“We look to Scotland for all our ideas of civilisation.” –Voltaire
In the face of nearly universal warnings from other nations, including England, the Scots have taken a pause from their legendary bravery to vote against full independence from the United Kingdom. Yet given the evident financial and monetary failures of most major developed economies in recent years, not only the UK, the Scots should take full advantage of the greater autonomy already promised by Westminster. In this report, I present a plan, inspired by the ‘Scottish Enlightenment’ of the 18th century, that would enable the Scots, probably in less than six years, to become the most prosperous Anglosphere region in the world. It won’t be easy, but then the easy isn’t for the brave.
who needs independence anyway?
The Scots may have shied away from decisive action on this particular occasion, but to paraphrase Shakespeare, “Independence is the undiscovered country.” Like death, it can be rather intimidating. But then the Scots, including their cousins the Scots-Irish, once settled the New World in vast numbers—an act of supreme bravery if ever there was—and played a critical role in the formation of the United States. This role included providing the bulk of the militia that would fight and eventually vanquish the formidable British army and their Hessian mercenaries.
There was another critical role played by the Scots in the 18th century, however, a rather more civilised one to be sure. This was the intellectual movement known as the ‘Scottish Enlightenment’, to which belonged prominent philosophers such as David Hume and the father of so-called ‘classical’ economics, Adam Smith. These ideas, in particular that of Scottish ‘Common Sense Realism’, would provide much of the basis for the original, Jeffersonian political culture of the United States, as documented by Alexis de Tocqueville, among others.
The US founding documents, including the Declaration of Independence—drafted by Jefferson—and the Constitution, are replete with Enlightenment concepts, including those of Natural Law; the centrality of commerce in society; private property rights; individual responsibility and the essential but limited role of government. Associated documents such as the Federalist Papers elaborate on the official documents, making the Enlightenment associations more obvious.
While not a term used in any of the above, the concept of ‘lasseiz faire’ economics, associated with Adam Smith’s famous ‘invisible hand’ of the marketplace, in time became a commonplace explanation for the astonishing prosperity of the young United States. Indeed, notwithstanding notable exceptions, such as the two Banks of the United States and a handful of national infrastructure projects, the US government remained but a tiny part of the national economy prior to the exigencies brought about by the Civil War. Even thereafter, the US government remained small in comparison with that of most European countries. Indeed, the US government had almost zero debt and financed itself almost entirely though excise taxes (eg customs duties) until the creation of the Federal Reserve and introduction of the federal income tax in 1913.
THE ORIGINAL SCOTTISH SUCCESS STORY
It is perhaps no coincidence that, given the prominence of Scots in early American commerce, culture and politics, and the English dejection at losing the Colonies, Scotland would emerge as the most important trading partner of the US in the early 19th century. Glasgow soon became the world’s largest shipyard and due to associated local advances in engineering and science, it has as strong a claim as any city in the world to being the heart of the industrial revolution that would eventually sweep the globe. This was no doubt assisted by the ‘Scottish Diaspora’ of engineers, scientists, skilled tradesmen and businessmen of all stripes.
This astonishing success can be repeated again with sufficient home rule autonomy, as has already been promised by Westminster. Scotland need only reach back into its own past for guidance in order to secure a prosperous future and, quite possibly, overtake not only England but the entire Anglosphere world. The most important ingredients for success can be broken down into six essential elements.
SIX SCOTTISH ELEMENTS FOR SUCCESS WITHIN SIX YEARS
The Scots’ legendary bravery is equalled by legendary parsimony, the first essential element of success. There is no growth without investment and no sustainable investment without savings. It stands to reason that you aren’t a parsimonious society if you carry around a massive, accumulating national debt. Debt service is also a drag on future growth. Thus if the Scots want to prosper long-term, they are going to need to pay down their share of the UK national debt.
Of course, this is easier said than done. It is also highly preferable to pay down debt out of a growing rather than stagnating income. Thus the key to successful debt reduction is strong growth, which to be sustainable requires strong private investment, the next essential element.
Although parsimonious with respect to consumption, the Scots were once great investors. As mentioned above, Glasgow and the Scottish Lowlands generally have as strong or stronger a claim than the English Midlands as the heart of the industrial revolution, the most rapid accumulation of productive capital in recorded human history. But how could the Scots best facilitate investment today?
There are several policies that would quickly create an investment boom. Most important, Scotland should do better than celtic rival Ireland, with a low corporate tax rate, and abolish the corporate income tax altogether. Yes, you read that right: The effective corporate income tax in many countries now approaches zero anyway, due to all manner of creative cross-border accounting. But while it might be creative, international tax arbitrage accounting is also expensive. Corporations the world over would far prefer to put clever employees to work on real productive activities, if possible, rather than on elaborate accounting schemes requiring constant updating, a dead-weight loss for their customers who pay higher prices as a result.
For those concerned about the tax revenue implications of a zero corporate tax rate, don’t be. What is not paid by corporations in tax is eventually paid out in profits (dividends). Those can be taxed instead, as ordinary income like anything else, thereby simplifying the local personal income tax, which ideally should be a flat amount, say 20%, prepared on a single sheet of paper once a year. So not only will corporations want to relocate to and invest in Scotland; skilled workers will be attracted by the only ‘One-Rate, One-Page’ personal income tax in the entire Anglosphere. Already resident Scots will benefit most from the associated general expansion of the domestic labour market.
Another tax policy that would both attract global investment and simplify things would be to tax capital gains at the same flat rate as on ordinary income. Capital gains are really nothing more than deferred investment income anyway, so by leaving the interim income untaxed, a huge incentive to save is created, thereby providing for the domestic savings required to fund the high investment rates enabling strong and sustainable growth.
As for other taxes, there is much more that Scotland could do to attract investment and support healthy, sustainable growth. Willie Walsh, CEO of BA, has suggested the Scots might sharply reduce duties on airfares. This would have the effect of re-routing much transcontinental air traffic, including profitable connecting flights, from congested London area airports to Scotland.
Developing human capital, at which the Scots excelled in the 19th century, is the third element. Consider which industries are most likely to relocate to Scotland: Those requiring neither natural resources nor extensive industrial infrastructure, that is, those comprised primarily of human capital. Although financial services comes to mind, there is tremendous overcapacity in this area in England and Ireland, including in unproductive yet risky activities, so that is better left to the English and Irish for now. Better would be to concentrate on health care, for example, an industry faced with soaring costs and stifling regulation in much of the world.
Scotland could, inside of six years, become the world’s premier desination for so-called ‘healthcare tourism’. Scotland lies directly under some of the world’s busiest airline routes, an ideal location. Medical professionals from all over the world would be attracted by the zero tax rates on their small businesses and low tax rates on paid-out profits, passing much of the savings along to their patients. In turn, patients from all over the world would travel to Scotland, attracted by the low cost and high quality of healthcare. To further lower costs, the Scots could leverage off their strong legal traditions to reduce opaque malpractice liability disputes to a minimum, thereby making certain that the healthcare industry remains centred around doctors, nurses and patients, rather than lawyers, regulators and bureaucrats, as has become the case in the US, for example.
By attracting much global healthcare talent, Scotland could easily become the leading global location for medical research, development, training and education. Healthcare could thus provide the 21st century equivalent of Scottish shipbuilding in the 19th: A central industry that, in turn, facilitated the development of many other associated industries.
No doubt, in addition to Healthcare and Air Transport, at a minimum a handful of other industries would take advantage of sensible Scottish tax policies. Software firms, nearly devoid of anything other than human capital, would almost certainly respond. Film makers and artists of all stripes would be enticed by the low tax rates on their creative productions. Accountancy and business services firms would follow all of the above.
A fourth essential element to success is to implement Scottish Enlightenment principles for sound banking. This is of utmost importance due to the potential monetary and financial instability of the UK and much of the broader Anglosphere.
As a first step, Scotland should forbid any bank from conducting business in Scotland if they receive any direct financial assistance from the Bank of England or from the UK government. In turn, Scotland should make clear to Westminster that Scottish residents will not contribute to any taxpayer bail out of any UK financial institution. No ‘lender of last resort’ function will exist for financial activities in Scotland, unless such action, if formally requested by a bank, is approved by the Scots in a referendum. (Taxpayers are always on the hook for bailouts one way or the other; why not make this explicit?) The Scots deserve to make any bank bailout decision for themselves, should they deem it necessary or desirable, rather than leave it to an unelected bureaucracy easily captured by the financial industry, as appears to be the case with the Bank of England and the US Federal Reserve.
How then will banks operating in Scotland be perceived as safe and credible institutions? Well, the old-fashioned Scottish way: They will capitalise themselves sufficiently so that investors and depositors will consider their investments and deposits to be secure under all reasonable scenarios. Yes, this implies a high cost of capital and low financial leverage, which in turn imply that bank profitability will be very low. But the Scottish future should not belong to economic financialisation, rather in real, productive activities. Finance should serve the economy, not the other way around.
The fifth element reaches particularly deep into Scottish history: Self-Reliance. Peoples that inhabit relatively inhospitable or infertile lands tend to establish cultures with self-reliance at the core. No, this does not make them culturally backward, but it does tend to contribute to a distrust of foreign or central authority. The Scots, while brave, were frequently disunited in their opposition to English rule, something that had unfortunate consequences for many, not just William Wallace.
While disunity may not be effective in the face of foreign invasion and occupation, there are few who argue that modern governance structures in most developed economies, including the EU, have not become inefficiently over-centralised in recent decades. The Scottish independence movement is not merely a local phenomenon. There are peoples throughout the EU seeking greater local autonomy. The Belgian Flemings have been at it for years. The elder Catalonians have memories of the Spanish Civil War. Various regional organisations in northern Italy have pressed for degrees of independence from Rome. And anti-EU sentiment, in general, has been on the rise over the past decade, even before so-called ‘austerity’ set in post-2008.
Local government tends to be more responsive and accountable to the citizenry, in particular a culturally self-reliant one not tolerant of abuses. More efficiency and effectiveness in government is the result. Decentralisation and self-reliance, together with the adoption of modern communications technologies will make it possible for Scotland, in a short time, to serve as a governance model for others to emulate.
Finally, there is the sixth element: the collective cultural traditions of Scottish Presbyterianism. There are few religions in the world that hold not only faith, but hard work, thrift and charity in such high regard as that of traditional Presbyterianism. Yes, as with most all Europeans, the Scots have become more secular in recent decades. But the same could be said of the Germans, who nevertheless cling to their own, solid Protestant work ethic and associated legal and moral anti-corruption traditions.
The charitable tradition is misinterpreted by some to support a unique form of Scottish socialism, but this contradicts the core Presbyterian concept of man’s direct relationship with God. Presbyterianism holds that to work hard, to be thrifty, to be charitable, is to do God’s work and thus all three can be understood as forms of worship in their own right. However, genuine faith in God, genuine worship, cannot somehow be coerced by a central authority. It must be left to the individual, through their direct relationship to God, to find enlightenment, albeit with the strong support and influence of the local community. To put it somewhat humorously, a Presbyterian minister might say to a Scottish socialist: “Jesus told YOU to help the poor, not to create some centralised government bureaucracy to coerce others into doing so on your behalf!”
Nowhere in the developed world today is private charity taken so seriously as in the United States. Notwithstanding certain wayward cultural traits of modern America, active private charity remains an integral part of the society. This is without doubt a legacy of Presbyterian cultural tradition: Limited government yes, but with limited government comes far greater private and personal responsibility to help the poor or otherwise needy in the community.
So in the home-ruled Scotland of the future, in which self-reliance reasserts itself and government becomes more limited as per Scottish tradition, so the vacuum can be filled by private charitable initiative. This will serve to assist those who struggle to wean themselves off a shrinking public sector safety net, notwithstanding the strong labour market associated with high rates of domestic and foreign investment.
Yes, some Scots might be intimidated by this ambitious six-year plan, notwithstanding its firm rooting in Scottish cultural traditions, the Scottish Enlightenment, and the Scottish industrial revolution. But I’m hopeful that bravery will carry the day, with or without full, formal independence from the UK.
When it comes to the world of international finance, Jim Rickards has quite nearly seen it all. As a young man, he worked for Citibank in Pakistan, of all places. In the 1990s, he served as General Counsel for Long-Term Capital Management, Jim Merriwether’s large, notorious hedge fund that collapsed spectacularly in 1998. In recent years, he has been a regular participant in Pentagon ‘wargames’, in particular those incorporating financial or currency warfare in some way, and he has served as an advisor to the US intelligence community.
Yet while his experiences are vast in breadth, they have all occurred within the historically narrow confines of a peculiar international monetary regime, one lacking a gold- or silver-backed international reserve currency. Yes, reserve currencies have come and gone through history, but it is the US dollar, and only the US dollar, that has ever served as an unbacked global monetary reserve.
Nevertheless, in CURRENCY WARS and THE DEATH OF MONEY, Jim does an excellent job of exploring pertinent historical parallels to the situation as it exists today, in which the international monetary regime has been critically undermined by a series of crises and flawed policy responses thereto. He also applies not only economic but also complexity theory to provide a framework and deepen understanding.
As for what happens next, he does have a few compelling ideas, as we explore in the following pages. To begin, however, we explore what it was that got him interested in international monetary relations in the first place.
BACK TO THE 1970S: THE DECADE OF DISCO AND DOLLAR CRISES
JB: Jim, you might recall the rolling crises of the 1970s, beginning with the ‘Nixon Shock’ in 1971, when the US ‘closed the gold window’, to the related oil shocks and then the de facto global ‘run on the dollar’ at the end of the decade. At the time, as a student, did you have a sense as to what was happening, or any inclination to see this as the dollar’s first real test as an unbacked global monetary reserve? Did these events have any influence on your decision to study international economics and to work in finance?
JR: I was a graduate student in international economics in 1972-74, and a law student from 1974-77, so my student years coincided exactly with the most tumultous years of the combined oil, inflation and dollar crises of the 1970s. Most observers know that Nixon closed the gold window in 1971, but that was not considered the end of the gold standard at the time. Nixon said he was ‘temporarily’ suspending convertibility, but the dollar was still officially valued at 1/35th of an ounce of gold. It was not until 1975 that the IMF officially demonitised gold although, at French insistence, gold could still be counted as part of a country’s reserve position. I was in the last class of students who were actually taught about gold as a monetary asset. Since 1975, any student who learns anything about gold as money is self-taught because it is no longer part of any economics curriculum. During the dark days of the dollar crisis in 1977, I spoke to one of my international law professors about whether the Deutschemark would replace the dollar as the global reserve currency. He smiled and said, “No, there aren’t enough of them.” That was an important lesson in the built-in resilience of the dollar and the fact that no currency could replace the dollar unless it had a sufficiently large, liquid bond market – something the euro does not yet have to this day. From law school I joined Citibank as their international tax counsel. There is no question that my academic experiences in a period of borderline hyperinflation and currency turmoil played a powerful role in my decision to pursue a career in international finance.
JB: As you argued in CURRENCY WARS and now again in THE DEATH OF MONEY, the US debt situation, public and private, is now critical. It would be exceedingly difficult for another Paul Volcker to arrive at the Federal Reserve and shore up confidence in the system with high real interest rates. But why has it come to this? Why is it that the ‘power of the printing press’ has been so abused, so corrupted? Is this due to poor federal governance, as David Stockman argues in THE GREAT DEFORMATION? Is it due to the incompetence or ignorance of the series of Federal Reserve officials who failed to appreciate the threat of global economic imbalances? Or is it due perhaps to a fundamental flaw in the US economic and monetary policy regime itself?
