The Bitcoin phenomenon has now reached the mainstream media where it met with a reception that ranged from sceptical to outright hostile. The recent volatility in the price of bitcoins and the issues surrounding Bitcoin-exchange Mt. Gox have led to additional negative publicity. In my view, Bitcoin as a monetary concept is potentially a work of genius, and even if Bitcoin were to fail in its present incarnation – a scenario that I cannot exclude but that I consider exceedingly unlikely – the concept itself is too powerful to be ignored or even suppressed in the long run. While scepticism towards anything so fundamentally new is maybe understandable, most of the tirades against Bitcoin as a form of money are ill-conceived, terribly confused, and frequently factually wrong. Central bankers of the world, be afraid, be very afraid!
Any proper analysis has to distinguish clearly between the following layers of the Bitcoin phenomenon: 1) the concept itself, that is, the idea of a hard crypto-currency (digital currency) with no issuing authority behind it, 2) the core technology behind Bitcoin, in particular its specific algorithm and the ‘mining process’ by which bitcoins get created and by which the system is maintained, and 3) the support-infrastructure that makes up the wider Bitcoin economy. This includes the various service providers, such as organised exchanges of bitcoins and fiat currency (Mt. Gox, Bitstamp, Coinbase, and many others), bitcoin ‘wallet’ providers, payment services, etc, etc.
Before we look at recent events and recent newspaper attacks on Bitcoin, we should be clear about a few things upfront: If 1) does not hold, that is, if the underlying theoretical concept of an inelastic, nation-less, apolitical, and international medium of exchange is baseless, or, as some propose, structurally inferior to established state-fiat money, then the whole thing has no future. It would then not matter how clever the algorithm is or how smart the use of cryptographic technology. If you do not believe in 1) – and evidently many economists don’t (wrongly, in my view) – then you can forget about Bitcoin and ignore it.
If 2) does not hold, that is, if there is a terminal flaw in the specific Bitcoin algorithm, this would not by itself repudiate 1). It is then to be expected that a superior crypto-currency will sooner or later take Bitcoin’s place. That is all. The basic idea would survive.
If there are issues with 3), that is, if there are glitches and failures in the new and rapidly growing infra-structure around Bitcoin, then this neither repudiates 1), the crypto-currency concept itself, nor 2), the core Bitcoin technology, but may simply be down to specific failures by some of the service providers, and may reflect to-be-expected growing pains of a new industry. As much as I feel for those losing money/bitcoin in the Mt Gox debacle (and I could have been one of them), it is probably to be expected that a new technology will be subject to setbacks. There will probably be more losses and bankruptcies along the way. This is capitalism at work, folks. But reading the commentary in the papers it appears that, all those Sunday speeches in praise of innovation and creativity notwithstanding, people can really deal only with ‘markets’ that have already been neatly regulated into stagnation or are carefully ‘managed’ by the central bank.
Those who are lamenting the new – and yet tiny – currency’s volatility and occasional hic-ups are either naïve or malicious. Do they expect a new currency to spring up fully formed, liquid, stable, with a fully developed infrastructure overnight?
Recent events surrounding Mt Gox and stories of raids by hackers would, in my opinion, only pose a meaningful long-term challenge for Bitcoin if it could be shown that they were linked to irreparable flaws in the core Bitcoin technology itself. There were indeed some allegations that this was the case but so far they do not sound very convincing. At present it still seems reasonable to me to assume that most of Bitcoin’s recent problems are problems in layer 3) – supporting infrastructure – and that none of this has so far undermined confidence in layer 2), the core Bitcoin technology. If that is indeed the case, it is also reasonable to assume that these issues can be overcome. In fact, the stronger the concept, layer 1), the more compelling the long-term advantages and benefits of a fully decentralized, no-authority, nationless global and inelastic digital currency are, the more likely it is that any weaknesses in the present infrastructure will quickly get ironed out. One does not have to be a cryptographer to believe this. One simply has to understand how human ingenuity, rational self-interest, and competition combine to make superior decentralized systems work. Everybody who understands the power of markets, human creativity, and voluntary cooperation should have confidence in the future of digital money.
None of what happened recently – the struggle at Mt. Gox, raids by hackers, market volatility – has undermined in the slightest layer 1), the core concept. However, it is precisely the concept itself that gets many fiat money advocates all exited and agitated. In their attempts to discredit the Bitcoin concept, some writers do not shy away from even the most ludicrous and factually absurd statements. One particular example is Mark T. Williams, a finance professor at Boston University’s School of Management who has recently attacked Bitcoin in the Financial Times and in this article on Business Insider.
Money and the state: Fact and fiction
Apart from all the scare-mongering in William’s article – such as his likening Bitcoin to an alien or zombie attack on our established financial system, stressing its volatility and instability – the author makes the truly bizarre claim that history shows the importance of a close link between currency and sovereignty. Good money, according to Williams, is state-controlled money. Here are some of his statements.
“Every sovereignty uses currency.”
“Trust and faith that a sovereign is firmly standing behind its currency is critical.”
“Sovereigns understand that without consistent economic growth and stability, the standard of living for its citizens will fall, and discontentment will grow. Nation-state treasuries print currency but the vital role of currency management– needed to spur economic growth — is reserved for central bankers.”
Williams reveals a striking lack of historical perspective here. Money-printing, central banking and any form of what Williams calls “currency management” are very recent phenomena, certainly on the scale that they are practiced today. Professor Williams seems to not have heard of Zimbabwe, or of any of the other, 30-odd hyperinflations that occurred over the past 100 years, all of which, of course, in state-managed fiat money systems.
Williams stresses what a long standing concept central banking is, citing the Swedish central bank that was founded in 1668, and the Bank of England, 1694. Yet, human society has made use of indirect exchange – of trading with the help of money – for more than 2,500 years. And through most of history – up to very recently – money was gold and silver, and the supply of money thus practically outside the control of the sovereign.
The early central banks were also very different animals from what their modern namesakes have become in recent years. Their degrees of freedom were strictly limited by a gold or silver standard. In fact, the idea that they would “manage” the currency to “spur” economic growth would have sounded positively ridiculous to most central bankers in history.
Additionally, by starting their own central banks, the sovereigns did not put “trust and faith” behind their currencies – after all, their currencies were nothing but units of gold and silver, and those enjoyed the public’s trust and faith on their own merit, thank you very much – the sovereigns rather had their own self-interest at heart, a possibility that does not even seem to cross William’s mind: The Bank of England was founded specifically to lend money to the Crown against the issuance of IOUs, meaning the Bank of England was founded to monetize state-debt. The Bank of England, from its earliest days, was repeatedly given the legal privilege – given, of course, by its sovereign – to ignore (default on) its promise to repay in gold and still remain a going concern, and this occurred precisely whenever the state needed extra money, usually to finance a war.
Bitcoin is cryptographic gold
“Gold is money and nothing else.” This is what John Pierpont Morgan said back in 1913. At the time, not only was he a powerful and influential banker, his home country, the United States of America, had become one of the richest and most dynamic countries in the world, yet it had no central bank. The history of the 19th century US – even if told by historians such as Milton Friedman and Anna Schwarz who were no gold-bugs but sympathetic to central banking – illustrates that monetary systems based on a hard monetary commodity (in this case gold), the supply of which is outside government control, is no hindrance to vibrant economic growth and rising prosperity. Furthermore, economic theory can show that hard and inelastic money is not only no hindrance to growth but that it is indeed the superior foundation of a market economy. This is precisely what I try to show with Paper Money Collapse. I do not think that this was even a very contentious notion through most of the history of economics. Good money is inelastic, outside of political control, international (“nationless”, as Williams puts it), and thus the perfect basis for international cooperation across borders.
Money was gold and that meant money was not a tool of politics but an essential constraint on the power of the state.
As Democritus said “Gold is the sovereign of all sovereigns”.
It is clear that on a conceptual level, Bitcoin has much more in common with a gold and silver as monetary assets than with state fiat money. The supply of gold, silver and Bitcoin, is not under the control of any issuing authority. It is money of no authority – and this is precisely why such assets were chosen as money for thousands of years. Gold, silver and Bitcoin do not require trust and faith in a powerful and privileged institution, such as a central bank bureaucracy (here is the awestruck Williams not seeing a problem: “These financial stewards have immense power and responsibility.”) Under a gold standard you have to trust Mother Nature and the spontaneous market order that employs gold as money. Under Bitcoin you have to trust the algorithm and the spontaneous market order that employs bitcoins as money (if the public so chooses). Under the fiat money system you have to trust Ben Bernanke, Janet Yellen, and their hordes of economics PhDs and statisticians.
Hey, give me the algorithm any day!
Money of no authority
But Professor Williams does seem unable to even grasp the possibility of money without an issuing and controlling central authority: “Under the Bitcoin model, those who create the software protocol and mine virtual currencies would become the new central bankers, controlling a monetary base.” This is simply nonsense. It is factually incorrect. Bitcoin – just like a proper gold standard – does not allow for discretionary manipulation of the monetary base. There was no ‘monetary policy’ under a gold standard, and there is no ‘monetary policy’ in the Bitcoin economy. That is precisely the strength of these concepts, and this is why they will ultimately succeed, and replace fiat money.
Williams would, of course, be correct if he stated that sovereigns had always tried to control money and manipulate it for their own ends. And that history is a legacy of failure.
The first paper money systems date back to 11th century China. All of those ended in inflation and currency disaster. Only the Ming Dynasty survived an experiment with paper money – by voluntarily ending it and returning to hard commodity money.
The first experiments with full paper money systems in the West date back to the 17th century, and all of those failed, too. The outcome – through all of history – has always been the same: either the paper money system collapsed in hyperinflation, or, before that happened, the system was returned to hard commodity money. We presently live with the most ambitious experiment with unconstrained fiat money ever, as the entire world is now on a paper standard – or, as James Grant put it, a PhD-standard – and money production has been made entirely flexible everywhere. This, however does not reflect a “longstanding bond between sovereign and its currency”, as Williams believes, but is a very recent phenomenon, dating precisely to the 15th of August 1971, when President Nixon closed the gold window, ended Bretton Woods, and defaulted on the obligation to exchange dollars for gold at a fixed price.
The new system – or non-system – has brought us persistent inflation and budget deficits, ever more bizarre asset bubbles, bloated and unstable banking systems, rising mountains of debt that will never be repaid, stagnating real incomes and rising income disparities. This system is now in its endgame.
But maybe Williams is right with one thing: “If not controlled and tightly regulated, Bitcoin — a decentralized, untraceable, highly volatile and nationless currency — has the potential to undermine this longstanding bond between sovereign and its currency.”
Three cheers to that.
This article was previously published at DetlevSchlichter.com.
