “The Central Bank Revolution I – Well ‘Nominally’ So” we explored the arguments for and against NGDPLT in some depth. We wanted to highlight one flaw here, which is the potential implementation of NGDPLT.

The single biggest problem for a NGDPLT is what is the start date from which to project a trend path for NGDP. If one recalls NGDP Level targeting is where a central bank determines a path along which NGDP would grow, and using its monetary policy tools to affect that end; either conventional or unconventional if at the zero bound.

Christina Romer, professor at the University of California, Berkeley in a NY Times article making the case for NGDPLT explained how it would work:

The Fed would start from some normal year — like 2007 — and say that nominal G.D.P. should have grown at 4 1/2 percent annually since then, and should keep growing at that pace. Because of the recession and the unusually low inflation in 2009 and 2010, nominal G.D.P. today is about 10 percent below that path. Adopting nominal G.D.P. targeting commits the Fed to eliminating this gap. HOW would this help to heal the economy? Like the Volcker money target, it would be a powerful communication tool. By pledging to do whatever it takes to return nominal G.D.P. to its pre-crisis trajectory, the Fed could improve confidence and expectations of future growth.

The key phrase here is – “is some normal year – like 2007”.

We nearly choked on our morning Weetabix when reading this comment. This encapsulates to us how market monetarists have totally misunderstood that we have witnessed a super credit cycle that culminated in a blow-off bubble in 2007. Now this is hardly a year that we would term ‘normal.’

Normal is brushing your teeth before you go to bed, normal is filling your car with petrol because that is what provides the essential ingredient to propel it; normal is not gunning your car at 200 mph down the motorway so you won’t be late for a speeding offence, which would be somewhat analogous to starting the economy again at some excessive price rate of the likes we witnessed in 2007. This graph below illustrates beautifully how far we are away from Romer’s concept of norm:

Our next graph illustrates that if we started with 1994 when the FOMC signalled base rate changes then one could argue that late 90s and early 2000s were over-trending and 4.5% is the correct growth rate. This fits with our understanding of credit induced NGDP. We would emphasise that this suggests the Fed should do nothing more as it is at the target level, finally.

The same thought process can be applied to analysis of UK NGDP. The next graph shows a NGDP growth level of 5% by which the BoE could signal its intentions. It is clear that prior to 2008 the UK NGDP was running ahead of this pathway. One can see the gap that now exists – this is the output gap that policymakers like to refer to, and why market monetarists advocate that NGDP should rise by more than 5% to get back to its original trend path.

Anthony J. Evans of Kaleidic Economics illustrates that using a 4.5% NGDP target level extrapolated from 1997 shows the boom up to 2007 was significantly above trend. So depending on what target level one uses determines if you are back at trend levels, or undershooting. And if you want to get back to a 2007 projection M will have to rise considerably, and no doubt P will do too. So what is the correct growth rate required to get back to trend levels?

Again, one can see it all depends on a start point that is totally arbitrary.

UK 4.5% Target Level – Are we at the trend growth rate already? 

Evans has a keen sense of humour when his observation on an extrapolated 2007 trajectory for NGDPL targets:

But by this logic we should believe that since Usain Bolt can run the 100 metres in under 10 seconds, he could run 600 metres in under a minute.

Market Monetarists have overlooked credit, in the same way the US Federal reserve did away with collating data on M3 credit supply. This oversight and misdiagnosis renders NGDPLT as a non-starter.

The great Monetarist Milton Friedman who persistently argued that the main reason still to have an independent central bank was that over the medium and longer term monetary forces influence only monetary variables. Other real, ie supply-side, factors determine long-term growth. So are Market Monetarists really now telling us that faster and higher inflation will generate sustainable long-term growth rates and faster to boot? Really…

In our latest HindeSight Investor Letter – The Central Bank Revolution I (Well ‘Nominally’ So) – we explore and counter this new wave of economics called Market Monetarism, which advocates NGDPLT and which appears to be revolutionising central bank monetary policy.

This article was previously published at


The Central Bank Revolution I (well ‘nominally’ so)

“The Checklist Manifesto – How to get things right”, is a masterful book for its narrative and practical application. Written by Atul Gawande, an acclaimed surgeon based in the US, he takes us on a journey of how the simple checklist helps individuals deal with immensely complex situations, where risks can be calculated and often lives protected – skyscraper construction, medicine and investment banking.

First introduced into the US Air Force to assist pilots, the humble checklist in all its simplicity has helped generations of pilots navigate the complexity of flying modern aeroplanes. Gawande himself has introduced the concept into operating theatres and hospitals around the world with astounding success.

At Hinde Capital we have embraced such a concept almost naturally in an attempt to codify both our objective and subjective observations of the market place. Our hope is to eliminate behavioural biases that can lead to a misdiagnosis of events before an investment decision.