JR: It is still possible to strengthen the dollar and cement its position as the keystone of the international financial system, but not without costs. Reducing money printing and raising interest rates would strengthen the dollar, but they would pop the asset bubbles in stocks and housing that have been re-created since 2009. This would also put the policy problem in the laps of Congress and the White House where it belongs. The problems in the economy today are structural, not liquidity-related. The Fed is trying to solve structural problems with liquidity solutions. That will never work, but it might destroy confidence in the dollar in the process. Federal Reserve officials have misperceived the problem and misapprehend the statistical properties of risk. They are using equilbirium models in a complex system. (Ed note: Complexity Theory explores the fundamental properties of dynamic rather than equilibrium systems and how they react and adapt to exogenous or endogenous stimuli.) That is also bound to fail. Fiat money can work but only if money issuance is rule-based and designed to maintain confidence. Today’s Fed has no rule and is destroying confidence. Based on present policy, a complete loss of confidence in the dollar and a global currency crisis is just a matter of time.
JB: Thinking more internationally, the dollar is in quite good company. ‘Abenomics’ in Japan appears to have failed to confer any meaningful, lasting benefits and has further undermined what little confidence was left in the yen; China’s bursting credit and investment bubble threatens the yuan; the other BRICS have similar if less dramatic credit excess to work off; and while the European Central Bank and most EU fiscal authorities have been highly restrained for domestic political reasons in the past few years, there are signs that this may be about to change. Clearly this is not a situation in which countries can easily trust one another in monetary matters. But as monetary trust supports trust in trade and commerce generally, isn’t it just a matter of time before the currency wars of today morph into the trade wars of tomorrow? And wouldn’t a modern-day Smoot-Hawley be an unparalleled disaster for today’s globalised, highly-integrated economy?
JR: Currency wars can turn into trade wars as happened in the 1920s and 1930s. Such an outcome is certainly possible today. The root cause is lack of growth on a global basis. When growth is robust, large countries don’t care if smaller trading partners grab some temporary advantage by devaluing their currencies. But when global growth in anemic, as it is now, a positive sum game becomes a zero-sum game and trading partners fight for every scrap of growth. Cheapening your currency, which simultaneously promotes exports and imports inflation via the cross rate mechanism, is a tempting strategy when there’s not enough growth to go around. We are already seeing a twenty-first century version of Smoot-Hawley in the form of economic sanctions imposed on major countries like Iran and Russia by the United States. This has more to do with geopolitics than economics, but the result is the same – reduced global growth that makes the existing depression even worse.
JB: You may recall that, in my book, THE GOLDEN REVOLUTION, I borrow your scenario of how Russia could, conceivably, undermine the remaining international trust in the dollar with a pre-emptive ‘monetary strike’ by backing the rouble with gold. Do you regard the escalating situation in Ukraine, as well as US policies in much of the Black Sea/Caucasus/Caspian region generally, as a potential trigger for such a move?
JR: There is almost no possibility that either the Russian rouble or the Chinese yuan can be a global reserve currency in the next ten years. This is because both Russia and China lack a good rule or law and a well-developed liquid bond market. Both things are required for reserve curreny status. The reason Russia and China are acquiring gold and will continue to do so is not to launch a new gold-backed currency, but rather to hedge their dollar positions and reduce their dependence on dollar reserves. If there is a replacement for the dollar as the leading reserve currency, it will either be the euro, the special drawing right (SDRs), or perhaps a new currency devised by the BRICS.
JB: Leaving geo-politics aside for the moment, you mention right at the start of THE DEATH OF MONEY, citing the classic financial thriller ROLLOVER, that even non-state actors could, perhaps for a variety of reasons, spontaneously begin to act in ways that, given the fragility of the current global monetary order, cascade into a run on the dollar and rush to accumulate gold. If you were to do a remake of ROLLOVER today, how would you structure the plot? Who could be the first to begin selling dollars and accumulating gold? Who might join them? What would be the trigger that turned a trickle of dollar selling into a flood? How might the US government respond?
JR: If Rollover were re-made today, it would not be a simple Arab v. US monetary plot. The action would be multilateral including Russia, China, Iran, the Arabs and others. Massive dumping of dollars might be the consequence but it would not be the cause of the panic. A more likely scenario is something entirely unexpected such as a failure to deliver physical gold by a major gold exchange or dealer. That would start panic buying of gold and dumping of dollars. Another scenario might begin with a real estate collapse and credit crash in China. That could cause a demand shock for gold among ordinary Chinese investors, which would cause a hyperbolic price spike in gold. A rising gold price is just the flip side of a collapsing dollar.
JB: This entire discussion all follows from the fragility of the current international monetary system. Were the system more robust, we could leave the dollar crisis topic to Hollywood for entertainment rather than to treat it with utmost concern for personal, national or even international security. But what is it that makes systems fragile? Authors ranging from George Gilder (KNOWLEDGE AND POWER), to Joseph Tainter (THE COLLAPSE OF COMPLEX SOCIETIES) and even Edward Gibbon (THE RISE AND FALL OF THE ROMAN EMPIRE) have applied such thinking to ancient and modern economies and societies. They all conclude that, beyond a certain point, centralisation of power is destabilising. Does this mean that a robust monetary system would ‘de-centralise’ monetary power? Isn’t this incompatible with any attempt by the G20 and IMF to transform the Special Drawing Right (SDR) from a unit of account into a centrally-managed, global reserve currency?
JR: Yes. Complex systems collapse because increases in complexity require exponential increases in energy to maintain the system. Energy can take many forms including money, which can be thought of as a form of stored energy. We are already past the point where there is enough real money to support the complexity of the financial system. Elites are now resorting to psuedo-money such as deriviatives and other forms of leverage to keep the system going but even that will collapse in time. The proper solution is to reduce the complexity of the system and restore the energy/money inputs to a sustainable level. This means reducing leverage, banning most derivatives and breaking up big banks. None of this is very likely because it cuts against the financial interests of the power elites who run the system. Therefore a continued path toward near-term collapse is the most likely outcome.
JB: In CURRENCY WARS you make plain that, although you are highly critical of the current economic policy mainstream for a variety of reasons, you are an agnostic when it comes to economic theory. Yet clearly you draw heavily on economists of the Austrian School (eg Hayek) and in THE DEATH OF MONEY you even mention the pre-classicist and proto-Austrian Richard Cantillon. While I doubt you are a closet convert to the Austrian School, could you perhaps describe what it is about it that you do find compelling, vis-à-vis the increasingly obvious flaws of current, mainstream economic thinking?
JR: There is much to admire in Austrian economics. Austrians are correct that central planning is bound to fail and free markets produce optimal solutions to the problem of scarce resources. Complexity Theory as applied to capital markets is just an extension of that thinking with a more rigorous scientific foundation. Computers have allowed complexity theorists to conduct experiments that were beyond the capabilities of early Austrians. The results verify the intuition of the Austrians, but frame the issue in formal mathematical models that are useful in risk management and portfolio allocation. If Ludwig von Mises were alive today he would be a complexity theorist.
JB: You may have heard the old Irish adage of the young man, lost in the countryside, who happens across an older man and asks him for directions to Dublin, to which the old man replies, unhelpfully, “Well I wouldn’t start from here.” If you were tasked with trying, as best you could, to restore monetary stability to the United States and by extension the global economy, how would you go about it? You have suggested devaluing the dollar (or other currencies) versus gold to a point that would make the existing debt burdens, public and private, credibly serviceable. But does this solve the fundamental systemic problem? What is to stop the US and global economy from printing excessive money and leveraging up all over again, and in a decade or two facing the same issues, only on a grander scale? Is there a better system? Could a proper remonetisation of gold a la the classical gold standard do the trick? Might there be a role for new monetary technology such as cryptocurrency?
JR: The classic definition of money involves three functions: store of value, medium of exchange and unit of account. Of these, store of value is the most important. If users have confidence in value then they will accept the money as a medium of exchange. The unit of account function is trivial. The store of value is maintained by trust and confidence. Gold is an excellent store of value because it is scarce and no trust in third parties is required since gold is an asset that is not simultaneously the liability of another party. Fiat money can also be a store of value if confidence is maintained in the party issuing the money. The best way to do that is to use a monetary rule. Such rules can take many forms including gold backing or a mathematical formula linked to inflation. The problem today is that there is no monetary rule of any kind. Also, trust is being abused in the effort to create inflation, which is form of theft. As knowledge of this abuse of trust becomes more widespread, confidence will be lost and the currency will collapse. Cryptocurrencies offer some technological advantages but they also rely on confidence to mainatin value and, in that sense, they are not an improvement on traditional fiat currencies. Confidence in cryptocurrencies is also fragile and can easily be lost. It is true that stable systems have failed repeatedly and may do so again. The solution for individual investors is to go on a personal gold standard by acquiring physical gold. That way, they will preserve wealth regardless of the monetary rule or lack thereof pursued by monetary authorities.
JB: Thanks Jim for your time. I’m sure it is greatly appreciated by all readers of the Amphora Report many of whom have probably already acquired a copy of THE DEATH OF MONEY.
In a world of rapidly escalating crises in several regions, all of which have a clear economic or financial dimension, Jim’s answers to the various questions above are immensely helpful. The world is changing rapidly, arguably more rapidly that at any time since the implosion of the Soviet Union in the early 1990s. Yet back then, the changes had the near-term effect of strengthening rather than weakening the dominant US position in global geopolitical, economic and monetary affairs. Today, the trend is clearly the opposite.
Jim’s use of Complexity Theory specifically is particularly helpful, as the balance of power now shifts away from the US, destabilising the entire system. Were the US economy more robust and resilient, perhaps a general global rebalancing could be a gradual and entirely peaceful affair. But with the single most powerful actor weakening not only in relative but arguably in absolute terms, for structural reasons Jim explains above, the risks of a disorderly rebalancing are commensurately greater.
The more disorderly the transition, however, the less trust will exist between countries, at least for a time, and as Jim points out it is just not realistic for either the Russian rouble or Chinese yuan to replace the dollar any time soon. As I argue in THE GOLDEN REVOLUTION, this makes it highly likely that as the dollar’s share of global trade declines, not only will other currencies be competing with the dollar; all currencies, including the dollar, will increasingly be competing with gold. There is simply nothing to prevent one or more countries lacking trust in the system to demand gold or gold-backed securities of some kind in exchange for exports, such as oil, gas or other vital commodities.
Jim puts the IMF’s SDR forward as a possible alternative, but here, too, he is sceptical there is sufficient global cooperation at present to turn the SDR into a functioning global reserve currency. The world may indeed be on the path to monetary collapse, as Jim fears, but history demonstrates that collapse leads to reset and renewal, and in this case it seems more likely that not that gold will provide part of the necessary global monetary foundation, at least during the collapse, reset and renewal period. Once trust in the new system is sufficient, perhaps the world will once again drift away from gold, and perhaps toward unbacked cryptocurrencies such as bitcoin, but it seems unlikely that a great leap forward into the monetary unknown would occur prior to a falling-back onto what is known to have provided for the relative monetary and economic stability that prevailed prior to the catastrophic First World War, which as readers may note began 100 years ago this month.
“I say to all those who bet against Greece and against Europe: You lost and Greece won. You lost and Europe won.” –Jean-Claude Juncker, former prime minister of Luxembourg and president of the Eurogroup of EU Finance Ministers, 2014
“We have indeed at the moment little cause for pride: As a profession we have made a mess of things.” –Friedrich Hayek, Nobel Laureate in Economic Science, 1974
Jean-Claude Juncker is a prominent exception to the recent trend of economic and monetary officials openly expressing doubt that their interventionist policies are producing the desired results. In recent months, central bankers, the International Monetary Fund, the Bank for International Settlements, and a number of prestigious academic economists have expressed serious concern that their policies are not working and that, if anything, the risks of another 2008-esque global financial crisis are building. Thus we have arrived at a ‘Crisis of Interventionism’ as the consequences of unprecedented monetary and fiscal stimulus become evident, fuelling a surge in economic nationalism around the world, threatening the end of globalisation and the outbreak of trade wars. Indeed, a tech trade war may already have started. This is is perhaps the least appreciated risk to financial markets at present. How should investors prepare?
THE FATAL CONCEIT
Friedrich Hayek was the first Austrian School economist to win the Nobel Memorial Prize in Economic Science. Yet Hayek took issue with the characterisation of modern economics as a ‘science’ in the conventional sense. This is because the scientific method requires theories to be falsifiable and repeatable under stable conditions. Hayek knew this to be impossible in the real world in which dynamic, spontaneous human action takes place in response to an incalculable number of exogenous and endogenous variables.
Moreover, Hayek believed that, due to the complexity of a modern economy, the very idea that someone can possibly understand how it works to the point of justifying trying to influence or distort prices is nonsensical in theory and dangerous in practise. Thus he termed such hubris in economic theory ‘The Pretence of Knowledge’ and, in economic policy, ‘The Fatal Conceit’.
History provides much evidence that Hayek was correct. Interventionism has consistently failed either to produce the desired results or has caused new, unanticipated problems, such as in the 1920s and 1930s, for example, an age of particularly active economic policy activism in most of the world. Indeed, as Hayek wrote in his most famous work, The Road to Serfdom, economic officials tend to respond to the unintended consequences of their failed interventions with ever more interventionism, eventually leading to severe restrictions of economic liberty, such as those observed under socialist or communist regimes.
Hayek thus took advantage of his Nobel award to warn the economics profession that, by embracing a flawed, ‘pseudo-scientific method’ to justify interventionism, it was doing itself and society at large a great disservice:
The conflict between what in its present mood the public expects science to achieve in satisfaction of popular hopes and what is really in its power is a serious matter because, even if the true scientists should all recognize the limitations of what they can do in the field of human affairs, so long as the public expects more there will always be some who will pretend, and perhaps honestly believe, that they can do more to meet popular demands than is really in their power. It is often difficult enough for the expert, and certainly in many instances impossible for the layman, to distinguish between legitimate and illegitimate claims advanced in the name of science…
If we are to safeguard the reputation of economic science, and to prevent the arrogation of knowledge based on a superficial similarity of procedure with that of the physical sciences, much effort will have to be directed toward debunking such arrogations, some of which have by now become the vested interests of established university departments.
Hayek made these comments in 1974. If only the economics profession had listened. Instead, it continued with the pseudo-science, full-steam ahead. That said, by 1974 a backlash against traditional Keynesian-style intervention had already begun, led by, among others, Milton Friedman. But Friedman too, brilliant as he no doubt was, was seduced also by the culture of pseudo-science and, in his monetary theories, for which he won his Nobel prize in 1976, he replaced a Keynesian set of unscientific, non-falsifiable, intervention-justifying equations with a Monetarist set instead.
Economic interventionism did, however, fall out of intellectual favour following the disastrous late-1970s stagflation and subsequent deep recession of the early 1980s—in the US, the worst since WWII. It never really fell out of policy, however. The US Federal Reserve, for example, facilitated one bubble after another in US stock and/or property prices in the period 1987-2007 by employing an increasingly activist monetary policy. As we know, this culminated in the spectacular events of 2008, which unleased a global wave of intervention unparalleled in modern economic history.
THE KEYNESIANS’ NEW CLOTHES
Long out of fashion, Keynesian theory and practice returned to the fore as the 2008 crisis unfolded. Some boldly claimed at the time that “we are all Keynesians now.” Activist economic interventionism became the norm across most developed and developing economies. In some countries, this has taken a more fiscal policy form; in others the emphasis has been more on monetary policy. Now six years on, with most countries still running historically large fiscal deficits and with interest rates almost universally at or near record lows, it is entirely understandable that the economics profession is beginning to ask itself whether the interventions it recommended are working as expected or desired.
While there have always been disputes around the margins of post-2008 interventionist policies, beginning in 2012 these became considerably more significant and frequent. In a previous report, THE KEYNESIANS’ NEW CLOTHES, I focused on precisely this development:
In its most recent World Economic Outlook, the International Monetary Fund (IMF) surveys the evidence of austerity in practice and does not like what it finds. In particular, the IMF notes that the multiplier associated with fiscal tightening seems to be rather larger than they had previously assumed. That is, for each unit of fiscal tightening, there is a greater economic contraction than anticipated. This results in a larger shrinkage of the economy and has the unfortunate result of pushing up the government debt/GDP ratio, the exact opposite of what was expected and desired.