This is the final blog entry in the ‘Schlichter Files’. Pretty soon, DetlevSchlichter.com will be taken offline. I would like to take this opportunity to thank all my readers for following my commentaries, essays and occasional rants over the past two-and-a-half years. Thank you.
I would like to express a special gratitude to all who provided comments. I have found so many of the comments from readers to be perceptive and thoughtful, and enjoyed them even when I didn’t respond (as has usually been my policy). Somewhat to my surprise, the feedback to the blog entries has predominantly been positive, and there have only been a few negative or hostile responses. However, I am not deluded and think that a majority out there agrees with me. I think that those who dislike my general outlook have simply not bothered to comment.
Why the sudden and abrupt end? – Well, truth be told, it was not an abrupt or sudden decision at all. The primary purpose of my website has always been to promote my book (for most of its life the website was called papermoneycollapse.com), and to try and find a larger audience for my economic views. The website gave me a platform to comment on current events, market discussions and policy initiatives, and in doing so, apply the ideas I had developed in Paper Money Collapse. I hoped that this would generate more interest in the book and, by extension, the ideas of the Austrian School of Economics in general and those of Ludwig von Mises in particular. I never expected to make ‘blogging’ my new profession. I always expected that this would be a project with a limited life-span.
Having said this, I very much enjoyed writing for the website. I love writing and I love economics, and the experience of writing a semi-academic book on money and a running blog on economic developments was great fun. If some readers out there have enjoyed reading the blogs only half as much as I enjoyed writing them, the whole effort was not in vain. The most important contribution that I have made over the past four years of being an author and commentator, however, remains, in my assessment, Paper Money Collapse. This was the book that was ‘in me’ back in 2009 when I decided to resign from my position as a senior investment professional in the City of London and to pursue my intellectual interests. The book has now found its audience. Only time will tell if it made a lasting impression. It was certainly fun to write and promote it, I stand by everything I say in it, but it is now time to move on.
There are a couple of projects that I am excited about and that I now want to pursue in earnest. I do not want to have a stale, non-updated website on the net with my name on it, so within a week or two DetlevSchlichter.com will disappear. If anybody is still interested in my old blogs, you should be able to find them on the website of the Cobden Centre, which has published my essays almost from the start in early 2011, or on Jim Puplava’s FinancialSense site. A couple of other websites have also republished my work, sometimes translated into other languages, so whatever I wrote remains in the public domain.
Thanks again for all your interest and support, and please remember….
…the debasement of paper money still continues.
With best wishes,
The British media is obsessed with Mark Carney, the new boss at the Bank of England, who, this week, made his first public appearance as governor with a speech in Nottingham. There were adoring comments about his looks (the vague resemblance with George Clooney, supported with plenty of photographs) and his voice (deep, confident, reassuring), and as most journalists are more in awe of money and wealth than they are willing to admit, references to his generous pay package were also not missing. But there was also consternation that the words of the ‘most talented central banker of his generation’ seemed to carry so little weight with the markets.
The Wall Street Journal had previously described Carney as ‘a pioneer of forward guidance’. Forward guidance is the allegedly new central bank technique of telling the market where policy will be heading (or rather, assuring the market where it will not be heading), supposedly in order to make policy more effective. Despite Mr. Carney’s repeated assurances that rates will only be moved higher when unemployment drops to a certain level (7% is Mr. Carney’s magic number) and that this will not occur until 2016, the market has recently been happily selling fixed income securities, and in the process, has allowed the forward curve to start pricing in earlier rate hikes. To Mr. Carney’s pledge to keep rates low, the market has practically been saying, in the words of the inimitable Jeffrey “The Dude” Lebowski, ”Yeah, well, that’s just like…your opinion, man.”
Whether the market will be proven right and whether rates really will move higher earlier than Carney contemplates today, is a question we cannot answer. The future will tell. (Personally, I remain of the opinion that the talk of ‘tapering’ in the US is overdone, that central banks will not manage a smooth ‘exit’ from their position of extreme accommodation, and certainly not anytime soon.) But the market is undoubtedly correct to not allow itself to be guided in its assessment of the economy’s future performance, and therefore future policy, by the BoE’s new super-bureaucrat.
The whole idea of forward guidance is, of course, preposterous. The market knows full well that policy will change if circumstances change. Should the economy recover more quickly, should the Fed’s actions put pressures on other central banks to also remove accommodation, should inflation rise faster, or should the pound come under pressure, the policy elite at the BoE will most certainly have to respond. Conversely, if the economy nosedives again or if another financial accident occurs, central bankers will cut rates again (maybe to negative levels?), and throw more money at the problem.
The market is, of course, frequently wrong in assessing the future. Also, the market’s assessment is constantly changing. But the market is still the most awesome machinery for data-collection and data-processing, and it remains unmatched by any institution, individual or group of individuals, even overpaid George Clooney lookalikes.
Most bizarre about this whole episode is the reverence with which the commentariat still treats the central bankers. Based on their exaggerated view of their own powers to do good, and their importance for ongoing growth, and based on their erroneous and self-serving belief that money-printing is costless as long as certain conveniently self-selected measures of consumer prices remain under control, central bankers have, for years, happily fed the housing bubbles and allowed bank balance sheets to balloon beyond all proportion. They then sleepwalked into the crisis of their own making, and once the house of cards had collapsed, they feverishly tried to recreate semblances of stability and solvency, usually by printing more money faster and by manipulating various asset markets through targeted purchases. Recent financial history is a legacy of central bank failure, yet the media remains uninterested in economics and obsessed with personalities. Politicians, bureaucrats and central bankers – no matter the disasters they produce, the hope persists that the next guy will do better and save the world.
Markets, however, are rather less sentimental and much less prone to political romanticism.
In this respect, the ongoing debate about who will be the next Fed chairman, Janet Yellen or Larry Summers, is equally unenlightened and undignified. Summers strikes me as the more interesting and unpredictable thinker and he would probably make a more entertaining chairman. Nevertheless, the impact of the selection on future policy is marginal, in my view.
And one final thought: if the market is correct and economies are presently recovering with more momentum, then this is most likely the result of reflationary monetary policy finally gaining traction and of accelerating credit growth. In that case, prices won’t stay still. (As an aside, farmland in the US keeps appreciating at double-digit clips.) Inflation and inflation expectations could quickly be on the rise. If that is indeed the case, and if central bankers then keep sitting on their hands because of their forward-guiding commitments, the bond market could continue to be in trouble.
The potential for central bankers to do harm remains bigger than that to do good.
This article was previously published at DetlevSchlichter.com.
Within the Austrian School of Economics there has long been disagreement and therefore occasionally fierce debate about the nature and consequences of fractional-reserve banking, from here on called simply FRB. FRB denotes the practice by banks of issuing, as part of their lending activities, claims against themselves, either in the form of banknotes or demand deposits (fiduciary media), that are instantly redeemable in money proper (such as gold or state fiat money, depending on the prevailing monetary system) but that are not fully backed by money proper. To the extent that the public accepts these claims and uses them side by side with money proper, gold or state fiat money, as has been the case throughout most of banking history, the banks add to the supply of what the public uses as money in the wider sense.
Very broadly speaking, and at the risk of oversimplifying things, we can identify two camps. There is the 100-percent reserve group, which considers FRB either outright fraud or at least some kind of scam, and tends to advocate its ban. As an outright ban is difficult for an otherwise libertarian group of intellectuals to advocate – who would ban it if there were no state? – certain ideas have taken hold among members of this group. There is the notion that without state support – which, at present, is everywhere substantial – the public would not participate in it, and therefore it would not exist, or that it constitutes a fundamental violation of property rights, and that it would thus be in conflict with libertarian law in a free society. This position is most strongly associated with Murray Rothbard, and has, to various degrees and with different shadings, been advocated by Hans-Hermann Hoppe, Jesus Huerta de Soto, and Jörg Guido Hülsmann.
The opposing view within the Austrian tradition is mainly associated with George Selgin and Larry White, although there are other notable members of this group, such as Steve Horwitz. This camp has assumed the label “free bankers” and it defends FRB against accusations of fraud and misrepresentation, maintains that FRB is a normal feature of a free society, and that no property rights violations occur in the normal conduct of it. But this group takes the defence of banking practices further, as it also maintains that FRB is not a disruptive influence on the economy, a position that may put the free bankers in conflict with the Austrian Business Cycle Theory, although the free bankers deny this. This point is different from saying that FRB is not fraudulent or suspect. We should always consider the possibility that otherwise perfectly legitimate activities could still be the cause of economic imbalances, even in a free market. If we did find that to be the case, we might still not follow from this that state intervention or bans are justified.
But the free bankers go even further than this. Not only is FRB not problematic, either on grounds of property rights nor on economic stability, FRB is even beneficial as it tends to maintain what the free bankers call short term monetary equilibrium, that is, through FRB the banks tend to adjust the supply of money (by issuing or withdrawing deposit money on the margin) in response to discretionary changes in money demand in such a way that disruptions would not occur that otherwise seem unavoidable under inelastic forms of money when changes in money demand would have to be absorbed by changes in nominal prices. FRB is thus not just legitimate, it is highly beneficial.
Purpose of this essay
As I said before, this is an old debate. Why should we reheat it? – Before I answer this question, I should briefly state my position: I am not fully in agreement with either camp. I do believe that the free bankers’ defence of FRB is largely successful but that their claims as to it being entirely innocuous and certainly their claims as to its efficiency in flexibly meeting changes in money demand are overstated. In my view, their attempts to support these claims fail.
FRB is, in principle and usually, neither fraud nor a scam, and the question to what extent the depositing public fully grasps how FRB works is not even material in settling this issue. In their 1996-paper ‘In defense of fiduciary media’, Selgin and White argue that the type of money that FRB brings into circulation has to be distinguished from fiat money; they explain that FRB is not fraudulent and that it does not necessarily involve a violation of property rights; third party effects, that is any potentially adverse effects that FRB may have on those who do not participate in it, are not materially different from adverse effects that may emanate from other legitimate market activity, and thus provide no reason for banning FRB; furthermore, Selgin and White claim that FRB is popular and that it would occur in a free market. I agree with all these points. There is no basis for banning FRB, so it should not be banned. This position is, in my view, correct, and it also happens to be obviously libertarian. I may add that I believe it is also almost impossible to ban FRB, or something like FRB, completely. We could ban FRB as practiced by banks today but in a developed financial system it is still likely that other market participants may from time to time succeed in bringing highly liquid near-money instruments into circulation, and that may cause all the problems that the 100-percent-reserve crowd associates with traditional FRB. The question is now the following: do these problems with FRB exist? The free bankers say no. FRB, in a free market, is not only not a source of instability, it is a source of stability as it manages to satisfy changes in money demand smoothly. These positive claims as to the power of FRB are the topic of this essay. I do not believe that these claims hold up to scrutiny.