It has long been our contention that central bankers have misdiagnosed the dynamics of the global economy, particularly in this last decade. Right up until the implosion of equity markets in 2007 and 2008 Bernanke said there was no housing bubble, that inflation was benign, even though almost every asset price from equities to gold was trending in a succession of levitating new highs. When considering how to guide a system as complex as the global economy with so many independent countries and decision makers, we often wonder what type of checklist a modern central bank was actually employing. The crucial ingredient, though, is not only a checklist but the correct checklist.

Central Bank Checklist Manifesto

In a hospital one of the most basic but effective checklists deployed since the 1960s as introduced by nurses was a vital signs chart – every few hours or so nurses would check the following:

  • Pulse
  • Blood pressure
  • Temperature
  • Respiration

Likewise a central bank observes certain vital signs to observe the state of the economy – their patient. To have an understanding of what the ‘vital signs’ checklist is for the Fed, let’s look at their duties as outlined in their manifesto The Federal Reserve System – Purposes & Functions.

The Federal Reserve’s duties fall into four general areas:

• conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates

• supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers

• maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

• providing financial services to depository institutions, the US government, and foreign official institutions, including playing a major role in operating the nation’s payments system

Let’s focus on the first point. The Fed’s objectives include economic growth in line with the economy’s potential to expand; a high level of employment; stable prices (that is, stability in the purchasing power of the dollar); and moderate long-term interest rates. So their vital signs checklist may go something like this:

  • Growth
  • Employment
  • Inflation
  • Interest rates

Alan Blinder, a former Fed governor and Vice Chairman (1994-96) wrote an insightful working paper called Monetary Policy Today: Sixteen Questions and about Twelve Answers’. These questions in many ways are a checklist questioning parts of the Fed manifesto. Blinder himself resigned as Vice Chairman under Greenspan as he was in disagreement with his diagnosis of the US and global economy.

Central banks have tried to be omnipotent in guiding economic behaviour rather like a surgeon accustomed to holding centre stage in his ‘operatic’ theatre. The central banker can’t enforce his will on agents in the economy because it does not allow for human beings’ subjective preferences on how to spend and live. Using a policy of market expectations to direct human action, based on assumptions of some rational expectation, has been proven to be flawed. Besides which, who leads? The marketplace or the central bank? – the dog or the dog’s tail?

The great US humourist of the Depression era, Will Rogers once famously said, “There have been three great inventions since the beginning of time: fire, the wheel, and central banking”.  His comment, laced with no small amount of irony, may have well been uttered today.

Central Bank CAnniBALism

Central banks are the devil. They are like drug dealers except they administer regular doses of supposedly legally prescribed barbiturates to their addicts. The ‘easy money’ or ‘credit’ they create is an opiate, and like all addictions there is a payback for the addicts, one exacted only in loss of health, misery, and death.

Our reliance on ‘easy money’ as facilitated by credit has become terminal.  Like drug users we continue to attempt to find a heightened state of nirvana. We continue to hark for the utopian days prior to the eruption of the post-2008 crisis, even though our well-being was fallacious and based on an illusion of wealth paid for by credit – a creditopia. The abuse of credit is what defined the Great Financial crisis and one that still defines our economic system and one which will define a much worse crisis to come.

Central bankers have begun a concerted effort to fight the global debt problem which has been stifling growth as tax revenues merely serve to finance debt servicing rather than addressing the repayment of principal outstanding. Omnipotent governors, Bernanke, Carney, Draghi, Svensson and Iwata or Kuroda (either are likely to replace Shirakawa at the BoJ) are to take a far more aggressive and activist role in pursuing a new framework for growth and inflation by seeking an alternative way to conduct monetary policy. It’s called Nominal GDP Level targeting (NGDPLT) and it is in our opinion as significant a moment as Volcker’s appointment to the Federal Reserve governorship in 1978.

Many will recall Volcker’s moment was to engineer a swift monetary contraction and deceleration of the money velocity to try and reign in excessively high inflation and stabilise growth. It worked. Today we are witnessing an ‘Inverse Volcker’ moment, whereby the opposite is likely true.

The question remains: are they all still ‘inflation nutters’ as Mervyn King, the BoE Governor glibly referred to those central bankers who focussed solely on inflation targets to the potential detriment of stable growth, employment and exchange rates.

Are central bankers merely expanding the boundaries of monetary largesse by focusing on a broader mandate and merely evolving the singular variable approach of inflation targeting, or have they finally found a solution to eradicating boom-bust business cycles? This is a question we need to answer as we are currently witnessing a Central Bank Revolution which could portend severe consequences for prices in our economies, and all the attendant misery that comes with very high inflation.

Nominal GDP Level targeting advocates believe they have a plausible case for a change of mandate by central banks and one which is being gradually adopted, but we believe that like central banks they have misdiagnosed the cause of the crisis by failing to examine the impact of credit creation in our global economy. Money matters, but credit matters more.

In our latest HindeSight Investor Letter – The Central Bank Revolution I (Well ‘Nominally’ So) – we explore and counter this new wave of economics called Market Monetarism, which advocates NGDPLT and which appears to be revolutionising central bank monetary policy.

This article was previously published at