While the IMF might not prefer to use the term, what I have just described above is a ‘debt trap’. Beyond a certain point an economy has simply accumulated more debt than it can pay back without resort to currency devaluation. (In the event that a country has borrowed in a foreign currency, even devaluation won’t work and some form of restructuring or default will be required to liquidate the debt.)
The IMF is thus tacitly admitting that those economies in the euro-area struggling, and so far failing, to implement austerity are in debt traps. Austerity, as previously recommended by the IMF, is just not going to work. The question that naturally follows is, what will work?
Well, the IMF isn’t exactly sure. The paper does not draw such conclusions. But no matter. If austerity doesn’t work because the negative fiscal multiplier is larger than previously assumed, well then for now, just ease off austerity while policymakers consider other options. In other words, buy time. Kick the can. And hope that the bond markets don’t notice.
Now, nearly two years later, the IMF has been joined in its doubts by a chorus of economic officials and academics from all over the world increasingly concerned that their interventions are failing and, in some cases, putting forth proposals of what should be done.
Let’s start with the Bank of England. Arguably the most activist central bank post-2008, as measured by the expansion of its balance sheet, several members of the Banks’ Monetary Policy Committee have expressed concern about the risks to financial stability posed by soaring UK property prices, a lack of household savings and a financial sector that remains highly leveraged. In a recent speech, BoE Chief Economist Charlie Bean stated that:
[T]he experience of the past few years does appear to suggest that monetary policy ought to take greater account of financial stability concerns. Ahead of the crisis, Bill White and colleagues at the Bank for International Settlements consistently argued that when leverage was becoming excessive and/or asset prices misaligned, central bankers ought to ‘lean against the wind’ by keeping interest rates higher than necessary to meet the price stability objective in the short run. Just as central banks are willing to accept temporary deviations from their inflation targets to limit output volatility, so they should also be willing to accept temporary deviations to attenuate the credit cycle. Essentially it is worth accepting a little more volatility in output and inflation in the short run if one can thereby reduce the size or frequency of asset-price busts and credit crunches.
In other words, perhaps central bank policy should change focus from inflation targeting, which demonstrably failed to prevent 2008, and instead to focus on money and credit growth. This is clearly an anti-Kenyesian view in principle, although one wonders how it might actually work in practice. In closing, he offered these thoughts:
I opened my remarks tonight by observing that my time at the Bank has neatly fallen into two halves. Seven years of unparalleled macroeconomic stability have been followed by seven years characterised by financial instability and a deep recession. It was a salutary lesson for those, like me, who thought we had successfully cracked the problem of steering the economy, and highlighted the need to put in place an effective prudential framework to complement monetary policy. Policy making today consequently looks a much more complex problem than it did fourteen years ago.
Indeed. Policy making does look increasingly complex. And not only to the staff of the IMF and to Mr Bean, but also to the staff at the Bank for International Settlements, to which Mr Bean referred in his comments. In a recent speech, General Manager of the BIS, Jaime Caruana, taking a global view, expressed fresh concern that:
There is considerable evidence that, for the world as a whole, policy interest rates have been persistently below traditional benchmarks, fostering unbalanced expansions. Policy rates are comparatively low regardless of the benchmarks – be these trend growth rates or more refined ones that capture the influence of output and inflation… Moreover, there is clear evidence that US monetary policy helps explain these deviations, especially for small open and emerging market economies. This, together with the large accumulation of foreign exchange reserves, is consistent with the view that these countries find it hard, economically or politically, to operate with rates that are considerably higher than those in core advanced economies. And, alongside such low rates, several of these economies, including some large ones, have been exhibiting signs of a build-up of financial imbalances worryingly reminiscent of that observed in the economies that were later hit by the crisis. Importantly, some of the financial imbalances have been building up in current account surplus countries, such as China, which can ill afford to use traditional policies to boost domestic demand further. This is by no means new: historically, some of the most disruptive financial booms have occurred in current account surplus countries. The United States in the 1920s and Japan in the 1980s immediately spring to mind.
The above might not sound terribly controversial from a common-sense perspective but to those familiar with the core precepts of the neo-Keynesian mainstream, this borders on economic heresy. Mr Caruana is implying that the Great Depression was not caused primarily by the policy failures of the early 1930s but by the boom preceeding it and that the stagnation of Japan in recent decades also has its roots in an unsustainable investment boom. In both cases, these booms were the product of economic interventions in the form of inappropriately easy monetary policy. And whence does current inappropriate policy originate? Why, from the US Federal Reserve! Mr Caruana is placing the blame for the renewed, dangerous buildup of substantial global imbalances and associated asset bubbles specifically on the Fed!
Yet Mr Caruana doesn’t stop there. He concludes by noting that:
[T]he implication is that there has been too much emphasis since the crisis on stimulating demand and not enough on balance sheet repair and structural reforms to boost productivity. Looking forward, policy frameworks need to ensure that policies are more symmetrical over the financial cycle, so as to avoid the risks of entrenching instability and eventually running out of policy ammunition.
So now we have had the IMF observing that traditional policies aren’t working as expected; BoE Chief Economist Bean noting how policy-making has become ‘complex’; and BIS GM Caruana implying this is primarily due to the boom/bust policies of the US Federal Reserve. So what of the Fed itself? What have Fed officials had to say of late?
Arguably the most outspoken recent dissent of the policy mainstream from within the Fed is that from Jeffrey Lacker, President of the regional Richmond branch. In a recent speech, he voiced his clear opposition to growing central bank interventionism:
There are some who praise the Fed’s credit market interventions and advocate an expansive role for the Fed in promoting financial stability and mitigating financial system disruptions. They construe the founders of the Federal Reserve System as motivated by a broad desire to minimize and prevent financial panics, even beyond simply satisfying increased demand for currency. My own view, which I must note may not be shared by all my colleagues in the Federal Reserve System, favors a narrower and more restrained role, focused on the critical core function of managing the monetary liabilities of the central bank. Ambitious use of a central bank’s balance sheet to channel credit to particular economic sectors or entities threatens to entangle the central bank in distributional politics and place the bank’s independence at risk. Moreover, the use of central bank credit to rescue creditors boosts moral hazard and encourages vulnerability to financial shocks.
By explicitly referencing moral hazard, Mr Lacker is taking on the current leadership of the Federal Reserve, now headed by Janet Yellen, which denies that easy money policies have had anything to do with fostering financial instability. But as discussed earlier in this report, the historical evidence is clear that Fed activism is behind the escalating boom-bust cycles of recent decades. And as Mr Caruana further suggests, this has been a global phenomenon, with the Fed at the de facto helm of the international monetary system due to the dollar’s global reserve currency role.
EURO ‘MISSION ACCOMPLISHED’? UH, NO
As quoted at the start of this report, Jean-Claude Juncker, prominent Eurocrat and politician, recently claimed victory in the euro-crisis. “Greece and Europe won.” And who lost? Why, those who bet against them in the financial markets by selling their debt and other associated assets.
But is it really ‘mission accomplished’ in Europe? No, and not by a long shot. Yes, so-called ‘austerity’ was absolutely necessary. Finances in many EU countries were clearly on an unsustainable course. But other than to have bought time through lower borrowing costs, have EU or ECB officials actually achieved anything of note with respect to restoring economic competitiveness?
There is some evidence to this effect, for example in Ireland, Portugal and Spain, comprising some 15% of the euro-area economy. However, there is also evidence to the contrary, most clearly seen in France, comprising some 20% of the euro-area. So while those countries under the most pressure from the crisis have made perhaps some progress, the second-largest euro member country is slipping at an accelerating rate into the uncompetitive abyss. Italy, for many years a relative economic underperformer, is not necessarily doing worse than before, but it is hard to argue it is doing better. (Indeed, Italy’s recent decision to distort its GDP data by including estimates for non-taxable black-market activities smacks of a desperate campaign to trick investors into believing its public debt burden is more manageable than it really is.)
There is also a surge in economic nationalism throughout the EU, as demonstrated by the remarkable surge in support for anti-EU politicians and parties. It is thus far too early for Mr Juncker to claim victory, although politicians are naturally given to such rhetoric. The crisis of interventionism in the euro-area may is not dissipating; rather, it is crossing borders, where it will re-escalate before long.
THE SHORT HONEYMOON OF ‘ABENOMICS’
Turning to developments in Japan, so-called ‘Abenomics’, the unabashedly interventionist economic policy set implemented by Prime Minister Abe following his election in late 2012, has already resulted in tremendous disappointment. Yes, the yen plummeted in late 2012 and early 2013, something that supposedly would restore economic competitiveness. But something happened on the way, namely a surge in import prices, including energy. Now Japan is facing not just economic stagnation but rising inflation, a nasty cocktail of ‘stagflation’. Not that this should be any surprise: Devaluing your way to prosperity has never worked, regardless of when or where tried, yet doing so in the face of structural economic headwinds is guaranteed to produce rising price inflation, just as it did in the US and UK during the 1970s.
With reality now having arrived, it will be interesting to see what Mr Abe does next. Will he go ‘all-in’ with even more aggressive yen devaluation? Or will he consider focusing on structural reform instead? Although I am hardly a Japan expert, I have travelled to the country regularly since the late 1990s and my sense is that the country is likely to slip right back into the ‘muddle through’ that characterised the economy during most of the past decade. Of course, in the event that another major global financial crisis unfolds, as I regard as inevitable in some form, Japan will be unable to avoid it, highly integrated as it is.
THE BUCK STOPS HERE: A ‘BRIC’ WALL
In my book, THE GOLDEN REVOLUTION, I document how the BRIC economies (Brazil, Russia, India, China, now joined by South Africa to make the BRICS) have been working together for years to try and reorient themselves away from mercantilist, dollar-centric, export-led economic development, in favour of a more balanced approach. Certainly they have good reasons to do so, as I described in a 2012 report, THE BUCK STOPS HERE: A BRIC WALL:
[T]he BRICS are laying the appropriate groundwork for their own monetary system: Bilateral currency arrangements and their own IMF/World Bank. The latter could, in principle, form the basis for a common currency and monetary policy. At a minimum it will allow them to buy much global influence, by extending some portion of their massive cumulative savings to other aspiring developing economies or, intriguingly, to ‘advanced’ economies in need of a helping hand and willing to return the favour in some way.
In my new book, I posit the possibility that the BRICS, amid growing global monetary instability, might choose to back their currencies with gold. While that might seem far-fetched to some, consider that, were the BRICS to reduce their dependence on the dollar without sufficient domestic currency credibility, they would merely replace one source of instability with another. Gold provides a tried, tested, off-the-shelf solution for any country or group of countries seeking greater monetary credibility and the implied stability it provides.
Now consider the foreign policy angle: The Delhi Declaration makes clear that the BRICS are not at all pleased with the new wave of interventionism in Syria and Iran. While the BRICS may be unable to pose an effective military opposition to combined US and NATO military power in either of those two countries, they could nevertheless make it much more difficult for the US and NATO to finance themselves going forward. To challenge the dollar is to challenge the Fed to raise interest rates in response. If the Fed refuses to raise rates, the dollar will plummet. If the Fed does raise interest rates, it will choke off growth and tax revenue. In either case, the US will find it suddenly much more expensive, perhaps prohibitively so, to carry out further military adventures in the Middle East or elsewhere.
While the ongoing US confrontations with Iran and Syria have been of concern to the BRICS for some time, of acute concern to member Russia of late has been the escalating crisis in Ukraine. The recent ‘Maidan’ coup, clearly supported by the US and possibly some EU countries, is regarded with grave concern by Russia, which has already taken action to protect its naval base and other military assets in the Crimea. Now several other Russian-majority Ukrainian regions are seeking either autonomy or independence. The street fighting has been intense at times. The election this past weekend confirming what Russia regards as an illegitimate, NATO-puppet government changes and solves nothing; it merely renders the dipute more intractable and a further escalation appears likely. (Russia is pressing Kiev as I write to allow it to begin providing humanitarian assistance to the rebellious regions, something likely to be denied.)
US economic sanctions on Russia have no doubt helped to catalyse the most recent BRICS initiative, in this case one specific to Russia and China, who have agreed a landmark 30-year gas deal while, at the same time, preparing the groundwork for the Russian banking system to handle non-dollar (eg yuan) payments for Russian gas exports. This is a specific but nevertheless essential step towards a more general de-dollarisation of intra-BRICS trade, which continues to grow rapidly.
The dollar’s international role had been in slow but steady decline for years, with 2008 serving to accelerate the process. The BRICS are now increasingly pro-active in reducing their dollar dependence. Russia has been dumping US dollar reserves all year and China is no longer accumulating them. India has recently eased restrictions on gold imports, something that is likely to reduce Indian demand for US Treasuries. (Strangely enough, and fodder for conspiracy theorists, tiny Belgium has stepped in to fill the gap, purchasing huge amounts of US Treasuries in recent months, equivalent to some $20,000 per household! Clearly that is not actually Belgian buying at all, but custodial buying on behalf of someone else. But on behalf of whom? And why?)
As I wrote in my book, amid global economic weakness, the so-called ‘currency wars’ naturally escalate. Competitive devaluations thus have continued periodically, such as the Abenomics yen devaluation of 2012-13 and the more recent devaluation of the Chinese yuan. As I have warned in previous reports, however, history strongly suggests that protracted currency wars lead to trade wars, which can be potentially disastrous in their effects, including on corporate profits and valuations.
THE END OF GLOBALISATION?
Trade wars are rarely labelled as such, at least not at first. Some other reason is normally given for erecting trade barriers. A popular such reason in recent decades has been either environmental or health concerns. For example, the EU and China, among other countries, have banned the import of certain genetically modified foods and seeds.
Rather than erect formal barriers, governments can also seek ways to subsidise domestic producers or exporters. While the World Trade Organisation (WTO) aims to prevent and police such barriers and subsidies, in practice it can take it years to effectively enforce such actions.
Well, there is now a new excuse for trade barriers, one specific to the huge global tech and telecommunications industry: Espionage. As it emerges that US-built and patented devices in widespread use around the world contain various types of ‘backdoors’ allowing the US National Security Agency to eavesdrop, countries are evaluating whether they should ban their use. Cisco’s CEO recently complained of losing market share to rivals due to such concerns. Somewhat ominously, China announced over the past week that it would prohibit public entities from using Microsoft Windows version 8 and would require banks to migrate away from IBM computer servers.
There has also been talk amongst the BRICS that they should build a parallel internet infrastructure to avoid routing information via the US, where it is now assumed to be automatically and systematically compromised. Given these concerns, it is possible that a general tech trade war is now breaking out under an espionage pretext. What a convenient excuse for protecting jobs: Protecting secrets! What do you think the WTO will have to say about that?
Imagine what a tech trade war would do to corporate profits. Name one major tech firm that does not have widely dispersed global supply chains, manufacturing operations and an international customer base. Amid rising trade barriers, tech firms will struggle to keep costs down. Beyond a certain point they will need to pass rising costs on to their customers. The general deflation of tech in recent decades will go into reverse. Imagine what that will do to consumer price inflation around the world.
Yes, a tech trade war would be devastating. Household, ‘blue-chip’ tech names might struggle to survive, much less remain highly profitable. And the surge in price inflation may limit the ability of central banks to continue with ultra-loose monetary policies, to the detriment also of non-tech corporate profits and financial health. This could lead into a vicious circle of reactionary protectionism in other industries, a historical echo of the ‘tit-for-tat’ trade wars of the 1930s that were part and parcel of what made the Great Depression such a disaster.
Given these facts, it is difficult to imagine that the outbreak of a global tech trade war would not result in a major equity market crash. Current valuations are high in a historical comparison and imply continued high profitability. Major stock markets, including the US, could easily lose half their value, even more if a general price inflation led central banks to tighten monetary conditions by more than financial markets currently expect. Of all the ‘black swans’ out there, a tech trade war is not only taking flight; it is also potentially one of the largest, short of a shooting war.