Why is this relevant?
At first it does not appear to be relevant. Selgin and White declare in their 1996 paper, and I assume their position on this has not changed, that they are opposed to state fiat money and central banking. This sounds similar to the conclusions that I develop in my book, Paper Money Collapse. I advocate the strict separation of money and state. No central bank and no state fiat money. I think it is extremely likely that an entirely uninhibited free market in money and banking would again chose some kind of inflexible commodity – a natural commodity with a long tradition as a medium of exchange, such as gold, or maybe a new, man-made but scarce commodity, such as the cryptographic commodity Bitcoin, or something similar – as the basis for the financial system, and even if the market were to continue with the established denominations of dollars, yen, and so forth, as the public is, for now at least, still comfortable using them, would somehow link the issuance of these monetary units again to something inelastic that was not under anybody’s discretionary control.
In any case, if we assume that some type of ‘market-gold-standard’ would again resurface, it is very clear that under such purely market-driven, voluntary arrangements and with essentially hard money at its core, any FRB activity would be strictly limited. FRB-practicing banks would not have lender-of-last resort central banks watching their backs. There would be no limitless well of new bank reserves to bail out overstretched banks and to restart new credit cycles whenever the old ones have run their course. There would be no state-administered and tax-payer-guaranteed deposit insurance, or any other arrangement by which the cost of failure in banking could be socialized. Lowering reserve ratios and issuing additional fiduciary media (substitute money, i.e. deposit money) would be legal (the state would abstain from any involvement in monetary affairs, including the banning of any such activities) but it would come with considerable business risk, as it should be.
Would there still be FRB? Certainly. And in my view, the remaining FRB activity, adding as it does to the elasticity of the money supply at the margin and thus potentially distorting interest rate signals, is going to lead to capital misallocations to some degree, and thus initiate the occasional business cycle. That, in my view, is the price we have to pay for having a developed monetary economy and entire freedom in money and banking with all the undeniable advantages such a system brings. Importantly, I believe that these costs are unavoidable. But they are minor due to the absence of FRB-boosting state policy. – No, an entirely free market would not fulfil any dreams of uninterrupted bliss or realise the macroeconomist’s fantasy of everlasting ‘equilibrium’, both notions that Ludwig von Mises frequently rejected and ridiculed, but it would for sure be considerably better, and much more stable, than anything our present elastic monetary system can produce.
In Paper Money Collapse, I argue that inelasticity of supply is a virtue in money. That is why gold is such an excellent monetary asset. Complete inelasticity is unattainable in the real world but something like a proper gold standard is close enough. But for the ‘free bankers’ the remaining elasticity under restricted FRB (restricted by a stable commodity base) would be a boon. It would further stabilize the economy and establish…equilibrium. In my view, these claims are unsupported. But, you may say, why should we argue about the specific features of the post-fiat-money world if we are in agreement that such a post-fiat money world is in any case preferable to the present one?
The reason is simply this: how do we evaluate current policies? On this question I thought that most Austrians, as advocates of gold or something similar, and as critics of fiat money, would still be in broad agreement. But to my initial shock and my lasting amazement I found that some Austrian free bankers frequently cannot bring themselves to reject ‘quantitative easing’ and other heavy-handed central bank intervention on principle, and that they are able to embrace monetarist policy proposals, such as nominal GDP targeting by central banks, as a kind of second-best-solution that will do for as long as our first choice of separation of money and state is not realised. I believe these positions to stand in fundamental conflict with key tenets of the Austrian School of Economics and, apart from that and more importantly, to be simply unjustifiable. I think they are misguided. But it seems to me that the occasional support for them among free bankers originates in certain expectations as to what the equilibrating forces of ‘free banking’ would bring about in a free market in terms of a stable nominal GDP, and the free bankers can thus advocate certain forms of central bank activism if these are bound to generate these same outcomes. Therefore, in order to refute the idea of nominal GDP targeting we have to show that the free bankers’ expectations as to ‘monetary equilibrium’ under free banking lack a convincing analytical foundation. In this essay I want to pose some challenges for the free bankers. In a later article I hope to address NGDP-targeting as such.
Money does not need a producer
Among all goods money has a special place. It is the most liquid good and the only one that is demanded only for its exchange value, that is, its price in other goods and services. Anybody who has demand for money has demand for real money balances, that is, for effective purchasing power in the form of money. Nobody has demand for a specific quantity of the monetary asset per se, like a certain number of paper notes or a particular quantity of gold, but always for the specific purchasing power that these monetary assets convey.
In contrast to all other goods and services, changes in money demand can in theory be met by either producing additional quantities or by withdrawing and eliminating existing quantities of the monetary asset (changing the physical quantity of money), or by allowing the price of money, money’s exchange value, to change in response to the buying and selling of money versus non-money goods by the public (changing money’s purchasing power). Furthermore, it can be argued, as I do in Paper Money Collapse, that the superior market process for bringing demand for and supply of money in balance is the latter, i.e. the market-driven adjustment of nominal prices in response to the public’s buying and selling of money for non-money goods according to money demand. Why? – Well, mainly because the process of adjusting the physical quantity of money does not work. 1) We lack a procedure by which we can detect changes in money demand before they have begun to affect prices, and if prices are already beginning to change then these price changes already constitute the very process that satisfies the new money demand. This makes changing the quantity of money superfluous. 2) We lack a procedure by which we can expand and contract the supply of money without affecting the supply of credit and without changing interest rates. This makes changing the quantity of money dangerous. Money demand and loan demand are different things. Our modern fiat money systems are, in any case, not really designed for occasionally reducing the supply of money but for a continuous expansion of the money supply. As the Austrian Business Cycle Theory explains, expanding the supply of money by expanding bank credit must distort interest rates (artificially depress them) and lead to mismatches between voluntary saving and investment and thus to capital misallocations.
To this analysis the free bankers appear to voice a few objections. Before we look at the differences, however, let’s first stress an important agreement: the free bankers agree that nominal prices can do the adjusting and bring demand for and supply of money in balance. But they introduce an important condition: in the long run. In the short run, they argue, the process is not quite as smooth as many hard-money Austrians portray it to be.
Selgin and White (‘Defence’, 1996):
In the long run, nominal prices will adjust to equate supply and demand for money balances, whatever the nominal quantity of money. It does not follow, however, that each and every change in the supply of or demand for money will lead at once to a new long-run equilibrium, because the required price adjustments take time. They take time because not all agents are instantly and perfectly aware of changes in the money stock or money demand, and because some prices are costly to adjust and therefore “sticky.” It follows that, in the short run (empirically, think “for a number of months”), less than fully anticipated changes to the supply of or demand for money can give rise to monetary disequilibrium.
Thus, the first objection of the free bankers is that the account of the hard-money Austrians about the smooth adjustment of prices in response to changes in money demand is a bit superficial and slick. In the real world, not all prices will respond so quickly. Not all goods and services are being priced and re-priced in a continuous auction process, and when the public reduces money-outlays at the margin in an attempt to increase money-holdings, not every producer of goods and services will quickly adjust the price tags of his wares.
I do think some of this criticism is valid, and I am not excluding myself from it. My own account of the process of adjustment of money’s purchasing power sometimes runs the risk of glossing over the real-life frictions involved. However, to my defence, I acknowledged some of these problems in Paper Money Collapse, although I do not treat them extensively. See page 144-145:
In the absence of a flexible money supply, sudden changes in money demand will have to be fully absorbed by changes’ in money’s purchasing power. One could argue that this, too, has the potential to disrupt the otherwise smooth operation of the economy. Indeed, as we have seen, this phenomenon will also affect the prices of different goods differently. [This refers to the fact that when, for example, people try to raise their money holdings, they will reduce money-outlays on non-money goods or sell non-money goods for money, but they won’t cut every single expenditure item by an equal amount, or liquidate a tiny portion of each of their assets but will always cut the expenditure or sell the asset that is lowest on their present value scale. Downward pressure on prices from rising money demand will thus not be the same for all prices.]…A change in the demand for money will change overall prices but also relative prices and therefore the relative position of economic actors and the allocation of resources in the economy. All of this is true but it must lead to a different question: Is any of this avoidable….?
Is ‘monetary disequilibrium’ a unique phenomenon?
The free bankers are correct to point to these problems but it is also true that every change in the preferences of economic agents leads to similar problems. If consumer tastes change and money-flows are being redirected from certain products to certain other products, this, too, means that nominal spending on some items is being reduced. Profitability will decline in some parts of the economy and increase in others. This, too, will ultimate redirect resources and change the economy but all of these processes “take time because not all agents are instantly and perfectly aware …” of what is going on, and also for other reasons, including the stickiness of some prices. I think agents are never “instantly and perfectly aware” of anything, and that the slickness of economic models is never matched by reality. Accordingly, the real world is constantly in disequilibrium, and as economists we can only explain the underlying processes that tend towards equilibrium without ever reaching it. I wonder, however, if the concerns of the free bankers, valid though they are, are not just examples of the frictions that always exist in the real world, in which tastes and preferences change constantly, and change in an instant, but prices, knowledge, and resource use always move more slowly.
Furthermore, the issue of stickiness of prices should not be overstated. These days many prices do appear rather flexible and tend to adjust rather quickly: not only those of financial assets but also industrial commodities, and even many consumer goods, from used cars to hotel stays to flight tickets to everything on eBay. Discounting in response to a drop in nominal spending is the first of line of defense for almost every entrepreneur, I would guess, and if what the entrepreneur faces is indeed a higher money demand among his clientele, rather than a genuine change in consumption preferences, then sales should stabilize quickly at the lower price.
But I think the main point is this: how can the banks do better? What do the free bankers say to my two points above that changing the quantity of money is not really a viable alternative to allowing changes in nominal prices? Let’s address the first point first:
Point 1) We lack a procedure by which we can detect changes in money demand before they have begun to affect prices, and if prices are already beginning to change then these price changes already constitute the very process that satisfies the new money demand. This makes changing the quantity of money superfluous.
How do banks detect a change in money demand – before it has affected prices?
Banks have no facility to create money and money alone (deposit money, fiduciary media). New money is always a byproduct of banks’ lending operations. Banks can only create money by expanding their balance sheets. Thus, they always create an asset (a new loan) at the same time they create a new liability (the demand deposit in which the bank pays out the loan to the borrower, and which is part of the money supply). Therefore, if you suddenly experience a rise in money demand, if you suddenly feel the urge to hold more of your wealth in the form of the most fungible object (money), the bank can’t help you. Of course, you could go to the bank and borrow the money and then keep it in cash. This is a possibility but I think we all agree – and the free bankers seem to agree as well – that this is very unusual, and that it must be rare. Banks meet loan demand, not money demand, and the two are not only different, they are the opposite of one another. Borrowers do not have a high marginal demand for money; quite to the contrary, they have a high marginal demand for goods and services, i.e. non-money items (that is why they are willing to incur interest expense). The loan is in the form of money but the borrowers usually spend the money right away on whatever they really desire.
Banks are not in the money-creation business (or only in it by default – no pun intended); they are really in the lending business. The idea that rising money demand would articulate itself as higher loan demand at banks is wrong, and the free bankers do not usually make that mistake. They know (and some of them even stress) that money demand articulates itself in the markets for non-money goods and services (including, but not restricted to, financial assets). People reduce or increase spending in order to establish the desired money holdings.
To the extent that, when people experience a higher money demand, they sell financial assets to banks, the banks do indeed directly experience the heightened money demand, and if the banks increase their FRB activities in response and expand their balance sheets accordingly (the financial assets they buy enter the asset side of the balance sheet – they are the new loans – and the new demand deposits the banks issue to pay for them sit on the liability side of the balance sheet), the quantity of money is indeed being expanded in response to money demand. But to the extent that the public does not sell to FRB-practicing banks or that the public reduces other outlays or sells non-financial assets, the banks are not directly involved as counterparties. How can they still detect a rising money demand?
[As an aside, the free bankers sometimes speak of ‘the public having a higher demand for demand deposits or ‘inside money’ ’, and that the banks should be allowed to ‘accommodate’ this. I think these statements are confusing. Depositing physical cash in a bank, or conversely liquidating demand deposits to increase holdings of physical cash, are transactions between various forms of money. In a functioning FRB system, both forms of money, physical cash and bank-produced deposit money, are almost perfect surrogates. Both are used side by side, and both satisfy the demand for money. That is the precondition for FRB to work. The factors that occasionally determine preferences for a specific form of money are fundamentally different from those that affect the demand for money overall. If the public, for example, reduces demand deposits and accumulates physical cash, i.e. switches from ‘inside money’ to ‘outside money’, this may be because it is concerned about the health of the banks, and this is unrelated to the public’s demand for money, which in this case may be unchanged. As an example, in the recent crisis, the demand for physical cash increased in many countries, relative to the demand for bank deposits. At the same time, overall money demand also probably increased. But importantly, both phenomena are fundamentally different.]
The answer is this: if the public, in an attempt to raise money holdings, reduces money spending, this will slow the velocity of money, and to the banks this will be clearly visible. Money doesn’t change hands as quickly as before, and that includes transaction-ready deposit money at banks. Importantly, the slower velocity of money means a reduced risk of money outflows for each bank, in particular the likelihood of transfers to other banks that are a drain on existing bank reserves. Thus, the banks now have more scope to conduct FRB, that is, to reduce their reserve ratios, lower loan rates and issue more loans, and obviously to produce more deposit money in the process.
In the essay mentioned above, ‘In defence of fiduciary media’, this explanation appears in footnote 29, the emphasis here is different and so is the wording but the essence is the same, in my view. Banks increase FRB in response to a drop in money velocity. A rising money demand articulates itself in a lower velocity and thus a tendency for more FRB:
But how can the banks manage to expand their demand deposits, if total bank reserves have not changed? The increased demand to hold demand deposits, relative to income [increased money demand, DS], means that fewer checks are written per year per dollar of account balances. The marginal deposit dollar poses less of a threat to a bank’s reserves. Thus a bank can safely increase its ratio of deposits to reserves, increasing the volume of its deposits to the point where the rising liquidity cost plus interest and other costs of the last dollar of deposits again equals the marginal revenue from a dollar of assets.
I think this explanation is exceedingly clever and accurate. I do not, because I cannot, object to the logic. But does it help us? I have two observations:
1) Is it really probable that this process is faster and more efficient than the adjustment of nominal prices? The objection of the free bankers was that the adjustment of nominal prices takes time. But so does this process. The bankers will not be “instantly and perfectly aware” of what is happening anymore than the producers of goods and services. When the public reduces spending in order to preserve money balances the effect will be felt as soon by the producers of whatever the public now spends less money on, as by the bankers who see fewer cheques being written. Why would we assume that the bankers respond faster? Sure, prices can be sticky, but does that mean that accelerated FRB will always beat nominal price changes in terms of speed? Will the bankers always expand their loan book faster than the affected producers discount their product? It is not clear to me why this would be the case.
2) More importantly, the banks will, by definition, give the new deposit money first not to those who have a higher demand for money but to their loan clients who, we just established, have no demand for money but for goods and services, and who will quickly spend the money. From there, the money will circulate and may, finally, reach those who do indeed have a higher demand for money. But there is no escaping the fact that this is a roundabout process. For the very reason that banks can only produce money as a byproduct of their lending business, those who do demand higher money balances can only ever be reached via a detour through other markets, never directly. Bank-produced money has to go through the loan market first, and has to change hands a few times, before it can reach those who originally experienced a high money demand. There is no process as part of which we could ever hear a banker say to any of his customers: you have a higher money demand? Here, have some. – The question is now, what type of frictions or unintended consequences of this procedure of satisfying money demand do we encounter? Are these frictions likely to be smaller or even greater than the frictions inherent in allowing nominal prices to do the adjusting to meet changes in money demand?
Before we address these frictions a few words on a related topic: the free bankers sometimes seem to imply that unwanted fiduciary media (demand deposits, inside money) would return to the banks. This is not correct, or rather, it would only be correct if people wanted to exchange the demand deposit for physical cash but this is a transaction that is, as we have seen, unrelated to money demand. Claims against any specific bank may be unwanted, or demand deposits may be wanted less than physical cash, but this is unrelated to overall money demand. If deposit money is seen as a viable money good, and this is the precondition for FRB to work, any excess holding of money, whether inside money or outside money, whether cash or demand deposit, will not be returned to a bank and exchanged but will be spent! If banks increase their FRB activities and bring new fiduciary media into circulation, this money will circulate until it reaches somebody with genuine money demand. Often – when money demand has not risen simultaneously – this process involves inflation as a lower purchasing power for each monetary unit is required to get the public to voluntarily hold the new monetary units.
Is money demand a form of desired saving?
According to the free bankers, banks respond to a drop in money velocity as a result of rising money demand by engaging in extra FRB. At lower velocity, the risks inherent in FRB are smaller and this encourages banks to reduce their reserve ratios marginally, create extra loans and produce extra money, i.e. new deposit money that is now satisfying at least some of the new money demand. But what about the extra bank credit that also comes into existence? Hasn’t Mises shown that bank credit expansion is a source of economic instability; that bank credit expansion sets off business cycles? If extra loans at lower interest rates are not the result of additional voluntary saving but simply of money printing, and these loans still encourage extra investment and capital spending, then these additional projects will ultimately lack the real resources, resources that only voluntary saving can free up and redirect towards investment, that are needed to see the projects through to conclusion and to sustain them. Extra bank credit is thus bound to upset the market’s process of coordination between saving and investment – coordination that is directed via market interest rates. Would the extra FRB not start a Misesian business cycle? Would the allegedly faster and smoother process of satisfying changed money demand via FRB, via the adjustment in the nominal quantity of money rather than nominal price changes, not create new instabilities as a result of the artificially lower interest rates and the extra bank credit that are the necessary mirror image of new deposit money?
In Austrian theory, desired savings are a function of time preference. A lower time preference means the public attaches a lower importance to consumption in the near future relative to consumption in the more distant future. The discount rate at which future goods are discounted is lowered and the propensity to save rises, i.e. the willingness to reallocate income from meeting present consumption needs to meeting future consumption needs rises. The extra savings are offered on the loan markets at marginally lower rates. This encourages a marginal increase in investment. The marginally lower rates on the loan market thus accurately reflect the marginally lower time preference of the public. But lower rates as a result of credit expansion and FRB can unhinge this process. That is the core message of the Austrian Business Cycle Theory. How can the free bankers get out of this dilemma?
The free bankers counter this point by claiming that an increased demand for money reflects a lower time preference. Holding more money is a form of saving.
Although in the already quoted “Defence of Fiduciary Media”, Selgin and White at some point state that
We agree that time preference and money demand are distinct, and that a change in one does not imply a change in the other.
They also write, and this is more crucial to the case they are making, I believe,
The argument for the equilibrating properties of free banking rests in part on recognizing that an increased demand to hold claims on intermediaries, including claims in the form of banknotes and demand deposits, at the expense of holding additional consumer goods, is equivalent to an increase in desired saving.
In any case, in the examples they provide later, time preference, desired saving, and money demand always move together.
While I agree that accumulating money balances can be a form of saving (I say that much in Paper Money Collapse), it does not have to be the case, and I think it is more helpful to disentangle saving, consumption and money demand. Holding money is non-consuming, as Selgin and White point out, but it is equally non-investing.
If I sell my laptop on e-Bay so I have more readily spendable money (demand deposits) in my bank account so that I can take advantage of any unforeseen spending opportunities during my holiday in Greece, would we say that my time preference has declined, and that this is an act of saving? This is a switch from a consumption good to money, and Selgin and White would label this an act of saving, at least as I understand them. But the laptop would have delivered its use-value to me over a long period of time. Now I hold instantly spendable demand deposits instead. Has my time preference really dropped?
Here is a different example, one where we encounter a switch from investment goods to money, an example that Selgin and White put forward in their paper and where they argue that in such an operation total desired saving remains unchanged. Time preference remains the same. In the example given, the public sells bonds and accumulates cash or demand deposits instead. Both, money and bonds are non-consumption goods and thus saving-instruments in the Selgin and White definition. According to their theory, the banks would now acquire the bonds and issue deposit money against them. By doing this (increased FRB activity), the banks satisfy the demand for more money and keep interest rates from rising – which is appropriate as overall desired savings have not changed and time preference is still the same. – However, has the public’s time preference really not changed? Rather than holding a less liquid, long-term debt instrument the public now holds the most fungible asset (money). Is it fair to say that when people liquidate their bond portfolios that their time preference remains unchanged? – Maybe the public does this precisely for the reason that time preference has increased. The public may spend the money soon on consumption goods, or the public considers market interest rates too low and as no longer representative of the public’s time preference, and a drop in bond prices (rise in yields) is thus warranted to reflect this, and should not be cancelled out by the banks’ accelerated FRB.
The short run versus the long run
Furthermore, I suspect that there is an inconsistency in claiming that, in the long run, nominal price changes do bring the demand for and supply of money in line and then to argue that in the short run, money demand is best – and automatically – met by quantitative changes in the supply of money via FRB. The long run is evidently only a string of short runs, and if changes in money demand have been satisfied in the short run via FRB, how can these changes then still exercise up- or downward pressure on nominal prices in the long run?