A SILVER LINING TO THE GLOOM AND DOOM
With equity valuations stretched and complacency rampant—the VIX volatility index dipped below 12 this week, a rare event indeed—now is the time to proceed with extreme caution. The possible outbreak of a tech trade war only adds to the danger. Buying the VIX (say, via an ETF) is perhaps the most straightforward way to insure an equity portfolio, but there are various ways to get defensive, as I discussed in my last report.
Where there is risk, however, there is opportunity, and right now there is a silver lining: With a couple of exceptions, metals prices are extremely depressed relative to stock market valuations. Arguably the most depressed is silver. Having slipped below $20/oz, silver has given up all of its previous, relative outperformance vs other metals from 2010-11. It thus appears cheap vs both precious and industrial metals, with silver being something of a hybrid between the two. Marginal production capacity that was brought on line following the 2010-11 price surge is now uneconomic and is shutting down. But the long slide in prices has now attracted considerable speculative short interest. If for any reason silver finds a reason to recover, the move is likely to be highly asymmetric.
Investors seeing an opportunity in silver can, of course, buy silver mining shares, either individually or through an ETF. A more aggressive play would be to combine a defensive equity market stance—say buying the VIX—with a long position in the miners or in the metal itself. My view is that such a position is likely to perform well in the coming months. (Please note that volatility of the silver price is normally roughly double that of the S&P500 index, so a market-neutral, non-directional spread trade would require shorting roughly twice as much of the S&P500 as the purchasing of silver. Also note, however, that correlations are unstable and thus must be dynamically risk-managed.)
As famed distressed-debt investor Howard Marks says, investing is about capturing asymmetry. Here at Amphora we aim to do precisely that. At present, there appears no better way to go about it than to buy silver, either outright or combined with a stock market short/underweight. From the current starting point, this could well be one of the biggest trades of 2014.
Although it might seem odd for a school of economics to largely ignore the role of money in the economy, this is indeed the case with traditional Keynesian economics. Declaring in 1963 that, “Inflation is, always and everywhere, a monetary phenomenon,” Milton Friedman sought to place money at the centre of economics where he and his fellow Monetarists believed it belonged. Keynesian policies continued to dominate into the 1970s, however, and were blamed by the Monetarists and others for the ‘stagflation’ of that decade—weak growth with rising inflation. Today, stagflation is re-appearing, the inevitable result of the aggressive, neo-Keynesian policy responses to the 2008 global financial crisis. In this report, I discuss the causes, symptoms and financial market consequences of the new stagflation, which could well be worse than the 1970s.
THE GOLDEN AGE OF KEYNESIANISM
During the ‘Roaring 20s’, US economists mostly belonged to various ‘laissez faire’ or ‘liquidationist’ schools of thought, holding that economic downturns were best left to sort themselves out, with a minimal role for official intervention. President Hoover’s Treasury Secretary Andrew Mellon (in)famously represented this view following the 1929 stock market crash when he admonished the government to stay out of private affairs and allow businesses and investors to “Liquidate! Liquidate! Liquidate!”
The severity of the Depression caught much of the laissez faire crowd off guard and thus by 1936, the year John Maynard Keynes published his General Theory, there was a certain open-mindedness around what he had to say, in particular that there was a critical role for the government to play in supporting demand during economic downturns through deficit spending. (There were a handful of prominent economists who did warn that the 1920s boom was likely to turn into a big bust, including Ludwig von Mises.)
While campaigning for president in 1932, Franklin Delano Roosevelt famously painted Herbert Hoover as a lasseiz faire president, when in fact Hoover disagreed with Mellon. As Murray Rothbard and others have demonstrated, Hoover was a highly interventionist president, setting several major precedents on which FDR would subsequently expand. But all is fair in politics and FDR won that election and subsequent elections in landslides.
With the onset of war and the command war economy it engendered, in the early 1940s the economics debate went silent. With the conclusion of war, it promptly restarted. Friedrich von Hayek fired an early, eloquent shot at the Keynesians in 1946 with The Road to Serfdom, his warning of the longer-term consequences of central economic planning.
The Keynesians, however, fired back, and with much new ammunition. Beginning in the early 20th century, several US government agencies, including the Federal Reserve, began to compile vast amounts of economic statistics and to create indices to aggregate macroeconomic data. This was a treasure-trove to Keynesians, who sought quantitative confirmation that their theories were correct. Sure enough, in 1947, a new, definitive Keynesian work appeared, Foundations of Economic Analysis, by Paul Samuelson, that presented statistical ‘proof’ that Keynes was right.
One of Samuelson’s core contentions was that economic officials could and should maintain full employment (ie low unemployment) through the prompt application of targeted stimulus in recessions. As recessions ended, the stimulus should be withdrawn, lest price inflation rise to a harmful level. Thus well-trained economists keeping an eye on the data and remaining promptly reactive in response to changes in key macroeconomic variables could minimise the business cycle and prevent Depression.
For government officials, Samuelson’s work was the Holy Grail. Not only was this a theoretical justification for an active government role in managing the economy, as Keynes had provided; now there was hard data to prove it and a handbook for just how to provide it. A rapid, historic expansion of public sector macroeconomics soon followed, swelling the ranks of Treasury, Commerce, Labor Department and Federal Reserve employees.
CHICAGO AND THE ‘FRESHWATER’ DISSENT
Notwithstanding the establishment of this new economic mainstream and a public sector that wholeheartedly embraced it, there was some dissent, in particular at the so-called ‘freshwater’ universities of the American Midwest: Chicago, Wisconsin, Minnesota and St Louis, among others.
Disagreeing with key Keynesian assumptions and also with Samuelson’s interpretation of historical data, Monetarists mounted an aggressive counterattack in the 1960s, led by Milton Friedman of the Chicago School. Thomas Sargent, co-founder of Rational Expectations Theory, also took part.
The Chicago School disagreed that there was a stable relationship between inflation and employment that could be effectively managed through fiscal policy. Rather, Friedman and his colleagues argued that Keynesians had made a grave error in largely ignoring the role of money in the economy. Together with his colleague Anna Schwarz, Friedman set out to correct this in the monumental Monetary History of the United States, which re-interpreted the Great Depression, among other major events in US economic history, as primarily a monetary- rather than demand-driven phenomenon. Thus inflation, according to Friedman and Schwarz, was “always and everywhere a monetary phenomenon,” rather than a function of fiscal policy or other demand-side developments.
By the late 1960s the dissent played a central role in escalating policy disputes, due primarily to a prolonged expansion of US fiscal policy. Following Keynesian policy guidance, the government responded to the gentle recession of the early 1960s with fiscal stimulus. However, even after the recession was over, there was a reluctance to tighten policy, for reasons both foreign and domestic. At home, President Johnson promised a ‘Great Society’: a huge expansion of various programmes supposedly intended to help the poor and otherwise disadvantaged groups. Abroad, the Vietnam War had escalated into a major conflict and, combined with other Cold War military commitments, led to a huge expansion of the defence budget.
DE GAULLE AND INTERNATIONAL DISSENT
In the early 1960s a handful of prescient domestic observers had already begun to warn of the increasingly inflationary course of US fiscal and monetary policy (Henry Hazlitt wrote a book about it, What Inflation Is, in 1961.) In the mid-1960s this also became an important international topic. Under the Bretton-Woods system, the US was obliged to back dollars in circulation with gold reserves and to maintain an international gold price of $35/oz. In early 1965, as scepticism mounted that the US was serious about sustaining this arrangement, French President Charles De Gaulle announced to the world that he desired a restructuring of Bretton-Woods to place gold itself, rather than the dollar, at the centre of the international monetary system.
This prominent public dissent against Bretton-Woods unleashed a series of international monetary crises, roughly one each year, culminating in President Nixon’s decision to suspend ‘temporarily’ the dollar’s convertibility into gold in August 1971. (Temporarily? That was 43 years ago this month!)
The breakdown of Bretton-Woods would not be complete until 1973, when the world moved formally to a floating-rate regime unbacked by gold. However, while currencies subsequently ‘floated’ relative to one another, they collectively sank in purchasing power. The price of gold soared, as did the price of crude oil and many other commodities.
Rather than maintain stable prices by slowing the growth rate of the money supply and raising interest rates, the US Federal Reserve fatefully facilitated the dollar’s general devaluation
with negative real interest rates. While it took several years to build, in part because Nixon placed outright price controls on various goods, eventually the associated inflationary pressure leaked into consumer prices more generally, with the CPI rising steadily from the mid-1970s. Growth remained weak, however, as the economy struggled to restructure and rebalance. Thus before the decade was over, a new word had entered the economic lexicon: Stagflation.
STAGFLATION IS A KEYNESIAN PHENOMENON
Keynesians were initially mystified by this dramatic breakdown in the supposedly stable and manageable relationship between growth (or employment) and inflation. Their models said it couldn’t happen, so they looked for an explanation to deflect mounting criticism and soon found one: The economy had been hit by a ‘shock’, namely sharply higher oil prices! Never mind that the sharp rise in oil prices followed the breakdown of Bretton-Woods and devaluation of the dollar: This brazen reversal of cause and effect was too politically convenient to ignore. Politicians could blame OPEC for the stagflation, rather than their own policies. But an objective look at history tells a far different story, that the great stagflation was in fact the culmination of years of Keynesian economic policies. To generalise and to paraphrase Friedman, stagflation is, always and everywhere, a Keynesian phenomenon.
Why should this be so? Consider the relationship between real economic activity and the price level. If the supply of money is perfectly stable, then any negative ‘shock’ to the economy may reduce demand, but that will result in a decline rather than a rise in the general price level. The ‘shock’ might also increase certain prices in relative terms, but amidst stable money it simply cannot increase prices across the board, as is the case in stagflation.
They only way in which the toxic stagflationary mix of both reduced growth and rising prices can occur is if the money supply is flexible. Now this does not imply that a flexible money supply is in of itself a Keynesian policy, but deficit spending is far easier with a flexible money supply that can be increased as desired to finance the associated deficits. Yes, this then crowds out real private capital, with negative long-term consequences for economic health, but as we know, politicians are generally more concerned with the short-term and the next election.
CONTEMPORARY EVIDENCE OF STAGFLATION
Contemporary examples provide support for the reasoning above. It is instructive that two large economies, Japan and France, have been chronically underperforming in recent years, slipping in and out of recession. Both run chronic budget deficits in blatant Keynesian efforts to stimulate demand. In Japan, where the money supply is growing rapidly, inflation has been picking up despite weak growth: stagflation. In France, where the money supply has been quite stable, there is price stability: That is merely stagnation, not stagflation.
The UK, US and Germany have all been growing somewhat faster. Following the large devaluation of sterling in 2008, the UK experienced a multi-year surge in prices amidst weak growth, clearly a stagflationary mix. The US also now appears to be entering stagflation. Growth has been weak on average in recent quarters—outright negative in Q1 this year—yet inflation has now risen to 4% (3m annualised rate). Notwithstanding a surge in labour costs this year, the US Fed has, up to this point, dismissed this rise in CPI as ‘noise’. But then the Fed repeatedly made similar claims as CPI began to rise sharply in the mid-1970s.
In Japan, the UK and US, the stagflation is highly likely to continue as long as the current policy mix remains in place. (For all the fanfare surrounding the US Fed’s ‘tapering’, I don’t consider this terribly meaningful. Rates are still zero.) In France, absent aggressive structural reforms that may be politically impossible, the stagnation is likely to remain in place.
Germany is altogether a different story than the rest of these mature economies. While sharing the same, relatively stable euro money supply as France, the price level in Germany is also stable. However, Germany has been growing at a faster rate than most other developed economies, notwithstanding a smaller deficit. This is compelling evidence that Germany is simply a more competitive, productive economy than either the US or UK. But this is nothing new. The German economy has outperformed both the US and UK in nearly every decade since WWII. (Postwar rebuilding provided huge support in the 1950s and 1960s but those days are long past.)
The persistence of German economic outperformance through the decades clearly demonstrates the fundamental economic superiority of what is arguably the least Keynesian set of policies in the developed world. Indeed, Germans are both famed and blamed for their embrace of sound money and fiscal sustainability. ‘Famed’ because of their astonishing success; ‘blamed’ because of, well, because of their astonishing success relative to economic basket cases elsewhere in Europe and around the world. As I sometimes say in jest to those who ‘blame’ the Germans for the economic malaise elsewhere: “If only the Germans weren’t so dammed productive, we would all be better off!”
INVESTING FOR STAGFLATION
Stagflation is a hostile environment for investors. As discussed above, Keynesian policies require that the public sector siphon off resources from the private sector, thereby reducing the ability of private agents to generate economic profits. So-called ‘financial repression’, a more overt seizure of private resources by the public sector, is by design and intent hostile for investors. Regardless of how you choose to think about it, stagflation reveals previously unseen resource misallocations. As these become apparent, investors adjust financial asset prices accordingly. (Perhaps this is now getting under way. The Dow fell over 300 points yesterday.)
The most recent historical period of prolonged stagflation was the 1970s, although there have been briefer episodes since in various countries. Focusing here on the US, although there was a large stock market decline in 1973-4, the market subsequently recovered these losses and then roughly doubled in value. The bond market, by contrast, held up during the first half of the decade but, as stagnation gradually turned into stagflation, bonds sold off and were sharply outperformed by stocks.
That should be no surprise, as inflation erodes the nominally fixed value of bonds. Stock prices, however, can rise along with the general price level along as corporate revenues and profits also rise. It would seem safe to conclude, therefore, that in the event stagflationary conditions intensify from here, stocks will outperform bonds.
While that might be a safe conclusion, it is not a terribly helpful one. Sure, stocks might be able to outperform bonds in stagflation but, when adjusted for the inflation, in real terms they can still lose value. Indeed, in the 1970s, stock market valuations failed to keep pace with the accelerating inflation. Cash, in other words, was the better ‘investment’ option and, naturally, a far less volatile one.
Best of all, however, would have been to avoid financial assets and cash altogether and instead to accumulate real assets, such as gold and oil. (Legendary investors John Exter and John van Eck did precisely this.) The chart below shows the total returns of all of the above and the relative performance of stocks, bonds and cash appears irrelevant when compared to the soaring prices of gold and oil, both of which rose roughly tenfold.
REAL VS NOMINAL ASSETS IN STAGFLATION
(Jan 1971 = 100)
Source: Bloomberg; Amphora
Some readers might be sceptical that, from their current starting point, gold, oil or other commodity
prices could rise tenfold in price from here. Oil at $100/bbl sounds expensive to those (such as I) who remember the many years when oil fluctuated around $20. Gold at $1,300 also seems expensive compared to the sub-$300 price fetched by UK Chancellor Brown in the early 2000s. In both cases, prices have risen by a factor of 4-5x. Note that this is the rough order of magnitude that gold and oil rose into the mid-1970s. But it was not until the late 1970s that both really took off, leaving financial assets far behind.
If anything, a persuasive case can be made that the potential for gold, oil and other commodity prices to outperform stocks and bonds is higher today than it was in the mid-1970s. Monetary policies around the world are generally more expansionary. Government debt burdens and deficits are far larger. If Keynesian policies caused the 1970s stagflation, then the steroid injection of aggressive Keynesian policies post-2008 should eventually result in something even more spectacular.
While overweighting commodities can be an effective, defensive investment strategy for a stagflationary future, it is important to consider how best to implement this. Here at Amphora, we provide investors with an advisory service for constructing commodity portfolios. Most benchmark commodity indices and the ETFs tracking them are not well designed as investment vehicles for a variety of reasons. In particular, they do not provide for efficient diversification and their weightings are not well-specified to a stagflationary environment. With a few tweaks, however, these disadvantages can be remedied, enabling a commodity portfolio to produce the desired results.
CURRENT COMMODITY OPPORTUNITIES
For those inclined to trade commodities actively, and relative to each other, there are an unusual number of opportunities at present. First, grains are now unusually cheap, especially corn. This is understandable given current global weather patterns supportive of high yields, but beyond a certain point producers are fully hedged and/or are considering withholding some production to sell once prices recover. That point is likely now close.