The free bankers are correct to point to real-life frictions in the process of satisfying a changed money demand via an adjustment of nominal prices. The process is neither smooth nor instant, but then almost no market process is in reality. Their explanation that a rise in money demand will lead to a drop in money velocity and that this will, on the margin and under normal conditions, encourage additional FRB and thus an expansion of bank-produced money also strikes me as correct. Yet, the free bankers fail, in my view, to show convincingly why this process would be faster and smoother than the adjustment of nominal prices, and in particular, why the extra bank credit that also comes into existence through FRB would not generate the problems that the Austrian School under Mises has explained extensively.
If only a subset of the population, rather than the entire public, experiences a higher money demand – and this must be the more likely scenario by far – and this subset than reduces nominal spending on those goods and services that are relevant to this group, and if this then leads to a marginal drop in the prices of these goods and services, the extra demand of this group for real money balances has been met with potentially fairly limited frictions and side-effects, I would argue. By comparison, FRB can never meet money demand of any group directly. Banks always have to inject the new money into the economy via the loan market, that is, at a point where money demand is low and demand for non-money goods is high. Money demand will always be met in a roundabout way. Furthermore, the lowering of interest rates through the additional FRB activity is only unproblematic if the additional demand for real money balances is identical with desired saving and reflects a reduce time preference. These are rather heroic assumptions indeed.
Ludwig von Mises – The real free banker
The 100-percent-reserve Austrians have stuck – correctly in my view – with one of the most important insights of Austrian monetary theory as developed by the school’s most distinguished 20th century representative, Ludwig von Mises, namely the destabilizing force of credit expansion. Unfortunately, the 100-percent-reserve Austrians have taken the critique of banking too far. Claims of misrepresentation, deception, and fraud as being constituting elements of FRB go too far and remain ultimately unsupported.
The self-styled ‘free bankers’ are correct to reject these claims but they are taking their defense of FRB too far as well. By claiming that FRB could smoothly and quickly satisfy any changes in money demand they assign equilibrating properties to FRB that are ultimately unsupportable. In the process, they risk ignoring some of the most relevant Misesian insights. In particular the free bankers, it seems to me, tend to ignore that in an established FRB system, bank-produced fiduciary media (such as demand deposits) will be seen as near-perfect surrogates for money proper (such as state fiat money or gold). In such an environment the banks can (within limits) expand FRB and thus create more fiduciary media regardless of present money demand. Unwanted money (deposit money) then leads to a rise in money velocity and an upward pressure on nominal prices – it does not lead to the public exchanging deposit money for physical cash, as that would be just a switch from one form of money to another. Therefore, the unwanted bank-produced money – that entered the economy via the bank loan market – does not return to the banks. In my view, the free bankers ignore some of the dangers in FRB and overstate its equilibrating powers.
Both camps refer to Mises as an authority, albeit the ‘free bankers’ generally less so. Selgin and White, in their 1996 paper, quote Mises as a champion of free banking. I do, however, believe that the quote, taken from Human Action, has to be read in the context of Mises’ life-long and unwavering commitment to a proper gold standard. Here is the quote:
Free banking is the only method for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all the information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular – one is tempted to say normal – feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.
Crises and depressions, in Misesian theory, do not come about because of short-term mismatches between money demand and money supply, or frictions in the adjustment of nominal prices, but because of credit expansion. In order to appreciate Mises’s concerns over credit expansion, one does not have to consider bankers fraudsters (or ‘banksters’), and I can see no evidence in Mises’ writing that he saw bankers that way. But in order to agree with him that banks should be as free as all other enterprises – which, importantly, includes the freedom to fail – you do not have to assign them mystical equilibrating powers, either.
Mises’ conclusions were consistent and his recommendations practical: introduce inelastic, inflexible, apolitical money as the basis of the financial system, a hard monetary core, such as in a proper gold standard, and then allow banks the same freedom, under the same laws of corporation, that all other businesses enjoy – no special bans and no special privileges, such as ‘lenders of last resort’ or tax-payer-backed deposit insurance – and you can allow the market to operate. I believe that this should be the policy proposal under which all Austrians can and should unite.
Any deviation from the core Misesian message also occasionally gets ‘Austrians’ into some strange political company. With their damnation of FRB and allegations of fraud, the 100-percent-reserve Austrians seem at times to play into the hands of populist anti-bank fractions that have recently grown in influence since the financial crisis started, and to inadvertently be associated with the statist proposals of organizations such as the UK’s Positive Money or IMF economists Benes and Kumhof, all of whom consider money-creation by private banks – FRB- as the root of all evil and propose full control over the monetary sphere by the state – a proposal that could not be further from Mises’ ideals.
On the other side, the free bankers are in such awe of the assumed equilibrating powers of FRB in a free market that they confidently predict a stable (or at least reasonably stable) nominal GDP – and if we do not have free banking and a free market yet, why not have today’s central banks target nominal GDP to get a similar result under today’s statist monetary infrastructure? Bizarrely, and completely indefensibly, in my view, these Austrians end up joining forces with aggregate-demand-managing Keynesians or money-supply-managing monetarists. This is not only in fundamental conflict with many tenets of the Misesian framework – it is simply misguided, even under considerations of monetary realpolitik, i.e. of what is politically practicable presently but better than the present system.
Banks should be free but can only ever be so within a proper capitalist monetary system, and that is a system with a market-chosen monetary commodity at its core, and most certainly a hard and inelastic one. No new ‘target’ for central bank policy can ever achieve results that mirror the outcome of a properly functioning monetary system and a free banking market. We do not have a gold standard and free banking at present, and under these conditions I would suggest that a central bank that imitates a gold standard as closely as possible – i.e. one that ultimately keeps the monetary base fairly stable – would be, under the circumstances, the second best’, or least worst, solution. But a full treatment of the NGDP-targeting proposal will have to wait for another blog.
In the meantime, the debasement of paper money continues.
This article was previously published at DetlevSchlichter.com.
After two decades of serial bubble-blowing, the world’s central bankers have maneuvered themselves into a corner. They created a monster in the form of an unbalanced global economy and a bloated financial system, laden with debt, addicted to cheap money, and in need of constantly rising asset prices. Now the monster is in charge and the central bankers dare not stop feeding it.
The US Fed did, of course, make some noises to the effect that the flow of cheap money may at some point slow and then even stop. How credible these projections really are is far from certain. Markets seem to take them quite seriously indeed, but the more they sell off in response – and in particular, the more yields and risk premiums rise – the more difficult it will be for the Fed to follow through. – And by the way, if the jobless rate does fall to 6.7 percent, or to whatever magic number Ben Bernanke, in his unlimited wisdom, has ascertained as being safe for a policy ‘exit’, and if he then indeed does withdraw the punchbowl– will the unemployment rate then rise again? – We may have to deal with that question some other time. The focus today is the ECB and the Bank of England.
Policy paralysis is the new strategy
Both central banks had their monthly policy meetings on Thursday and did – nothing. Though when you read the papers you get the impression they did quite a lot. They seem to have unveiled some powerful new policy tool: forward guidance.
Both stated that they were committed to leaving policy rates at ultra-low levels for a very long time indeed. The ECB added that it might even lower rates further. The Bank of England additionally chided the UK bond market for paying too much attention to what Bernanke says, and for evidently not supporting the national recovery effort enough. This was, of course, an attempt by both central banks to distance themselves from the Fed’s loose talk of potentially turning off the monetary spigot. There is nothing surprising about this. Both central banks are standing with their backs to the wall.
Let’s face the facts: years of relentless monetary doping have not solved anything – neither economy is anywhere near the self-sustaining recovery that Keynesian and Monetarist interventionists have promised us we would get in turn for all these monetary manipulations. For years, these central banks have been stubbornly sticking to the same game plan: inject unlimited new bank reserves into the banks and keep buying (or funding) bank asset so that the banks don’t fall over, and the credit house of cards doesn’t crumble, and the state and the banks can continue to fund themselves on the cheap. As the self-sustaining recovery remains elusive, they have no exit strategy. There is no way out.
Yesterday, the ECB and the Bank of England publicly admitted that they were boxed in and would remain so for the foreseeable future. They have no policy options, there is no (real) recovery, so they will keep rates super low, maybe even cut them again. Only in our bizarre modern world of relentless Orwellian Newspeak can this position of utter defeat be dressed up as the new policy program of ‘forward guidance’. To admit that you can’t move, to admit that your policy has not worked and is unlikely to work anytime soon – otherwise you would have to be ready for withdrawal of the stimulus, right? – is now presented as a skilful steering of market expectations and massaging of market psychology.
This was the first policy meeting under new Bank of England governor Mark Carney, the ‘most talented central banker of his generation’ to some, the most overpaid bureaucrat in the world to others. But credit where credit is due. Carney is a marketing genius. Not only when it comes to marketing himself, but also when it comes to selling policy paralysis as strategy. Never before has the phrase “What can we do? We can only stick to what we have done for years.”, so effectively been presented as at the BoE’s press conference yesterday. It is now called ‘guidance’, and it evidently requires a specific skill-set. The Wall Street Journal even described Mr. Carney as “one of the pioneers of guidance”, and I wonder if the chaps at the Journal kept a straight face.
Foreign Exchange markets and gold
The notion of policy divergence between the Fed and the other central banks has reawoken the foreign exchange markets. The dollar is rallying, and I think the speculator-community may try and run with this theme for a while. Divergence is naturally something that fx markets love but in this crisis it has never lived up to its expectations. Among the major nations, the similarities in terms of economic problems and in terms of policy responses are simply much greater than the differences. These countries are all pretty much in the same hole. This is a global crisis and I believe it is a global fiat money crisis. I cannot see that one of these paper monies is fundamentally better than the others. It is my view that any notion of divergence in economic performance and in policy will not last and market trends based on these notions will be short lived. I remain skeptical as to whether the Fed can really ‘exit’. (Again, the Fed SHOULD exit, in my view, as should the other central banks, but then again the Fed never shares my views.)
The idea of a Fed-exit is still a major problem for gold. I readily admit that I am baffled by what has happened here – and what is still happening. ‘Forward guidance’ from the Bank of England and the ECB has not helped gold, it has only strengthened the dollar versus pound and euro. The dollar is what matters. The dollar is the world’s leading fiat currency and gold its main opponent. It does not seem to matter much what the other paper money central banks do. As long as the notion of Fed-‘exit’ drives markets, and the threat of dollar-debasement seems to fade, gold continues to struggle. For obvious reasons, I do not believe this will last and I remain a gold bull. There could, however, be more pain in store first.
In the meantime, the debasement of paper money continues.
This article was previously published at DetlevSchlichter.com.
A new meme is spreading in financial markets: the Fed is about to turn off the monetary spigot. US Printmaster General Ben Bernanke announced that he might start reducing the monthly debt monetization program, called ‘quantitative easing’ (QE), as early as the autumn of 2013, and maybe stop it entirely by the middle of next year. He reassured markets that the Fed would keep the key policy rate (the Fed Funds rate) at near zero all the way into 2015. Still, the end of QE is seen as the beginning of the end of super-easy policy and potentially the first towards normalization, as if anybody still had any idea of what ‘normal’ was.
Fearing that the flow of nourishing mother milk from the Fed could dry up, a resolutely unweaned Wall Street threw a hissy fit and the dummy out of the pram.
So far, so good. There is only one problem: it won’t happen.
Now I am the first to declare that the Fed SHOULD abolish QE, and not only in the autumn of this year or the summer of next, but right now. Pronto. Why? Because a policy of QE and zero interest rates is complete madness. It distorts markets, sabotages the liquidation of imbalances, prohibits the correct pricing of risk, and encourages renewed debt accumulation. It numbs the market’s healing powers – by enabling more ‘pretend and extend’ in the financial industry – and it adds new imbalances to the old ones that it also helps to maintain.
This policy may have prevented – for now – debt deflation, but maybe debt deflation is what is needed.
QE is nothing but heavy-handed market intervention. It is destructive. It doesn’t solve the underlying problems. It creates new ones.
Larry Summers’ getaway car
However, none of these objections even register at the Fed. The Fed has a completely different perspective: this policy was a roaring success and as it has worked so well it can now be faded out. Soon there will be no need for it. Larry Summers’ dreadful phrase captures that thinking best: the economy will soon have achieved ‘escape velocity’.
Most analogies are somewhat poor but this one is particularly inept. Ironically, though, the reference to mechanics captures beautifully the logic of Keynesians and other interventionists: the economy is like a physical object moving through space and is occasionally in need of a little push to get moving again at an appropriate speed. Policy provides the push.
Bernanke doesn’t use these terms but his thinking is similar. He explained QE to the American public in 2010 by announcing that his job was to occasionally manipulate interest rates and asset prices to encourage lending, borrowing, spending, shopping, and other healthy economic activities, and that once his machinations had stimulated enough of those activities, the economy would again enter a virtuous cycle (his words) of self-sustained growth. Escape velocity has been restored.
I think this is nonsense – however appealing it may sound to many laypersons. The economy is not an object that needs a push, or a machine that needs to be jump-started, or a lazy mule that needs a gentle slap on its behind to get going again (of course, you should never hurt an animal!). The economy is a complex process of coordination, an elaborate system that allows an extensive and diverse group of actors with different and frequently conflicting goals and interests to co-operate with one another peacefully toward the best possible realization of their own material aims. A crisis is a failure of that coordination process. It is a cluster of errors. The only explanation for the occurrence of such a cluster of errors is a systematic distortion of the market’s coordinating properties, such as occurs when monetary expansion distorts interest rates and other relative prices, and leads to imbalances that unhinge the economy.
The economy went into recession because of massive financial deformations. Easy money had led to excessive indebtedness, a housing bubble and dangerous levels of leverage. The problems were such distortions, not lack of momentum. The real question is not whether the GDP statistics exhibit the right velocity but if the underlying dislocations – which, to the chagrin of the econometricians, cannot be easily ascertained from the macro-data – have now dissolved.
The Fed believes it has healed an economy that was sick from easy money with more easy money. The patient is feeling better and can soon be released from intensive care. In my view, the patient is still sick and now suffers from a dangerous addiction to boot. The ‘feeling-better’ bit maybe, just maybe, a lingering drug high from Dr. Bernanke’s generous medication. Withdrawal symptoms may surface soon. If they do, Dr. Bernanke will simply open the medicine cupboard again. Don’t forget, only a few weeks ago the man appeared on TV and tried to talk up the Russell 3000 stock index.
I do not doubt that, if measured by overall GDP, the US economy is presently doing better. I would be foolish to take on the Fed on this point. The Fed has a staff of 200-plus economists, most of them, I assume, from America’s finest universities, which doesn’t mean they are good economists but at any rate they are probably good statisticians. If they say there are signs of life in the economy, that’s good enough for me.
Where I disagree is on the narrative. The deformations are largely still there. How can they not, given the enormous policy effort to suppress the very market forces that would – in a free market – have exposed and liquidated these deformations? They are still visible, among other indicators, in high degrees of indebtedness. And they matter. That is why I am mistrustful of the Fed’s projections. Their theories compel them to believe in virtuous cycles and ‘escape velocity’ and to disregard imbalances and distortions. Any sustained removal of super-easy money will allow these deformations to resurface and immediately cloud the near term cyclical outlook. According to my worldview, this should be allowed to happen as it is part of the essential healing process. But it runs counter to the Fed’s worldview and the Fed’s view of its own mission.
The one institution that lacks ‘escape velocity’ is the Fed. It will remain hostage to the financial monsters it created and the dangerous misconception of its own grandeur.
This article was previously published at DetlevSchlichter.com.
Earlier this month, in an article for “Project Syndicate” famous American economist Nouriel Roubini joined the chorus of those who declare that the multi-year run up in the gold price was just an almighty bubble, that that bubble has now popped and that it will continue to deflate. Gold is now in a bear market, a multi-year bear market, and Roubini gives six reasons (he himself helpfully counts them down for us) for why gold is a bad investment. Roubini does not quite go so far as to tell his readers that there is no role whatsoever for the yellow metal. Investors should have a “very modest” share of gold in their portfolios, as a hedge against extreme risks, which, the good professor assures us, are almost so negligibly small that they are “irrational fears”, really, but beyond that there is little reason to bother with gold.
Interestingly, “very modest” is indeed a good description of gold’s share in the global asset mix. According to some studies gold accounts for only around 1 percent of global asset holdings. In terms of asset breakdown we already are where Roubini thinks we should be. So why bother? Those of us – such as yours truly – who hold a more pessimistic outlook as to the efficiency of current policies and the sustainability of the current monetary infrastructure, and who accordingly hold a bigger share of their wealth in gold, are evidently “paranoid”, and as they now reap the deserved reward for their dreadful negativity courtesy of a declining gold price, why not ignore them? It is, after all, a tiny minority. But it is evident from Roubini’s essay that he not only considers the gold bugs to be wrong and foolish, they also annoy him profoundly. They anger him. Why? – Because he thinks they also have a “political agenda”. Gold bugs are destructive. They are misguided and even dangerous people.
Roubini’s case against gold
But let’s first look at his arguments for a continued bear market in gold. They range, in my view, from the indisputably accurate to the questionable and contradictory to the simply false and outright bizarre. Here is the list (with some of my commentary. Apologies to Professor Roubini.):
1) Gold is only useful in extreme economic scenarios (such as 2008/2009) but even then its price is highly volatile (and so it was in 2008/2009).
2) Gold is only useful when there is risk of rising inflation. Despite unprecedented policy measures, such as multiple rounds of QE, there is no inflation, according to Roubini. – Why is there no inflation?- Because the newly created money is stuck in the banking system and the wider financial system where it finances a happy merry-go round of asset trading without boosting broader monetary aggregates. Outside finance (and government, I might add) nobody wants to take on more debt. The normal transmission mechanism is not working. – Additionally, Roubini makes some heroic assumptions about there being no pricing power and no wage inflation.
3) Gold produces no running income and will thus be at a disadvantage in a recovering economy when equities and bonds do better. – Wait a minute. Recovering economy? Where did that come from? I thought none of the monetary stimulus was getting through to the real economy and hence failed to ignite inflationary pressures? How can it then stimulate real activity? Or are the two somehow unrelated?
4) Gold does best when interest rates are low or negative but the present recovery – recovery, again! – will allow central banks to unwind their present easy monetary policy stance and to hike interest rates. –- OK. Good luck with that. But again we are asked to take the present talk of recovery at face value. On the one hand Roubini cites ubiquitous deleveraging pressures, “lack of pricing power” and “excess capacity” (these are his words!) as reasons for why the extraordinary expansion in base money supply is not translating into money growth in the wider aggregates that usually drive the wider economy, and why therefore standard inflation measures remain benign and, on the other hand, evidently sees none of this as an obstacle to the self-sustained recovery story. — And if the economy indeed does recover without the help from easy money then, maybe, monetary policy is easy for other reasons, such as keeping an overstretched banking system from collapsing. In that case, better growth momentum as such may not be sufficient to allow central bankers to exit their present policy program.
5) Fears of sovereign default have been driving people into gold but now the greater risk is that struggling sovereigns may sell their gold holdings. – This is potentially a risk but I would counter that while selling from official sources could affect the gold market in the short-term, liquidating the family silver (no pun intended!) and removing the remaining smidgeons of hard assets at the bottom of the inverted pyramid of the über-leveraged paper money economy and replacing it with government IOUs is not going to instil a lot of confidence on the part of the public. Gold liquidation is a further sign of stress, of a check-mated policy elite running out of options, and the public may end up scooping up willingly whatever desperate politicians sell. But I guess that reasonable people can disagree on this point. – But now it gets really interesting:
6) In large parts the gold bull market was the work of, wait for this, “extreme” political conservatives, of the “far-right fringe” and conspiracy theorists. That hype is now coming undone. According to Roubini gold is not simply another asset but an indicator of political extremism, of an unhealthy mistrust of the established order. Roubini: “These fanatics also believe that a return to the gold standard is inevitable as hyperinflation ensues from central banks’ ‘debasement’ of paper money.” – Well, I guess it is time for the IRS to conduct a couple of customized tax audits!
Monetary policy prevents economic healing
Roubini does not provide much explanation for his claim that we are now in a self-sustained recovery that will allow central bankers to exit the extreme policy positions they adopted in recent years. He seems to rely on the healing forces of the market. I am the first to agree that these forces do exist in a capitalist economy and that they are incredibly powerful. That is why the market should always be left to its own devices, be allowed to unwind and liquidate accumulated dislocations that are now barriers to renewed growth, and to bring the economy back into balance. But these are precisely the very processes that present monetary policy sabotages with all its might: zero interest rates and unlimited bank funding, plus ongoing asset price manipulations, numb the market’s power to cleanse and heal and re-adjust, and instead allow banks and other financial operators to continue in their policy of pretend and extend, to keep on their books underperforming, bad or even toxic assets at unrealistic prices. Policy makers have to decide whether they want the market to operate its healing powers (even if some of the healing imposes near-term pain on the patient), or whether they rather trust their own powers to continuously drive the economy, imbalances and all, to higher levels of performance with their money-printing, market manipulation and deficit spending. We know which path they have followed so far, and that is why placing your hope on self-healing market forces is naïve. Strangely, Roubini himself has on numerous occasions warned against a strategy of kicking the can down the road and has repeatedly warned of new credit bubbles. I wonder which Roubini wrote this article.