Second, taking a look at tropical products, cotton has resumed the sharp slide that began earlier this year. As is the case with grains, we are likely nearing the point where producer hedging and/or holding out for higher prices will support the price. By contrast, cocoa prices continue their rise and I note that several major chocolate manufacturers have recently increased prices sharply to maintain margins. That is a classic indication that prices are near a peak.
Third, livestock remains expensive. Hog prices have finally begun to correct lower but cattle prices are at record highs. There are major herd supply issues that are not easily resolved in the near-term but consumers are highly price sensitive in the current environment and substitution into pork or poultry products is almost certainly now taking place around the margins. Left to run for awhile, this is likely to place a lid on cattle prices, although I do expect them to remain elevated for a sustained period until herds have had a chance to re-build.
Fourth, following a brief correction lower several weeks ago, palladium prices have risen back near to their previous highs of just under $900/oz. Palladium now appears expensive relative to near-substitute platinum; to precious and base metals generally; and relative to industrial commodities. The primary source of demand, autocatalysts, has remained strong due to auto production, but recent reports of rising unsold dealer inventory in a handful of major countries, including the US, may soon weaken demand. In the event that the fastest growing major auto markets—the BRICS—begin to slow, then a sharp decline in palladium to under $700 is likely.
Finally, a quick word on silver and gold. While both have tremendous potential to rise in a stagflationary environment, it is worth noting that, following a three-year correction, they appear to have found long-term support. Thus I believe there is both near-term and well as longer-term potential and I would once again recommend overweighting both vs industrial commodities.
1Von Mises not only warned of a financial crash and severe economic downturn in 1929; he refused the offer of a prominent position at the largest Austrian bank, Kreditanstalt, around the same time, not wanting to be associated with what he correctly anticipated would soon unfold. A Wall Street Journal article discussing this period in von Mises’ life is linked here.
2A classic revisionist view is that of Murray Rothbard, AMERICAS GREAT DEPRESSION. More recent scholarship by Lee Ohanian has added much additional detail to Rothbard’s work. I briefly touch on this subject in my book and also in a previous Amphora Report, THE RIME OF THE CENTRAL BANKER, linked here.
Editor’s Note: This article was previously published in The Amphora Report, Vol 5, 09 May 2014.
“Capitalism is not chiefly an incentive system but an information system.” -George Gilder
“Don’t shoot the messenger” is an old aphorism taken primarily to mean that it is unjust to take out the frustrations of bad news on he who provides it. But there is another reason not to shoot the messenger: News, good or bad, is information, and in a complex economy information, in particular prices, has tremendous value. To suppress or distort the information industry by impeding the ability of messengers to do their jobs would severely damage the economy. As it happens, messengers in the price signals industry are normally referred to as ‘speculators’ and the importance of their economic role increases exponentially with complexity. So don’t shoot the speculator. Embrace them. And if you feel up to it, consider becoming one yourself. How? Read on.
IN ADMIRATION OF SPECULATION
Back in high school my sister had a boyfriend who was quite practical by nature and, by working odd jobs, saved up enough money for the down payment on a 4WD pickup truck before his 18th birthday. It was a powerful truck and as a result he was able to generate additional business doing landscaping and other work requiring off-road equipment transport.
His truck also had a winch, which was of particular use one night in 1982. A severe storm hit, flooding the primary commuting routes north of San Francisco. Hundreds of motorists got stranded in water on roads stretching all the way to the Sonoma County borders. The emergency services did their best but the gridlock severely curtailed their ability to reach many commuters, who ended up spending the night in the cars. Fortunately, it was not particularly cold, and the conditions, while unpleasant, were hardly life-threatening.
As word got round just how bad the situation was, among others, my sister’s boyfriend headed out in his truck and sought out stranded commuters to winch out of the water. Sure, he wanted to help. But he also had payments to make on his truck. And he needed money generally, not being from a wealthy family. So naturally he expected to get paid for his services. What he didn’t expect, at least not at first, was just how much he could get paid.
As he told the story the next day, at first he was charging $10 to winch a car to safety. But as it dawned on him just how much demand there was and how few motorists he could assist-attaching a winch to a car and pulling it to safety could take as long as 20mins-he began to raise his prices in response. $10 became $20. $20 became $50. By midnight, stranded drivers were willing to pay as much as $100 for his assistance (Marin County is a wealthy county so some drivers were not just willing but also able to pay this amount.)
I forget exactly, but I believe he earned nearly $3,000 that night, enough money to pay off the lease on the truck! He was thrilled, my sister was thrilled and my parents were duly impressed. Yet the next day the local papers contained stories disparaging of ‘price-gouging’ by those helping to rescue the stranded commuters, who also noted and complained about the lack of official emergency services.
This struck me as a bit odd. The way my sister’s boyfriend told the story, he thought he was providing a valuable service. At first he was charging very little but as people were obviously willing to pay more, he raised his prices in return. The price discovery went on into the wee hours and reached $100 in the end. Did he plan things that way? Of course he had no idea he would be in the right place, at the right time, to make nearly $3,000 and pay off the lease in one go. But to hear some of the stranded commuters talk as if he was a borderline criminal just didn’t fit.
I didn’t think of it at the time, but as I began the study of economics some years later and learned of the role that speculators play in a market-based economy, I recalled this episode as one that fit the definition rather well. Speculators provide essential price information. Yet their most important role, where they really provide economic value, is not when market conditions are simply ‘normal’-when supply and demand are in line with history-but rather when they help to determine prices for contingent or extreme events, such as capacity constraints. Without sufficient capacity for a rainy day-or a VERY rainy day such as that in 1982-consumers will find at critical times that they can’t get access to essential services at ANY price.
In that rare moment, when prices soar, it might be tempting to shoot the messenger-blame the speculator-but this is unfair. Sometimes they take big risks. Sometimes they take huge losses or reap huge rewards. But regardless, they provide essential price discovery signals that allow capacity to be built that otherwise might not exist.
Consider those who speculate in electricity prices as another example. Electricity demand naturally fluctuates. But electricity providers are normally contractually required to meet even unusually large surges in peak demand. Occasionally, due to weather or other factors, there are extreme spikes in demand and capacity approaches its limit. If there is a tradable market, the price then soars. At the limit of capacity, the last kw/hr goes to the highest bidder, much as at the end of an auction for a unique painting. Such is the process of price discovery.
Absent the unattractive option of inefficient and possibly corrupt central planning, how best to determine how much capacity should be made available? Who is going to finance the infrastructure? Who will assume the risks? Well, as long as there is a speculative market in the future price of electricity, the implied forward price curve provides a reference for determining whether or not it is economically attractive to add to available capacity or not, with capacity being an option, rather than the obligation, to produce power at a given price and point in time.
My sister’s boyfriend’s truck thus represented an undervalued ‘option’ with which to winch cars to safety. Under normal conditions this option had little perceived value. But on the occasion of the flood, it had tremendous value and the option was ‘exercised’ at great profit. Valuing the truck without speculating on the possibility of such a windfall would thus be incorrect. And failing to appreciate the essential role that speculators play in building and maintaining economic capacity generally, for all goods and services, can result in a temptation to shoot the messenger, rather than to get the message.(1)
HOW DO SPECULATORS SURVIVE?
If speculators are the ‘messengers’ of market economies, how are they compensated? Obviously, those who are consistently right generate trading profits. But what of those on the other side who are consistently wrong? How can speculators as a group, right and wrong, make money? And if they can’t, how can they exist at all? (Of course, if they are too big to fail, they can count on getting bailed out. But I’ve already flogged that dead horse in many a report.)
This was once one of the great mysteries of economics, but David Ricardo, Ludwig von Mises and others eventually figured it out. Speculators do more than just speculate, although from their perspective that is what they see. Speculators also provide liquidity for hedgers, that is, those who wish NOT to speculate. And they charge a small implied fee for doing so, in the form of a ‘risk premium’. This risk premium is what keeps them going through the inevitable ups and downs of markets. They assume risks others don’t want to take and are compensated for doing so. In practice, it is impossible to determine precisely what this implied fee is, although economists do have ways to approximate the ‘liquidity risk premium’ that exists in a market.
Hedgers can be those who have a natural exposure to the underlying economic good. Take wheat for example. A highly competent farmer running an efficient farm might want to concentrate full-time on his operations and leave the price risk of wheat to someone else. He can do so by selling his estimated production forward in the futures markets. On the other side, a baked goods business might prefer to focus on their operations too. In principle, the farmer and the baker could deal directly with one another, but this arrangement would give them little flexibility to dynamically adjust hedging positions as estimated wheat production or the demand for bread shifted, for example. With speculators sitting in the middle, the farmer and the baker needn’t waste valuable time seeking out the best counterparty and can easily hedge their risk dynamically. Yes, they will pay a small liquidity risk premium to the speculators by doing so, but advanced economies require a high degree of specialisation and thus the professional speculator is an essential component.
While it is nice to receive a small risk premium in exchange for providing essential price information and liquidity, what speculators most want is to be right. Sadly, pure speculation (ie between speculators themselves, not vis-à-vis hedgers) is a zero sum game. For every ‘right’ speculator there is a ‘wrong’ speculator. While there is an extensive literature regarding why some traders are more successful than others, I will offer a few thoughts.
THE UNWRITTEN ‘RULES’ OF SUCCESSFUL SPECULATION
There are several unwritten rules in speculation, and I would confirm these through my own experience. The first is that it is the rare trader who is right more than 60% of the time, so most successful traders are right within the narrow range of 51-60%. Then there is the second rule, that 20% of traders capture 80% of the available profits. Combining these two rules, what you have is that 20% of traders are correct 51-60% of the time: So 0.2 * 0.5 or 0.6 = 0.10 to 0.12 or 10-12% of all trades initiated are winning trades for winning traders. The remaining 88% are either losing trades or they are winning trades spread thinly amongst the less successful traders.
These numbers should make it clear that successful traders are largely just risk managers: Yes, they succeed in identifying the 10-12% of trades that really matter for profits but they are also wrong 40%+ of the time so they must know how to manage their losses as well as when to prudently take profits on the 10-12% of winning trades.
Internalising this negative skew in trading returns is an essential first step toward becoming a good trader. Just accept that something on the order of 50% of trades are going to go against you, possibly even more. Accept also that only 10-12% of your trades are going to drive your profits. Focus on finding these but keep equal focus on minimising exposure to the other 88-90% of trades that either don’t matter, or that could overwhelm the 10-12%.
At Amphora, we have an investment process that we believe is particularly good at identifying and isolating the most attractive trades in the commodities markets. Sure, we make mistakes, but our investment and risk management processes are designed to keep these mistakes to a minimum. Indeed, we miss out on many potentially winning trades because we are highly selective. So while speculation may have a cavalier reputation of bravado trading, day in and day out, the Amphora process is more patient; an opportunistic tortoise rather than a greedy, rushed hare.
CURRENT OPPORTUNITIES IN THE EQUITIES AND COMMODITIES MARKETS
In my last Report discussing the financial and commodities markets outlook, 2014: A YEAR OF INVESTING DANGEROUSLY, I took the view that the equity market correction (or crash) that I anticipated from spring 2013 was highly likely to occur in 2014, for a variety of reasons (2). While I did not anticipate that the Ukraine crisis would escalate as much as it did, as quickly as it did, thereby causing some concern, I did expect that corporate revenues and profits would increasingly disappoint, as they most certainly have done year to date. This is due in part to weaker-than-expected economic growth, with the drag from excessive inventory growth plainly visible in the Q1 US GDP data. But the news is in fact much worse than that, because labour productivity growth has gone sharply negative due to soaring costs. These costs may or may not be specifically associated with the ‘(Un?)Affordable Care Act’ depending on who you ask, but the fact that productivity has plunged is terrible news for business fixed investment, which is the single most important driver of economic growth over the long-term. While a recession may or may not be getting underway, the outlook is for poor growth regardless, far below what would be required to justify current corporate earnings expectations, as implied by P/Es, CAPEs and other standard valuation measures. For those who must hold an exposure to equities, my key recommendation from that previous Report holds:
[I]t is time to rotate into defensive, deep-value, income-generating shares. These could include, for example, infrastructure, consumer non-discretionary and well-capitalised mining shares, including gold miners. That may seem an odd combination, but it so happens that even well-capitalised miners are trading at distressed levels at present, offering unusually good value.
Turning to the commodities markets, I expressed a preference for ‘defensive’ commodities in the Report (Although I did recommend taking initial profits in coffee). Indeed, basic foodstuffs, in particular grains, have outperformed strongly of late, continuing their rise from the depressed levels reached last year. However, the large degree of such outperformance now warrants some rotation out of grains and into industrial metals, including copper, aluminium, iron and nickel. Yes, these are exposed to the business cycle, which does appear to be rolling over in the US, China, Japan, Australia and most of Asia, but the extreme speculative short positioning and relative cheapness of industrial metals at present makes them an attractive contrarian play.
Precious metals have not underperformed to the same degree and they are normally less volatile in any case, but given the nearly three-year bear market, attractive relative valuations and the potential for a surge in risk-aversion, I would add to precious metals. Silver in particular looks cheap, although gold is highly likely to be the better performer in a risk-off environment. My recommendation would be to favour gold until the equity markets suffer at least a 15-20% correction. At that point, incremental rotation into silver would be sensible, with a more aggressive response should equity markets suffer a substantial 30%+ decline.
Turning to the platinum group metals, palladium is unusually expensive due to Russian supply concerns. While this is entirely reasonable due to the Ukraine crisis, the fact is that near-substitute platinum is much cheaper. And the on-again, off-again strikes at the large platinum mines in South Africa could escalate in a heartbeat, providing ample justification for platinum prices to catch up to palladium. Alternatively, should the Ukraine crisis de-escalate meaningfully, palladium is highly exposed to a sharp downward correction, and I would recommend a strong underweight/short position at present.
(1) Perhaps one reason why many fail to appreciate the essential role that speculators play in a market economy is that mainstream, neo-Keynesian economics treats speculation as mere ‘animal spirits’, to borrow their classic depiction by Keynes himself.
(2) This report can be accessed here.
For those rich in assets, 2013 was a good year. Equity markets, especially in the US, rose substantially. Property markets continued their recovery. Even bonds, which lose value when interest rates rise, did well overall due to spread compression and the generous ‘roll-yield’ associated with steep yield curves. Indeed, declining risk premia and the associated fall in implied volatilities across all major asset classes was the single biggest financial market story of 2013. Why did this occur? Is it sustainable? In this report, I explain why it is not, and how, unseen by the economic mainstream, severe damage is being done to the global economy, in various ways, with the financial market consequences highly likely to be felt in 2014, and in the years to come.
THE PERILS OF FINANCIAL MARKET MANIPULATION IN THEORY AND PRACTICE
Other than a handful of economic officials and ivory-tower academics, few would argue that asset prices are where they are today independent of the unprecedented monetary and fiscal stimulus of recent years. Indeed, many economic officials openly admit that their actions have influenced financial market variables and that this is an important policy goal. Academic economists provide much theoretical although highly questionable support for this view.
Naturally, however, if asset prices are artificially supported by policy, then financial market participants will no doubt be concerned as to what happens when such policy is withdrawn. This is the single, best explanation for the recent, sharp correction in risky asset valuations around the world.
Economic officials, spooked by market developments, are thus now at pains to reassure all that they will only withdraw stimulus in a way that does not destabilise markets. While that sounds nice on paper, there is scant evidence that it can work in practice. Indeed, the entire modern history of economic officials managing financial market expectations has been an abject failure of economic boom and bust. In order to understand why, we need to revisit this history, beginning with the original ‘Maestro’ conductor of the financial orchestra…
BACK TO WHENCE IT ALL BEGAN: THE MAESTRO OF ‘FORWARD (MIS)GUIDANCE’
Alan Greenspan was at the height of his fame in 2003. Having already been the subject of a best-selling book, MAESTRO, by veteran Washington Post journalist (and Watergate sleuth) Bob Woodard, Mr Greenspan became ‘Sir’ Alan in 2002, receiving an honourary Knighthood from Her Majesty, Queen Elizabeth II. But it was in 2003 that Sir Alan claimed his special place in the annals of modern monetary history by introducing what is known today as ‘forward guidance’: explicit attempts to influence asset prices and, thereby, manage the economy to an even greater degree than that allowed by setting the level of interest rates, of bank reserve and other lending requirements, and through banking and financial regulation more generally. Announced to the world on 12 August 2003, for the first time in its history, the Fed included forward guidance (in bold) at the end of its policy statement:
The Federal Open Market Committee decided today to keep its target for the federal funds rate at 1 percent.