At the core of Roubini’s argument is a paradox: easy money – the monetary ‘stimulus’ – is stuck in the banking industry and the wider financial system, and that is his explanation – together with excess capacity, deleveraging and the absence of ‘pricing power’ – for why the standard measures of inflation – consumer price inflation in particular – have not risen more dramatically. Unless you are a derivatives trader or a hedge fund manager you have not seen any of the money. But when you will, finally, believe me, then the prices that matter to you will also go up. Roubini cannot have it both ways: easy money has no effect on inflation but a stimulating one on growth – not even his funny New Keynesianism can square that circle.
But the real criticism of present policies is not that they will lead to instant hyperinflation – I believe they will eventually lead to much higher inflation and probably hyperinflation – but that they don’t solve anything but make economic imbalances much worse. They do not have an exit, and this is why they will ultimately destroy money. Roubini is overstating the ‘healing’ argument considerably, and in the course makes some big blunders: “Ongoing private and public debt deleveraging has kept global demand growth below that of supply.” – This is evidently not supported by the facts. As I have argued before, private sector deleveraging is minor, and in most countries, governments are issuing massive amounts of new debt, certainly in the US, the UK (contrary to what the public debate there would make you believe), and Japan.
Are owners of gold ‘extremists’?
But what is most worrying, and most disturbing, is Roubini’s pathetic attempt to label gold bugs political extremists. Central banks run policies today that only a few years ago would have set the average middle-of-the-road central banker’s hair on fire. Of course, the public is worried, scared and skeptical. Because the political and monetary elite, the establishment of which Roubini – senior economist for the Council of Economic Advisors under Bill Clinton and senior economic advisor to Timothy Geithner when at the United States Treasury Department – is a member, has lost the plot. The paper money bureaucracy has painted itself into a corner. The public has very good reasons to be worried, skeptical and scared.
Early in his article, Roubini makes the following observation: “During the global financial crisis, even the safety of bank deposits and government bonds was in doubt for some investors.” [my emphasis.] – What does he mean, for some investors? Banks did fail and governments did go bankrupt in the crisis. Was that just a figment of the imagination of some investors? – The only reason that not more banks went under (yet) and more governments went bankrupt is unlimited money printing. Unless monetary policy changes meaningfully we won’t even know which entities are truly solvent and which are not. And then we might find out the hard way.
Of course, people who are already predisposed to skepticism towards the political elite and their ongoing meddling with the free market will be more inclined to buy gold. But that only makes them libertarians, or individualists, or simply people who are suspicious of power and politics. I have met many of them and have yet to meet anyone who deserves the label ‘far right’, with all the connotations that Roubini invokes here, deliberately, I assume. — I am the first to acknowledge that the pro-gold community – and it is not even a real community – has its fair share of eccentrics but the majority of those who piled into gold is simply worried about where our unhinged monetary system will take us next – and justifiably so.
Roubini simply resorts to smear tactics. The same approach has been shamelessly employed for many years by Paul Krugman. The idea is to unilaterally determine the acceptable parameters of enlightened economic debate. The high gospel of John Maynard Keynes is not to be questioned, and the wisdom of having highly-trained academicians running a central bureaucracy in charge of monetary policy, administratively setting interest rates, creating bank reserves at will, and manipulating the prices of a growing number of assets to the benefit of the greater good, a system that not only did not exist 50 years ago but that back then nobody even advocated, is not to be challenged under any circumstances. Those who do are not worthy of debate. They are evidently members of the Montana Militia. They are crackpots and dangerous subversives. As Roubini stated: advocates of a gold standard are fanatics.
This is, of course, utter gibberish. A well-articulated, rational and sophisticated theory exists for why paper money systems are unstable and why they fail, and why hard money systems work better. The Austrian School of economics explains this convincingly. Its leading intellectual light was Ludwig von Mises (1881 – 1973) – urbane, sophisticated, highly intelligent, and a man of principle, one of the greatest economists of the twentieth century, who lived and taught in Vienna, Geneva and New York. – Not your average backwoodsman.
Roubini may be right on one thing: maybe gold will go down to $1,000. So what? – It won’t stay there. For whatever happens next to the gold price, or whatever the Fed does next, Roubini’s over-geared paper money economy will not survive in its present form.
In the meantime, good luck with that ‘exit strategy’!
This article was previously published at DetlevSchlichter.com.
The last couple of weeks have been very interesting. Remember that, certain regional differences aside, Japan has, for the past two-plus decades, been the global trendsetter in terms of macroeconomic deterioration and monetary policy. It was the first to have a major housing and banking bubble, the first to see that bubble burst, to respond with years of 1 percent interest rates, then zero rates, then various rounds of quantitative easing. The West has been following Japan each step on the way – usually with a lag of about ten years or so, although it seems to be catching up of late. Now Japan is the first developed nation to go ‘all-in’, to implement a no-holds-barred money-printing regime to (supposedly) ‘stimulate’ the economy. This is called Abenomics, after Japan’s new prime minister, Shinzo Abe, the new poster-boy of policy hyper-activism. I expect the West to follow soon. In fact, the UK is my prime candidate. Wait for Mr. Carney to start his new job and embrace ‘monetary activism’. Carnenomics anybody?
But here is what is so interesting about recent events in Japan. At first, markets did exactly what the central bankers wanted them to do. They went up. But in May things took a remarkable and abrupt turn for the worse. In just eight trading days the Nikkei stock market index collapsed by 15%. And, importantly, all of this started with bonds selling off.
Are markets beginning to realize that all these bubbles have to pop sometime and that sometime may as well be now? Are markets beginning to refuse to dance to the tune of the central bankers and their printing presses? Are central bankers losing control?
‘Sell in May and go away’
Let’s turn back the clock for a moment, if only just a bit. Let’s revisit April 2013. At the time I spoke of central bankers enjoying a kind of ‘policy sweet spot’: they were either pumping a lot of liquidity into markets or promising to do so if needed, and all of them were keeping rates near zero and promising to keep them there. Some started to consider ‘negative policy rates’. Yet, despite all this policy accommodation, official inflation readings remained remarkably tame – indeed, inflation marginally declined in some countries – while all asset markets were on fire: government bonds, junk bonds, equities, almost all traded at or near all-time highs, undeniably helped in large part by super-easy money everywhere. Even real estate in the US was coming back with a vengeance. And then, in early April, central bankers got an extra bonus: their nemesis, the gold market, was going into a tailspin. I am sure Mr. Bernanke was sleeping well at the time: financial assets were roaring, happily playing to the tune of the monetary bureaucracy, seemingly falling in line with his plan to save the world with new bubbles, while the cynics and heretics in the gold market, the obnoxious nutters who question today’s enlightened policy pragmatism, were cut off at the knees.
But then came May and everything sold off.
However, that is not quite how the media presents it. Here, one prefers the phrase ‘volatility returned’, as that implies that everything could be fine again tomorrow. And it certainly can. Maybe this is just a blip. But what if it isn’t? And, more importantly, what is driving it?
A widely debated theory is that the prospect of the Fed ‘tapering’ its quantitative easing operation, of it oh-so carefully, ever-so slightly removing its unprecedentedly large and more than ever alcohol-filled punchbowl could end the party. There has for some time been concern about and even outright opposition to never-ending QE within the Fed. So there is, of course, a risk (a chance?) that the Fed may reduce or even halt its asset-buying program. (As a quick reminder, since the start of the year, the Fed has expanded the monetary base already by more than $340 billion, and at the present pace, the Fed is on course to create $1,000 billion by the end of the year.)
Ben Bernanke – tough guy?
However, I do not think that markets have a lot to fear from the Fed. Should a pause in QE lead to a sell-off in markets, to rising yields and rising risk premiums, then, I believe, the Fed will quickly revert course once more and switch on the printing press again. The critics inside the Fed will be silenced rather quickly. Remember that most of them seem to argue that additional QE is not needed; they do not appear to reject it on principle. Ultimately, nobody in policy circles is willing to sit on his or her hands when the markets seriously begin to liquidate. The ‘end’ to QE, if it is announced at all, is likely to be just an episode.
The last central banker who had the cojones to take on Wall Street was Paul Volcker. Ben Bernanke, as well as his predecessor Alan Greenspan, have been nothing but nice to the speculating and borrowing classes. Both subscribe to and have, on numerous occasions, articulated the notion that it is part of the central bank’s remit to bring good cheer to households and corporations by lifting their house prices and inflating their stock prices and executive option packages. What the country needs is optimism and what is more conducive to optimism than a rising stock market and happy faces on CNBC? Bernanke declared that boosting financial assets can kick-start a virtuous circle of borrowing, investing and self-sustained growth. David Stockman has aptly called this approach ‘prosperity management’ through ‘Wall Street coddling’. Of course, Greenspan tightened in 1994, and again very carefully in 2005, and yes, both times financial markets caved in. But this only serves to illustrate how unsustainably bloated and dislocated the financial system has become, and how addicted to cheap money from the Fed. I think the Fed will be very careful to reduce the dosage of its drug anytime soon.
Although he didn’t quite put it in those terms, global bond guru Bill Gross, founder and co-chief investment officer at asset management giant PIMCO, seems to see it similarly. In an interview with Bloomberg in the middle of May, he confirmed that he and his team saw “bubbles everywhere”, which certainly implied that everything could go pop at the same time. He also stated that the Fed would “not dare” to do anything drastic anytime soon as the system is so much more leveraged now than it was in 1994, when Greenspan briefly tried to play tough and tighten policy.
My conclusion is this: if market weakness is the result of concerns over an end to policy accommodation, then I don’t think markets have that much to fear. However, the largest sell-offs occurred in Japan, and in Japan there is not only no risk of policy tightening, there policy-makers are just at the beginning of the largest, most loudly advertised money-printing operation in history. Japanese government bonds and Japanese stocks are hardly nose-diving because they fear an end to QE. Have those who deal in these assets finally realized that they are sitting on gigantic bubbles and are they trying to exit before everybody else does? Have central bankers there lost control over markets? After all, money printing must lead to higher inflation at some point. The combination in Japan of a gigantic pile of accumulated debt, high running budget deficits, an old and aging population, near-zero interest rates and the prospect of rising inflation (indeed, that is the official goal of Abenomics!) are a toxic mix for the bond market. It is absurd to assume that you can destroy your currency and dispossess your bond investors and at the same time expect them to reward you with low market yields. Rising yields, however, will derail Abenomics and the whole economy, for that matter.