The Committee continues to believe that an accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, is providing important ongoing support to economic activity. The evidence accumulated over the intermeeting period shows that spending is firming, although labor market indicators are mixed. Business pricing power and increases in core consumer prices remain muted.
The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.
The minutes of this FOMC meeting were published just over a month later, on 18 September. The decision to include the statement was described thus:
The Committee also decided to include a reference in the announcement to its judgment that under anticipated circumstances policy accommodation could be maintained for a considerable period.
The minutes then documented the discussion which followed:
Several members commented that the nature of the Committee’s communications had evolved substantially over recent meetings and that it might be useful to schedule a separate session to review current practices. They agreed to do so prior to the next scheduled meeting on September 16.
Now, turning to that September meeting, we read in the minutes released later that year that:
The members also reviewed the further use of the reference concerning the maintenance of an accommodative policy stance “for a considerable period” that was included in the press statement issued for the August meeting. Given the uncertainties that characteristically surround the economic outlook and the need for an appropriate policy response to changing economic conditions, the members generally agreed that the Committee should not usually commit itself to a particular policy stance over some pre-established, extended time frame. The course of policy would be determined by the evaluation of the outlook, not the passage of time. The unusual configuration of already low interest rates and reservations about the strength of the expansion had justified the inclusion of the phrase “for a considerable period” in the statement issued in August. While changing circumstances would call for removal of that reference at some point, doing so at this meeting might suggest the members’ views on the economy had changed markedly. Accordingly, the Committee decided to release a statement after this meeting that was virtually identical to that used after the August meeting apart from some minor updating to reflect ongoing economic developments. (Emphasis added.)
In 2004, the Fed expanded on this precedent as it began to prepare financial markets for higher interest rates from the, at the time, unprecedented low of 1%.
January (rates unchanged):
…the Committee believes that it can be patient in removing its policy accommodation.
May (rates unchanged):
…the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.
June (rates raised by 0.25%):
…the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.
This last forward guidance was then left in place as the Fed raised rates in steady 0.25% increments through the remainder of 2004 and into late 2005. Finally, in December that year, having raised interest rates in a long series of 0.25% baby steps to over 4%‑a level that could be considered in a normal range—the Fed changed the forward guidance yet again and concluded its policy statement thus:
The Committee judges that some further measured policy firming is likely to be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.
In other words, the Fed indicated three things: First, that additional rate rises were probably on the way. Second, that these rises would not exceed 0.25% each. Third, that the FOMC believed that it was now approaching the end of the rate hiking cycle.
So, when looking back on this period as monetary historians, what are we to conclude about the effectiveness of this forward guidance? Did it work?
Well, as we know, 2003-05 were the years in which the US housing market went from strength to steroids. Borrowing costs remained low, especially for long maturities, something that Sir Alan once described as a ‘conundrum’. With the Fed pointing out with forward guidance that rates would rise slowly, in predictable fashion, leveraged mortgages and home equity extraction were all the rage. And with house prices rising so steadily, lending standards were relaxed. Subprime lending exploded. Light-doc or even no-doc mortgages were easy to come by. Interest-only mortgages and the substantial leverage they offered were also increasingly common. Entirely new segments of the population (eg, those without steady jobs or income) were taking out mortagages for which they never would have qualified in normal circumstances. The bubble, as it were, was being blown to colossal proportions.
If the goal of Fed policy was to create a housing and credit bubble, then yes, forward guidance was a huge success. If the goal was to nuture the US economy back towards a path of balanced, sustainable economic growth, it was an abject failure. We learned this the hard way, as we know, in 2008.
2013: THE BIGGEST BUBBLE YET?
Subsequent to the financial fireworks of 2008, central banks around the world have made extensive use of forward guidance in order to influence a broad range of asset prices. What was once regarded as highly unusual has become the apparently necessary norm. Sir Alan set the precedent that time commitments could and, in unusual circumstances, should be used to try and influence interest rates. Now we are living through an aggressive, global campaign to micromanage not only interest rates but financial markets generally.
Following round after round of QE and other forms of generally unprecendented (and, in some cases, probably illegal) monetary and fiscal stimulus in the US and around the world, risky asset markets entered 2013 with substantial positive momentum. Many ascribe this in part to the aggressive reflationary policies—colloquially known as ‘Abenomics’–adopted by Japan following the 2012 election of Prime Minister Shinzo Abe. Others ascribe it to the ECB’s 2012 commitment to do ‘whatever it takes’ to keep the euro-area financial system liquid and intact. What no one can ascribe it to, however, is anything fundamental to the long-term profit outlook for non-financial corporations—the lifeblood of a developed economy. On every important measure, non-financial corporations have seen a deterioration in their long-term profit outlook since 2012:
- Headline revenue growth has been stagnant and below expectations;
- Profit margins have shrunk;
- Inventories have built up;
- Fixed investment has been weak.
There has, however, been a modest improvement in their collective financial condition:
- Liquidity ratios have improved;
- Balance sheet leverage has declined (if only rather modestly);
- Interest costs are low.
These financial factors, however, are insufficient to support higher valuations on their own because the long-term outlook for corporate profits has far more to do with investment rates, revenues and profit margins than with financial conditions, which are artificially and temporarily benign. That said, a generally rising interest rate environment is a clear negative, something that could certainly occur in 2014 given the low starting point for corporate borrowing costs.
John Hussman does an excellent job at summarising just why we should be so concerned about the current level of US stock market valuations in his recent weekly commentary, PUSHING LUCK, which you can find here. And here’s my former colleague Andrew Lapthorne’s recent take on the same subject:
US profits are not growing, companies are over not underinvesting (they may in fact have overinvested), and corporates are carrying more (not less) net debt than they were in 2009. It would appear that many believe the opposite to be true, yet corporate report and accounts data seems to say otherwise.” But hey- stocks are at record highs, right, and the market is never wrong (except when it is), so who cares. Indeed “Thank goodness equities went up in 2013, otherwise it might have been a rather depressing year.
When it comes to having a market view there are typically (at least) two sides to every argument. When it comes down to the state of US quoted sector profits and balance sheets there should be little argument, but even here there is a great debate, and several viewpoints with which we do not entirely agree.
First is the notion that profits growth accelerated in the US last year. Yes, the pro-forma figures from popular providers such as I/B/E/S show EPS growth of around 6-7%, but pro-forma figures are whatever you wish them to be. Reported earnings growth slowed to almost zero in 2013 and EBIT is largely where it stood at the beginning of 2012.
Capital expenditure growth, the great hope for 2014, slowed throughout 2013 as did cash flow growth and sales growth. However, capex as a proportion of sales is at elevated (not depressed) levels. Why would a company step up investment when faced with contracting margins and lacklustre demand? Surely sales and profit growth recoveries lead investment and not the other way around?
US corporates do indeed hold lots of cash, which is currently at record levels, but they also hold record levels of debt. Net debt (so discounting those massive cash piles) is 15% above the levels seen in 2008/09. The idea that corporates are paying down debt is simply not seen in the numbers. What is true is that deleveraging has occurred through the usual mechanism of higher asset prices (no doubt an aim of central bank policy). This is the painless form of deleveraging. It is also the most temporary, for a simple pull-back in equities and rise in volatility will put the problem back on centre stage.
Financial market animal spirits being what they are, however, and encouraged no doubt by economic officials admitting their desire to support valuations, 2013 saw a relentless, prolonged compression of risk premia not only in US equities, but in most asset markets, and implied volatilities trended lower. At the start of 2014, the VIX volatility index had fallen to only 12, a level associated historically with what Sir Alan once called ‘irrational exuberance’ back in 1996.
The dramatic compression in risk premia and associated low implied volatility are but two major warning signs of a dangerously overinflated bubble in risky assets. Another is the resurgent growth of so-called ‘shadow’ banking activities, such as collateralised securities issuance, including the residential mortgage backed securities that helped to fuel the mid-2000s US housing bubble.
As reported recently in the Financial Times, these securities, and the entities investing in them such as Real Estate Investment Trusts (REITs), “enjoy lighter regulation, benefit from tax efficiencies and possess increasingly deep pockets that allow them to make aggressive loans to property developers… Their role in the market is growing—as is that of hedge funds and ‘business development companies’ that provide capital to middle-market companies, and a whole host of other specialty financiers.”
Also noted in the article cited above, regulators’ increasingly heavy hands on commercial banks are having the perverse affect of driving various risky activities into the shadows, obscuring them from regulatory view. There is also concern at the Bank for International Settlements (BIS) and among central bankers generally that the shadowy practice of so-called ‘collateral transformation’ could be a source of financial system fragility in future. Nor is such concern misplaced, as I wrote in a report last year, COLLATERAL TRANSFORMATION: THE LATEST, GREATEST FINANCIAL WEAPON OF MASS DESTRUCTION (link here). Here is a relevant excerpt from that report:
[I]f interbank lending is increasingly collateralised by banks’ highest quality assets, then unsecured creditors, including depositors, are being de facto subordinated in the capital structure and are highly likely to ‘run’ at the first signs of trouble. And if banks are holding similar types of collateral that suddenly fall in value, then they can all become subject to a run at the same time, for the same reason…
An obvious consequence of such collateral transformation is that it increases rather than decreases the linkages in the financial system and thus in effect replaces firm-specific, idiosyncratic risk with systemic risk, exactly the opposite of what the regulators claim they are trying to do by increasing bank regulatory capital ratios.
Financial regulators may believe that they are one step ahead of the next crisis, but then they also believed this in 2007, 2001, 1992, 1980, etc, etc. It would be highly naïve to trust them this time round when there is ample evidence of a global bubble in risky asset valuations quite possibly larger than that of 2007. The fact is the moral hazard associated with financial (mis)regulation and bail-outs only serves to increase the fragility of the system with each fresh application. Indeed, the boom-bust dynamic of the entire post-Bretton-Woods era is far easier to explain and understand as a policy-driven process rather than as a market-driven one. The growing activism of central bankers and other economic officials with each successive boom-bust clearly illustrates the point. (This is also the subject of chapter 3 of my book, THE GOLDEN REVOLUTION.)
MEA CULPA: I WAS WRONG
On two occasions in early 2013 I predicted that equity markets were due a correction or even a crash. I was wrong. There was a brief period over the summer when emerging markets and stocks began to roll over, but it was mild and short-lived. It did, however, demonstrate yet again the central role that Fed forward guidance plays in manipulating asset markets: The selloff was directly associated with the Fed’s initial ‘taper talk’; and the subsequent recovery in risk assets occurred when the Fed backed away from plans to imminently reduce the pace of QE. Later in the year, the Fed followed through with a very modest tapering plan that did not spook asset markets to the degree the initial talk did.
Markets continued to rally subsequent to the formal ‘taper’ announcement late last year, in what I would consider to be a classic ‘buy the rumour, sell the fact’ response. Underlying market momentum was strong and, on the surface at least, economic data appeared to confirm that the economy was growing, if only moderately.
Underneath the surface, however, the data were deteriorating. Specifically, the quality of growth was poor. Most growth was not due to business fixed investment or household income, but rather an extended inventory build. Real final sales, a measure of ‘core’ GDP that strips out inventories, was stagnant at under 2% last year. Meanwhile, the modest improvement in headline labour market data obscured a continuing decline in the work-force participation rate, something that normally only occurs during and in the aftermath of recessions.
More recently, even the headline data have begun to show reason for worry and I’m not the least surprised that the hugely overvalued US stock market has taken notice. Prices have declined sharply, if by a modest amount overall, and the VIX volatility index has spiked to above 20. Bulls will argue that this is but a necessary consolidation before the bull market resumes. They may be right. But their momentum arguments are increasingly removed from valuation reality, as discussed above. Momentum can carry the airplane into thin air, yes, but it can’t prevent the subsequent stall and possible crash. Risk-reward now strongly favours a defensive stance.
HOW TO PLAY IT FROM HERE
For those still overweight equities or risky assets generally, now is a good time to cash in your chips. To the extent that your portfolio guidelines and benchmarks require you to hold equities, then it is time to rotate into defensive, deep-value, income-generating shares. These could include, for example, infrastructure, consumer non-discretionary and well-capitalised mining shares, including gold miners. That may seem an odd combination, but it so happens that even well-capitalised miners are trading at distressed levels at present, offering unusually good value.
Another oddity is that, following a three-year bear market, global commodity prices in general are low. Yes, in the event that equity markets decline sharply, commodity prices are also likely to decline. However, the decline is likely to be relatively modest, in particular for what I consider to be ‘defensive’ commodities: those with little if any correlation to the business cycle. These include grains, other agricultural products and precious metals. Grains prices are currently very depressed following bumper crops and associated excess inventory. Coffee has only just begun to recover from a multi-year bear market. Sugar prices are also depressed. If stagflationary conditions set in during 2014 and beyond—as I expect and explain why in a moment—defensive commodities are the best place to be, as was also the case in the stagflationary 1970s.
In contrast to other defensive commodities, however, livestock prices are unusually expensive, in particular cattle. This is due in large part to extreme weather in North America. So high prices may be justified but their potential to rise further seems constrained at this point, in part due to the potential for substitution effects as cash-poor consumers gradually switch to more affordable protein sources, such as poultry or dairy products, for example.
Turning to precious metals, I remain a long-term gold and silver bull for a variety of reasons. Economic officials may claim their policies are succeeding at reducing deficits and thus future debt burdens but the truth is in fact the exact opposite. Yes, by blowing asset bubbles they can artificially reduce public sector deficits for a time, as much of the tax-base is asset-price-related in some way. But with the inevitable bust in asset prices comes the inevitable bust in tax revenues. And as Arthur Laffer and others have showed, beyond a certain point, inflationary marginal tax bracket creep no longer increases but rather decreases revenues, as a number of high-tax economies figured out during the 1990s and 2000s. Some countries, such as France, are still figuring this out, and increasingly suffering for it.
Faced with intractable future debt burdens, economic officials will continue to favour inflationary over deflationary economic policies. Rates of money creation are likely to remain elevated and populist, price-fixing economic policies purporting to support middle-class incomes—minimum wage increases or socialised health care come to mind—are highly likely to be stagflationary in their future effects. Combined with various forms of so-called ‘financial repression’, limiting the ability of savers to protect themselves from inflation, merely preserving existing wealth will be a challenge. As precious metals can be neither arbitrarily devalued as fiat currencies can, nor defaulted on as with corporate securities, they should now play an unusually important role in every defensive investor’s portfolio.
TOWARD A BRIGHTER FUTURE
These can be depressing times for those of us who don’t trust in the effectiveness of modern, neo-Keynesian economic micromanagement. Indeed, for those who believe that such micromanagement in fact misallocates resources, turning the economy’s capital stock into a deformed, mangled mess over time, it is difficult to remain at all optimistic for the future. However, while a great bust (or Misean ‘crack-up boom’) is an inevitable part of the global financial system reset that lies in the future, perhaps the near future, once that is out of the way there are reasons to be not just optimistic, but highly so.
Consider, for example, the great price deflation that has taken place in recent years across a broad range of technology goods. Cutting-edge research, entrepreneurial spirit and business acumen have completely transformed the ways in which we communicate, do business, transact and entertain, and the prices for such services have plummeted. The positive economic productivity shock provided by the full spectrum of what we call ‘tech’ is as if not more profound than that of mechanised agriculture; railroads; assembly line mass-production; antibiotics; plastics, synthetics and petrochemicals; air travel; intermodal container shipping; you name it.
Most regard our amazing modern capital stock as just a given, something that spontaneously came into existence. But no, it would never have come into existence without the tireless work of countless innovators, most of whom are and will remain essentially unknown, unlike past celebrities such as Thomas Edison, Henry Ford or Steve Jobs.
Just as important, there is a critical role for the state in all of this dynamism, to provide for the rule of law and the enforcement of property rights. Without those robust parameters, spontaneous entrepreurial activity cannot respond efficiently to information and thus will be suboptimal, as George Gilder’s best-selling new book, KNOWLEDGE AND POWER (find it here) convincingly demonstrates. Highlighting the crucial role of information in a capitalist economy, he argues compellingly that a market-based economy is at base a highly efficient if necessarily chaotic information system that cannot possibly be understood by any person or group of persons.
Central economic planning, by contrast, is highly counterproductive as it not only cannot use information efficiently; it distorts the flow of all economic information in countless if largely unseen ways. The more technologically advanced an economy, therefore, the more damaging central planning becomes.
This is one way to understand why the failed Anglo-Saxon financial system and associated economic micromanagement is such a drag on growth everywhere. It is sucking vital resources out of potentially highly dynamic regional and global industries and distorting the flow of information everywhere, to the detriment of job creation and income growth. Sure, shrinking the financial sector would require those workers to be re-trained to some extent to move into new industrial directions, but this sort of ‘creative destruction’ at the micro level is part and parcel of the dynamic nature of real, sustainable, qualitative economic advancement at the macro level. The sooner we bring it on the sooner the exponential economic progress associated with an information economy can resume.
Fortunately, in the coming financial market bust lie the seeds of such renewal. It will soon become painfully obvious to those in power that the financial system is beyond repair and, once they get out of the way, creative destruction will create a new one through the implementation of new technologies imbued with entrepreneurial spirit. Say what you will about Bitcoin, crowdfunding and other recent financial innovations; they provide examples for how new technologies may one day completely displace the archaic, ossified, ‘Too Big To Fail’ financial behemoths of our time.
A FINAL OBSERVATION
Those familiar with my book and following the relevant news flow around gold and central bank reserve policies may have noticed that the de-rating of the dollar and remonetisation of gold continues to take place in the dark background of international economic and monetary relations. (A superficial treatment of the topic was recently published in the Financial Times.) But much as astronomers can observe black holes indirectly, by the distortions they create in nearby space, so the remonetisation of gold can be inferred from keen observation of gold flows and economic policy shifts taking place around the world. The strongest such signals may be emanating from China at present, but there are others: in Germany, Russia and Nigeria, for example. (For a more thorough discussion on this topic, please see Cognitive Dollar Dissonance: Why a Global Rebalancing and Deleveraging Requires the De-Rating of the Dollar and Remonetisation of Gold, The Gold Standard Journal, issue 34, October 2013. The link is here.)
Care to comment on this report? Please send me a note: firstname.lastname@example.org
And if you like you can follow me on twitter: @butlergoldrevo
 The link to this FOMC statement is here.
 This research from Societe Generale was featured here.
 COMPETITION FOR SHADOW BANKING LURKS IN THE SHADOWS, Financial Times, 17 January 2014. The link is here.
 The most recent of these predictions was made in March. The link to the relevant report, ASSUME THE BRACE POSITION, is here.
 For a more thorough discussion of this episode from last year, please see my previous report, WILL THE FED RE-ARM THE BOND MARKET VIGILANTES? Amphora Report vol. 4 (July 2013). The link is here.
 George Gilder is hardly the first to have made this point, however. Among others, Friedrich von Hayek, Immanuel Kant, Confucius and innumerable quantum physicists have also explored the necessary limits to knowledge, in their various ways. One particularly poignant example is Leonard Read’s famous assay, I, PENCIL.
 The article, by veteran FT columnist Gillian Tett, can be found at the link here.
This article was previously published in The Amphora Report, Vol 5, 07 February 2014.
Back in 2006, as the debate was raging whether or not the US had a mortgage credit and housing bubble, I had an ongoing, related exchange with the Chief US Economist of a large US investment bank. It had to do with what is now commonly referred to as the ‘shadow banking system’.
While the debate was somewhat arcane in its specifics, it boiled down to whether the additional financial market liquidity created through the use of securities repo and other forms of collateralised lending were destabilising the financial system.
The Chief US Economist had argued that, because US monetary aggregates were not growing at a historically elevated rate, the Fed was not adding liquidity fuel to the house price inflation fire and that monetary policy was, therefore, appropriate. (Indeed, he denied that the rapid house price inflation at the time was cause for serious concern in the first place.) I countered by arguing that these other forms of liquidity (eg. securities repo) should be included and that, if they were, then in fact the growth of broad liquidity was dangerously high and almost certainly was contributing to the credit+housing bubble.
We never resolved the debate. My parting shot was something along the lines of, “If the financial markets treat something as a money substitute—that is, if the incremental credit spread for the collateral providing the marginal liquidity approaches zero— then we should treat it as a form of de facto money.”
He dismissed this argument although I’m not sure he really understood it; at least not until there was a run on money-market funds in the wake of the Lehman Brothers bankruptcy in November 2008. It was at that point that economic officials at the Fed and elsewhere finally came to realise how the shadow banking system had grown so large that it was impossible to contain the incipient run on money-market funds and, by extension, the financial system generally without providing explicit government guarantees, which the authorities subsequently did.
This particular Chief US Economist had previously worked at the Fed. This was and remains true, in fact, of a majority of senior US bank economists. Indeed, in addition to a PhD from one of the premiere US economics departments, a tour of duty at the Fed, as it were, has traditionally been the most important qualification for this role.
Trained as most of them were, in the same economics departments and at the same institution, the Fed, it should perhaps be no surprise that neither the Fed, nor senior economists at the bulge-bracket banks, nor the US economic academic and policy mainstream generally predicted the global financial crisis. As the discussion above illuminates, this is because they failed to recognise the importance of the shadow banking system. But how could they? As neo-Keynesian economists, they didn’t—and still don’t—have a coherent theory of money and credit.
FROM BLISSFUL IGNORANCE TO PARANOIA
Time marches on and with lessons learned harshly comes a fresh resolve to somehow get ahead of whatever might cause the next financial crisis. For all the complacent talk about how the “recovery is on ￼track” and “there has been much economic deleveraging” and “the banks are again well-capitalised,” the truth behind the scenes is that central bankers and other economic officials the world over remain, in a word, terrified. Of what, you ask? Of the shadow banking system that, I believe, they still fail to properly understand.
Two examples are provided by a recent speech given by Fed Governor Jeremy Stein and a report produced by the Bank of International Settlements (BIS), the ‘central bank of central banks’ that plays an important role in determining and harmonising bank regulatory practices internationally.
The BIS report, “Asset encumberance, financial reform and the demand for collateral assets,” was prepared by a “Working Group established by the Committee on the Global Financial System,” which happens to be chaired by none other than NYFed President William Dudley, former Chief US Economist for Goldman Sachs. (No, he is not the Chief US Economist referred to earlier in this report, although as explained above these guys are all substitutes for one another in any case.) 
In the preface, Mr Dudley presents the report’s key findings, in particular “evidence of increased reliance by banks on collaterised funding markets,” and that we should expect “[t]emporary supply-demand imbalances,” which is central banker code for liquidity crises requiring action by central banks.
He also makes specific reference to ‘collateral transformation’: when banks swap collateral with each other. This practice, he notes, “will mitigate collateral scarcity.” But it will also “likely come at the cost of increased interconnectedness, procyclicality and financial system opacity as well as higher operational, funding and rollover risks.”
Why should this be so? Well, if interbank lending is increasingly collateralised by banks’ highest quality assets, then unsecured creditors, including depositors, are being de facto subordinated in the capital structure and are highly likely to ‘run’ at the first signs of trouble. And if banks are holding similar types of collateral that suddenly fall in value, then they can all become subject to a run at the same time, for the same reason.
Collateral transformation is thus a potentially powerful FWMD. But don’t worry, the BIS and other regulators are on the case and doing the worrying. As a belated response to the financial crisis that they all failed to foresee, the latest, greatest trend in financial system oversight is ‘liquidity regulation’. Fed Governor Jeremy Stein explains the need for it thus:
[A]s the financial crisis made painfully clear, the business of liquidity provision inevitably exposes financial intermediaries to various forms of run risk. That is, in response to adverse events, their fragile funding structures, together with the binding liquidity commitments they have made, can result in rapid outflows that, absent central bank intervention, lead banks to fire-sell illiquid assets or, in a more severe case, to fail altogether. And fire sales and bank failures–and the accompanying contractions in credit availability–can have spillover effects to other financial institutions and to the economy as a whole. Thus, while banks will naturally hold buffer stocks of liquid assets to handle unanticipated outflows, they may not hold enough because, although they bear all the costs of this buffer stocking, they do not capture all of the social benefits, in terms of enhanced financial stability and lower costs to taxpayers in the event of failure. It is this externality that creates a role for policy. 
Ah yes, wouldn’t you know it, that ubiquitous, iniquitous enigma: market failure. Regulators have never found a market that doesn’t fail in some way, hence the crucial need for regulators to prevent the next failure or, at a minimum, to sort out the subsequent mess. In the present instance, so the thinking behind liquidity regulation goes, prior to 2008 the regulators were overly focused on capital adequacy rather than liquidity and, therefore, missed the vastly expanded role played by securitised collateral in the international shadow banking system. In other words, the regulators now realise, as I was arguing back in the mid-2000s, that the vast growth in shadow banking liquidity placed the stability of the financial system at risk in the event that there was a drop in securitised collateral values.
In 2007, house prices began to decline, taking collateral values with them and sucking much of the additional, collateral-based liquidity right back out of the financial system, unleashing a de facto wave of monetary+credit deflation, resulting in the subsequent financial crisis. But none of this was caused by ‘market failure’, as Governor Stein contends. Rather, there is another, simpler explanation for why banks were insufficiently provisioned against the risk of declining collateral values, yet it is not one that the regulators much like to hear, namely, that their own policies were at fault.
In one of my first Amphora Reports back in 2010 I discussed in detail the modern history of financial crises, beginning with the 1980s and concluding with 2008. A pattern rapidly becomes apparent:
[Newton’s] third law of universal motion was that for each and every action there is an equal and opposite reaction. While applicable to the natural world, it does not hold with respect to the actions of financial markets and the subsequent reactions of central banks and other regulators. Indeed, the reactions of regulators are consistently disproportionate to the actions of financial markets. In sinister dialectical fashion, the powers assumed and mistakes made by policymakers tend to grow with each crisis, ￼thereby ensuring that future crises become progressively more severe…
[W]as the Fed’s policy reaction to the 1987 crash proportionate or even appropriate? Was it “an equal but opposite reaction” which merely temporarily stabilised financial markets or did it, in fact, implicitly expand the Fed’s regulatory role to managing equity prices? Indeed, one could argue that this was merely the first of a series of progressively larger “Greenspan Puts” which the Fed would provide to the financial markets during the 18 years that the so-called “Maestro” was in charge of monetary policy and, let’s not forget, bank regulation…
By the late 1980s, a huge portion of the S&L industry was insolvent. The recession of 1990-91, made a bad situation worse. FSLIC funds were rapidly depleted. But a federal guarantee is supposed to be just that, a guarantee, so Congress put together a bailout package for the industry. A new federal agency, the Resolution Trust Corporation (RTC), issued bonds fully backed by the US Treasury and used the proceeds to make insolvent S&L depositors whole…
In retrospect, the entire S&L debacle, from its origins in regulatory changes and government guarantees, through the risky lending boom, bust, credit crunch and fiscal and monetary bailout can be seen as a precursor to the far larger global credit bubble and bust of 2003-2008: Just replace the S&Ls with Fannie/Freddie and the international shadow banking system. But there is no need to change the massive moral hazard perpetrated by incompetent government regulators, including of course the Fed, and the reckless financial firms who played essentially the same role in both episodes.
Notwithstanding this prominent pattern of market-distorting interest-rate manipulation, guarantees, subsidies and occasional bailouts, fostering the growth of reckless lending and other forms of moral hazard, the regulators continue their self-serving search for the ‘silver bullet’ to defend against the next ‘market failure’ which, if diagnosed correctly as I do so above is, in fact, regulatory failure.
Were there no moral hazard of guarantees, explicit or implicit, in the system all these years, the shadow banking system could never have grown into the regulatory nightmare it has now become and liquidity regulation would be a non-issue. Poorly capitalised banks would have failed from time to time but, absent the massive systemic linkages that such guarantees have enabled—encouraged even—these failures would have been contained within a more dispersed and better capitalised system.
As it stands, however, the regulators’ modus operandi remains unchanged. They continue to deal with the unintended consequences of ‘misregulation’ with more misregulation, thereby ensuring that yet more unintended consequences lurk in the future.
MIGHT COLLATERAL TRANSFORMATION BE THE CRUX OF THE NEXT CRISIS?
In his speech, Governor Stein also briefly mentions collateral transformation, when poor quality collateral is asset-swapped for high quality collateral. Naturally this is not done 1:1 but rather the low quality collateral must be valued commersurately higher. In certain respects these transactions are similar to traditional asset swaps that trade fixed for floating coupons and allow financial and non-financial businesses alike to manage interest rate and credit risk with greater flexibility. But in the case of collateral transformation, what is being swapped is the principal and the credit rating it represents, and one purpose of these swaps is to meet financial regulatory requirements for capital and, in future, liquidity.
An obvious consequence of such collateral transformation is that it increases rather than decreases the linkages in the financial system and thus in effect replaces firm-specific, idiosyncratic risk with systemic risk, exactly the opposite of what the regulators claim they are trying to do by increasing bank regulatory capital ratios. Liquidity regulation is an attempt to address this accelerating trend and the growing systemic risks it implies.
Those financial institutions engaging in the practice probably don’t see things this way. From the perspective of any one instution swapping collateral in order to meet changing regulatory requirements, they see it as necessary and prudent risk management. But within a closed system, if most actors are behaving in the same way, then the net risk is not, in fact, reduced. The perception that it is, however, can be dangerous and can also contribute to banks unwittingly underprovisioning liquidity and undercapitalising against risk.
Viewed system-wide, therefore, collateral transformation really just represents a form of financial alchemy rather than financial engineering. It adds no value in aggregate. It might even detract from such value by rendering opaque risks that would otherwise be more immediately apparent. So I do understand the regulators’ concerns with the practice. I don’t, however, subscribe to their proposed self-serving remedies for what they perceive as just another form of market failure.
PLAGARISED COPIES OF AN OLD PLAYBOOK
Already plagued by the ‘Too Big to Fail’ (TBTF) problem back in 2008, the regulators have now succeeded in creating a new, even more dangerous situation I characterise as MAFID, or ‘Mutual Assured FInancial Destruction.’ Because all banks are swapping and therefore holding essentially the same collateral, there is now zero diversification or dispersion of financial system risk. It is as if there is one massive global bank with thousands of branches around the world, with one capital base, one liquidity ratio and one risk-management department. If any one branch of this bank fails, the resulting margin call will cascade via collateral transformation through the other branches and into the holding company at the centre, taking down the entire global financial system.
Am I exaggerating here? Well, if Governor Stein and his central banking colleagues in the US, at the BIS and around the world are to be believed, we shouldn’t really worry because, while capital regulation didn’t prevent 2008, liquidity regulation will prevent the scenario described above. All that needs to happen is for the regulators to set the liquidity requirements at the right level and, voila, financial crises will be a thing of the past: never mind that setting interest rates and setting capital requirements didn’t work out so well. Setting liquidity requirements is the silver bullet that will do the trick.