It is, of course, too early to tell. The whole thing could end up being just a storm in a tea cup. It could be over soon and markets could fall back in line with what the central planners prescribe. But somehow I doubt that this is just a blip – and interestingly, so does Mohamed El-Erian, Bill Gross’ colleague at PIMCO and the firm’s other co-chief investment officer. In an interesting article on CNN Money, he contemplated the possibility that markets were beginning to lose confidence in central bankers.
If that is indeed the case it won’t be confined to Japan but will rapidly reverberate around the world. This is a much bigger story than a modest slowing of QE in the US. Could it be the beginning of the end?
I think the central bankers may not be sleeping so well now.
This article was previously published at DetlevSchlichter.com.
While the stance of monetary policy around the world has, on any conceivable measure, been extreme, by which I mean unprecedentedly accommodative, the question of whether such a policy is indeed sensible and rational has not been asked much of late. By rational I simply mean the following: is this policy likely to deliver what it is supposed to deliver? And if it does fall short of its official aim, then can we at least state with some certainty that whatever it delivers in benefits is not outweighed by its costs? I think that these are straightforward questions and that any policy that is advertised as being in ‘the interest of the general public’ should pass this test. As I will argue, the present stance of monetary policy only has a negligible chance, at best, of ever fulfilling its stated aim. Furthermore, its benefits are almost certainly outweighed by its costs if we list all negative effects of this policy and do not confine ourselves, as the present mainstream does, to just one obvious cost: official consumer price inflation, which thus far remains contained. Thus, in my view, there is no escaping the fact that this policy is not rational. It should be abandoned as soon as possible.
The policy and its aims
The key planks of this policy are super low interest rates and targeted purchases (or collateralized funding) of financial assets by central banks. While various regional differences exist in respect of the extent of these programmes and the assets chosen, all major central banks – the US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan – have been engaged and continue to be committed to versions of this policy. Its purpose is to facilitate exceptionally cheap funding for banks and to affect the pricing of a wide range of financial assets, in particular and most directly government bonds but also mortgage bonds in the US and real-estate investment trusts and corporate securities in Japan. There is an ongoing debate in the UK and in the Euro Zone, too, about directly boosting prices of other, ‘private’ securities, that is, to have their prices manipulated upwards by direct purchases from the central banks.
To the wider public this policy is described as ‘stimulating’ growth, ‘unlocking’ the flow of credit and ‘jump-starting’ the economy. If that is indeed the aim, this policy has already failed.
We have now had almost five years of near-zero interest rates around the world. If such low interest rates were indeed the required kick-starter for the economy, we should have seen the results by now. ‘Stimulus’ is something that incites or arouses to action, a kind of ‘ignition’ that sets off processes, in this case, one assumes, a self-sustained economic recovery. But if the world economy was really fundamentally healthy and only in need of a dose of caffeine to stir it back into action, then dropping rates from around 4 to 5 percent to zero, as happened 4 or 5 years ago, should have done the trick by now.
Defenders of the policy will argue that we would all be in much more of a bind without it, but this is not the point here. This is something we can discuss when comparing costs and benefits. There is no escaping the conclusion that this policy has failed if its aim is to provide a required ignition – the stimulus – to ‘jump start’ the economy.
In support of my conclusion that this policy has failed as a ‘kick-starter’ of self-sustained growth I can quote as witnesses the very officials and experts who advocated this policy in the first place and who are still implementing it. Not a single one of the major central banks is even close to announcing the successful conclusion of these policies or is even beginning to contemplate an exit. 5 years into ‘quantitative easing’ and zero interest rates, the Fed last week began to openly consider increasing its monthly debt monetization programme. Although the week ended on a bright note, at least for the professional optimists out there, as the unemployment rate came in a tad lower than expected, manufacturing data during the week was disappointing and the US economy is evidently entering another growth dip.
Still, many argue that the roughly 2 percent growth that the US economy may achieve this year is nothing to be sniffed at. Yet, for a $15 trillion dollar economy that is just $300 billion in new goods and services. In the first quarter of 2013, the Fed expanded the monetary base by $300 billion alone, and the central bank is on course for $1 trillion in new money by Christmas, while the federal government will run a close to $1 trillion deficit despite the ‘sequester’. That is very little growth ‘bang’ for a lot of stimulus ‘buck’. Self-sustained looks different.
Last week in the Euro-Zone, the ECB cut its repo rate to 0.5%, a record low. If suppressing interest rates from 3.75% in 2007 to 0.75% by 2012, has not lead to a meaningful, let alone self-sustaining recovery, or at a minimum the type of underachieving recovery that would at least allow the ECB to sit tight and wait a bit, what will another drop to 0.5% achieve?
Shamelessly, some economists and financial commentators cite high youth unemployment in countries such as Spain as a good reason to cut rates further. The image that is projected here is evidently one of countless Spanish entrepreneurs standing at the ready with their investment projects, willing and eager to employ numerous Spanish young people if only rates were 0.25% lower. Then all their ambitious investment plans would become potentially profitable, and the long promised recovery could finally commence.
The number of young Spanish people who will find employment thanks to the ECB cutting rates close to zero cannot be known but I suggest a number equally close to zero is a reasonably good guess.
The ‘benefits’ – or are they costs?
This is not to say that this policy has no effects. It even had benefits, for some.
By suppressing market yields and boosting the prices of financial assets this policy has delivered substantial windfall profits for owners of stocks, bonds, and real estate. Those who did, for example, speculate heavily on rising property prices in the run-up to the recent crisis, then were put through the wringer by the financial meltdown, now find themselves happily resurrected and restored to their previous wealth, if not more wealth, courtesy of central bank charity.
The 0.25% rate cut from the ECB may not lift many young Spaniards into employment but it surely makes ‘owning’ financial assets on credit cheaper. For every €1 billion of assets the rate cut means a €2.5 million saving per year in cost of carry, as duly noted by the big banks, ‘investment’ banks and hedge funds. After the ECB rate cut, German Bunds reached new all-time highs as did, a few days later, Germany’s main stock index.
That we are witnessing strange and dangerous deformations of the capitalist system, if we can still even call it capitalist, and that new bubbles are being blown everywhere, is not only evident by the increasingly grotesque dichotomy between a woefully underperforming real economy perennially teetering on the brink of renewed recession and a financial system, in which almost every sector is trading at record levels, but also by the fact that the high correlation among asset classes on the way up to new records is beginning to strain the minds of the economists to come up with at least marginally plausible fundamental justifications for such uniform asset inflation. ‘Safe haven’ government bonds that would usually prosper at times of economic pain are equally ‘bid only’ as are risky equities and the grottiest of high yield bonds. The common denominator is, of course, cheap money. And if cheap money for the foreseeable future is not enough, then how about cheaper money – forever?
A conflicted conscience or outright embarrassment are now stirring some financial economists to suggest that the joys of bubble finance should be brought straight to the economic war zones in the European periphery, and that in order to have a bigger impact on the ‘real’ economy, the ECB should buy private loans and other local assets in these regions and thus more directly interfere in their pricing. The manipulations of the monetary central planners are too blunt, they need to be more fine-tuned. These suggestions are dangerously wrongheaded. Extending the addiction to the monetary crack cocaine of cheap credit beyond the financial dealing rooms of London, New York and Frankfurt and to the economy’s productive heartland is not going to solve anything, at least not in the long run, and that is a timescale that may still matter to some people, at least outside of the financial industry. There is nothing Spain needs less than a new artificially propped up real estate boom. The aforementioned Spanish youth would only swap today’s dependency on state hand-outs for dependency on never-ending cheap-credit policies from the ECB and ongoing asset-boosting price manipulations. This has nothing whatsoever to do with sustainable growth, lasting and productive employment and real wealth creation.
The fact that trained economists today seriously contemplate these policies and are willing to dress them up as ‘solutions’ only goes to show how far the new ’entitlement culture’ on Wall Street and in the City of London, where everybody now feels entitled to cheap credit and ongoing asset-boosting policy programs as the universal cure-all, has affected economic thinking. The speculating classes are beginning to feel generous: “Hey, this free cash is great. Let’s extend it to everybody.”
Would a deflationary correction be better?
Back to our cost-benefit analysis. The defenders of the present policy will argue that without it GDP in the major economies would have dropped more, that asset prices and lending would be more depressed, and that we might even be in the middle of some dreadful debt deflation. Maybe so. But to the extent that the present GDP readings are the result of central bank pump priming and not the result of renewed growth momentum, they are simply artificial and thus ultimately unsustainable. In fact, the mere suspicion that this might be so must undoubtedly depress optimism and thus the willingness to engage in the economy and put capital at risk. Nobody knows any longer what the real state of the economy is.
While the unemployed Spanish youth may not benefit – or only very marginally so – from record high German stock prices and their own government’s renewed ability to borrow yet more and yet more cheaply – they may in fact ultimately benefit from a deflationary clear-out that would cause prices on many everyday items to drop. Deflation is not such a bad thing if you have to live on your savings or a modest, nominally fixed payment stream. Additionally, reshuffling the economy’s deck of cards could also offer opportunities. Tearing down the old structures and allowing the market to price things honestly again, according to real risks and truly available savings, may at first cause some shock but ultimately bring new possibilities. The present monetary policy is inherently conservative. It bails out those who got it wrong in the recent crisis at the expense of those who didn’t even participate in the last boom. Some Schumpeterian creative destruction is urgently needed.
I am not advocating deflation or economic cleansing for the sake of deflation and contraction, or out of some sense of economic sadism, or even out of moral considerations of any kind. However, it strikes me that what ails the economy is not a lack of money or lack of a powerful ‘kick-starting’ stimulant, and it may not suffer from unduly high borrowing costs either. Wherever borrowing costs are still high in this environment of ‘all-in’ central bank accommodation they may be high for a reason, maybe even a good one. What ails the economy are the structural impediments that are well established and that had been long in the making, such as inflexible labor markets with their permanently enshrined high unit labor costs and excessive regulation that have always protected current job-holders at the expense of those out of work or entering the labor market. Overbearing welfare systems, high tax rates and outsized public sectors have long held back major economies. Easy money that, for some time, enabled high public sector borrowing and spending, and facilitated local property booms, helped cover up these structural rigidities. Now these issues simply come to the fore again. New rounds of easy money will not make these problems disappear but only create a new illusion of sustainability.
I haven’t even touched upon the growing risk that never-ending monetary accommodation will end in inflation and monetary chaos but it is apparent already that this policy has no convincing claim on rationality. Nevertheless, it is almost certain that it will be continued.
This will end badly.
This article was previously published at DetlevSchlichter.com.