Sarcasm aside, it should be clear that all that is happening here is that the regulators are expanding their role yet again, thereby further shrinking the role that the markets can play in allocating savings, capital and liquidity from where they are relatively inefficiently utilised to where they are relatively more so. This concept of free market allocation of capital is a key characteristic of a theoretical economic system known as ‘capitalism’. But capitalism cannot function properly where capital flows are severely distorted by regulators. Resources will be chronically misallocated, resulting in a low or possibly even negative potential rate of economic growth.
The regulators don’t see it that way of course. Everywhere they look they see market failure. And because Governor Stein and his fellow regulators take this market failure as a given, rather than seeking to understand properly how past regulatory actions have severely distorted perceptions of risk and encouraged moral hazard, they are naturally drawn to regulatory ‘solutions’ that are really just plagiarised copies of an old playbook. What is that definition of insanity again, about doing the same thing over and over but expecting different results?
 Neo-Keynesians will deny this, claiming that their models take money and credit into account. But they do so only to a very limited extent, with financial crises relegated to mere aberrations in the data. The Austrian economic school of Menger, Mises, Hayek, etc, by contrast, has a comprehensive and consistent theory of money and credit that can explain and even predict financial crises.
 The entire paper can be found at the link here (PDF).
 This entire speech can be found at the link here.
 FINANCIAL CRISES AND NEWTON’S THIRD LAW, Amphora Report Vol. 1 (April 2010). The link is here.
This article was previously published in The Amphora Report, Vol 4, 10 June 2013.
Back in mid-March I made the latest of my somewhat rare specific, near-term market predictions, in this case that a US stock market correction or even a crash was imminent. Now some six weeks and a further 5% rally later, I revisit this view. Why, amid surprisingly weak economic data, corporate profit warnings and continued softness in global commodity prices, has the stock market risen to fresh highs? A key explanation is not one that the bulls are going to like: Central banks are increasingly monetising equities, implying further currency debasement. Investors should thus now begin to deploy idle cash; not in allocations to stocks, however, but to a broad basket of relatively depressed commodities, in particular metals and certain agricultural products.
THE (ONGOING) ROAD TO RECORD HIGHS
All investors make mistakes but not all investors learn from them. Those that do make better investors. I like to consider myself in this latter category.
Therefore, the time has come for me to evaluate my most recent prediction, from mid-March, that the US stock market was likely to suffer a serious correction or even a crash over the coming weeks. While there was indeed a slight stumble and loss of momentum in April, this has not prevented a net 5% rally in the S&P500 index to 1,630 this week.
For those not familiar with my prediction, here follow some brief excerpts from the relevant Amphora Report, ASSUME THE BRACE POSITION:
Year to date, both broad money and private sector credit growth are outright negative even through the monetary base is growing at nearly a 70% annualised rate. The Fed is, therefore, pushing harder than ever before, but still pushing on a string.
Corporate insiders… are cashing out at the fastest rate in years. Many companies are raising new capital through either initial or secondary offerings. Such activity is a sign of a market top…
[F]orward earnings growth estimates are in the double-digits, even though profit margins are already at record highs. If history is a guide, profit margins are highly unlikely to remain this wide for long.
[T]he current rally has been characterised by steadily declining volumes. In other words, a relatively small number of transactions have been responsible for pushing up prices. This is in sharp contrast to much research suggesting that a ‘wall of cash’ has been pushing the market higher.
As it happens, each of these cited conditions continues. Alongside a further weakening of broad money and credit growth, leading economic indicators have, on balance, been surprisingly soft. (Remember: jobs data lag, not lead.) By some measures the balance of negative economic data is the worst it has been for over two years.
Second, realised corporate profits and guidance have continued to miss expectations across most sectors. While this had a negative impact on the specific names affected, the rest of the market shrugged it off quickly and, more recently, even the firms that disappointed, including bellwethers such as Caterpillar and FedEx, have rallied to new highs for the year. Corporate insiders, meanwhile, continue to sell holdings and raise new capital.
Finally, turning to trading volumes, these have continued to decline. Daily market turnover in recent weeks has been only a fraction of the average through the entire rally which began in early 2009.
In my opinion, in this last observation lies to key to understanding why the market has continued to post gains when so many negative factors have suggested at a minimum a pause in the rally and possibly the correction or crash that I predicted.
Normally, a steady decline in volume is understood as an indicator that a given trend, bullish or bearish, may be tiring and due a reversal. But we do not live in normal times. We live in an age of unprecedented policymaker activism. Thin volumes, other factors equal, make it even easier for official agents—primarily central banks—to manipulate markets as a policy tool.
There is nothing conspiratorial about this. After all, central banks set short-term interest rates. They also increasingly set long-term interest rates, both via QE purchases and more subtle mechanisms, such as the ‘duration paradox’ phenomenon associated with a zero-rate policy. (For more on this somewhat esoteric topic please see my report linked here.) From time to time they intervene in the foreign exchange markets. Central banks are also active buyers of gold, or sellers for that matter. But did you know that, in recent months, central banks have also been unusually large buyers of… wait for it… equities!
As reported by Bloomberg News and elsewhere, central banks around the world, including the Bank of Japan, the Bank of Korea and the Swiss National Bank have been unusually large buyers of equities:
Among central banks that are buying shares, the SNB has allocated about 12 per cent of assets to passive funds tracking equity indexes. The Bank of Israel has spent about 3 per cent of its $77 billion reserves on U.S. stocks.
In Asia, the BOJ announced plans to put more of its $1.2 trillion of reserves into exchange-traded funds this month as it doubled its stimulus program to help reflate the economy. The Bank of Korea began buying Chinese shares last year, increasing its equity investments to about $18.6 billion, or 5.7 per cent of the total, up from 5.4 per cent in 2011. China’s foreign-exchange regulator said in January it has sought “innovative use” of its $3.4 trillion in assets, the world’s biggest reserves, without specifying a strategy for investing in shares.
MARKET MANIPULATION IS THE NEW NORMAL
These reports may surprise some, but when you line up what amounts to creeping equity monetisation against all the other market-manipulating activities of central banks, including rhetoric expressly supporting rising asset prices as a useful policy tool, then it is just par for the pathological course: central bankers will stop at nothing to reflate their respective economies in order to avoid any meaningful debt deleveraging and restructuring in their respective financial systems. Yes, some in Germany and a handful of other creditor countries may be putting up some resistance around the margins but the general thrust of policy is clear. And while printing money to purchase government bonds is monetisation—unless it is subsequently reversed—printing money to purchase equities is monetisation on steroids: it comes closer to an outright ‘helicopter drop’ of money in that it largely bypasses the financial system by directly supporting equity market valuations, providing corporations with a form of ‘currency’ that can be spent on actual, real expansion, acquisitions and job creation.
(For those sceptical that central bank equity purchases are highly relevant, consider the unusually strong relationship at present between central bank balance sheet expansion and the stock market: the correlation has reached 90%. Correlation is not causation but this is strong circumstantial evidence of an indirect link between central bank asset purchases and equity prices. If central banks are now switching to direct equity purchases then naturally the indirect link becomes direct and presumably more powerful.)
Still, as with money creation generally, there is no guarantee that the beneficiaries will choose to respond as the central banks desire. Indeed, corporations in most of the developed world are highly leveraged on average, face unusually high tax and regulatory regime uncertainty, and thus remain highly reluctant to invest. (As mentioned previously, some are even choosing to raise capital.)
So while there is zero guarantee that the corporate horses being led to water by outright central bank equity purchases and the elevated valuations they support will act as desired and increase investment, central banks are doing their part to repair what they see as a damaged monetary transmission mechanism by leapfrogging the impaired financial intermediaries.
But is the transmission mechanism in fact damaged at all, or does it largely just reflect a shift in the demand function for money? Keynesians and Monetarists argue the former; Austrian economists the latter. Regular readers of this report will know that I side with the Austrians in this matter and in all matters monetary. Indeed, I would go so far as to argue that the Austrian economic school is the only one that has a consistent or even coherent theory of money, notwithstanding the tangled web of abstruse equations proffered by the mainstream PhDs ensconced in the high ivory towers of academia and essentially non-accountable economic policy making.
In my opinion, the shifting demand function for money reflects the private sector’s efforts to rebuild savings following a series of bubbles, busts and the associated realised and as yet unrealised resource misallocations. Central banks wish at a minimum to halt or ideally outright reverse this reckoning process indefinitely. As I have written before, preventing the realisation of resource misallocations by introducing further resource misallocations merely accelerates the deterioration of the economy’s capital stock, leading to outright capital consumption and a permanently reduced standard of living. This is the road we are on.
In any case, as a direct result of unprecedented policymaker activism, the disconnect between lofty stock market valuations and the economic reality on the ground in the US, Europe, Japan and elsewhere grows and grows. Some still dare call this ‘capitalism’ but really, some who do are among those pulling the strings; you’d think they would know better. Perhaps they do and it simply remains their cover story to blame the supposedly ‘free’ market for the escalating failures of interventionism, thereby obfuscating their responsibility for the mess while excusing the next round of Hail-Mary interventionism.
For those who step outside the system and look back at it with unbiased eyes, the dysfunctionality is increasingly apparent. It also goes beyond ordinary politics. As I have written before, the addiction to fiscal deficits and monetary inflationism cross all major party lines in all major economies.
Around the margins, those who do understand the problems are beginning to get themselves organised. The US ‘Tea-Party’ revolt of 2010 was an inchoate example. The ‘Five Star’ movement in Italy has met with considerably greater success. In Germany, the ‘Alternative for Germany’ party has just got off the ground but with much potential. And in the UK, against all expectations, the alternative UKIP party’s support soared in the most recent local elections.
These are observations, not endorsements. None of the parties mentioned above could remotely be called a ‘sound money’ party. But they do demonstrate that the disgust with the inflationist status quo is growing rapidly. The terms of debate are shifting. This is a healthy if at times messy process and is likely to be regarded by future economic historians as an essential part of ending the current economic experiment with unsound, unbacked, manipulated fiat money. As I wrote way back in 2010, “Long may the activism continue.”
 To see just how dramatic these money and credit developments are please see the relevant charts from the St Louis Fed’s weekly US financial data publication here.
 For a discussion of this development please see this article from Zerohedge here.
David Stockman’s The Great Deformation is a tour de force of historical revisionism that demolishes the conventional economic and political wisdom prevailing both prior to and in the aftermath of the 2008 global financial crisis. Approaching his subject from many different angles, he demonstrates in thorough and specific detail, including much direct personal experience, that the roots of the crisis stretch back many decades. Few if any stones are left unturned; few if any major US political actors escape criticism; and all are subject to healthy scrutiny regardless of their orientation on the left-right spectrum. Indeed, Stockman makes clear that the facile left-right distinction of US politics obscures a deeper crisis of capitalism that spans the breadth of the American economic and political landscape. While he admits he has little hope that America can now change course, in closing he does offer a few specific policy recommendations that might, just might, lay the foundation for a Great American Reformation, were they to be implemented in future.
A most credible source
There is no more credible source for a book detailing the myriad policy failures collectively contributing to America’s decent into crony capitalism than David Stockman. Elected to Congress in the 1970s while still in his 20s, he was selected by President Reagan to be his first budget director at age 31 and was thus the youngest Cabinet-level US official to serve in the entire 20th century.
Bright-eyed and bushy-tailed in comparison to the seasoned older guard dominating the Reagan White House, Stockman became rapidly disillusioned by the striking contrast between Reagan’s lofty rhetoric on the one hand and the reality of White House policies on the other. He left politics in 1985 for the private sector and entered the world of private equity as a partner at the Blackstone Group.
As Stockman himself admits, however, he is not entirely above the criticism he levels repeatedly at others throughout the book. Three prominent examples include his admission of avoiding the Vietnam draft by enrolling in Harvard Divinity School; being repeatedly outmanoeuvred by highly experienced political operatives while serving in the Reagan White House; and bearing at least some responsibility for a handful of poor investment decisions while working at Blackstone.
This honest introspection only serves to make the book more credible. Stockman is an American taking a long look in the mirror and asking the tough questions that few in power will ask, associated as they all are, in some way, with the great tragedy he describes in thorough detail.
The first polemical punch
Stockman wastes no time in landing his first polemical punch: on the first page, he observes that the US ‘Fiscal Cliff’, around which there was such high political drama late last year, is both “permanent and insoluble,” and that the chronic US deficit and debt problem is “the result of capture of the state, especially its central bank, the Federal Reserve, by crony capitalist forces deeply inimical to free markets and democracy.”
What follows is page after page of shocking detail regarding the metastatising crony-capitalist cancer consuming the US economy’s once great potential. While primarily concerned with recent developments, a great strength of the book is that it seeks always to trace the roots of The Great Deformation back to their beginnings, for example, in early 20th century Progressivism; in President Roosevelt’s New Deal; or in the Republican Party’s fateful decision in the 1960s to sever its small-government roots.
Debunking the conventional wisdom
Throughout the book, Stockman relentlessly attacks the economic conventional wisdom. In one instance he reaches back into the Great Depression to demonstrate that numerous policy errors both in the United States and abroad contributed to the 1929 stock market crash and subsequent banking crises of the early 1930s. Moreover, he demonstrates convincingly that it was not the military Keynesianism of the 1940s that ended the Depression but rather a severe and prolonged household and corporate deleveraging facilitated by a combination of women entering the workforce en masse, a general shortage or outright absence of many consumption goods and the associated, unusually high national savings rate.
This goes directly against the mainstream interpretation that increased rates of savings only serve to make financial crises even worse. But Stockman does not stop there. He shows how the rapid public sector deficit reduction in the immediate postwar period and the general fiscal prudence of the Truman and Eisenhower years enabled the rapid, healthy, sustainable growth of the 1950s and 1960s to proceed absent any material increase in the public debt and absent inflationary pressures on prices.
This began to change during the Kennedy administration but it was under Johnson and Nixon that traditional American fiscal convervatism was shown the door for good. From this point forward, the tone of the book changes dramatically as Stockman initiates a devastating assault on the conventional wisdom: The entire left-right narrative of US politics is demonstrated to be a great charade. Even the early Reagan years in which Stockman was a direct policy participant are shown to be an exercise in the relentless growth of government, associated deficits and debt. As he explains it, “Rather than a permanent era of robust free market growth, the Reagan Revolution ushered in two spells of massive statist policy stimulation.” Indeed, Stockman characterises the Reagan and Bush years as a ‘Keynesian Boom’.
As Stockman explains, for all the talk to this day of Reagan’s fiscal conservatism, the only meaningful conservative policy victory of the time was achieved by the Fed, not the government. Paul Volcker did what was required to stabilise the dollar and bring down inflation following the disastrous stagflationary 1970s, the inevitable consequence of Johnson’s and Nixon’s fiscal largesse, the hugely expensive Vietnam war, soaring government deficits, de-pegging the dollar’s link to gold and the Fed’s accommodation of, among other associated phenomena, higher crude oil prices via OPEC.
As is the consistently the case throughout the book, however, Stockman highlights the links between failed economic policies and their unfortunate social consequences: The relentless growth of moral hazard and crony capitalism. Once Volker had left the stage, replaced by Alan ‘Bubbles’ Greenspan (sic), he explains how the Fed began de facto to target asset prices, in particular the stock and housing markets, and that “Under the Fed’s new prosperity management regime … the buildup of wealth did not require sacrifice or deferred consumption. Instead, it would be obtained from a perpetual windfall of capital gains arising from the financial casinos.” Wow.
That’s right, for decades the stock market has been a financial casino, rigged as desired by the Fed to (mis)manage the economy, and now all that is left is a “bull market culture” that has “totally deformed the free market.”
Stockman also points out how the decades leading up to 2008 were replete with ‘foreshocks’ of the eventual financial earthquake. For example, there was the S&L crisis of the late-1980s and early 1990s. There was the Long-Term-Capital debacle. And each and every time that the Fed’s economic management led, either directly or not, to near-calamity, the bailout beneficiaries were enriched anew.
With most of Stockman’s criticism is directed at Washington, Wall Street and the Fed, he nevertheless reserves some for the non-financial corporate sector. As he explains:
Alongside the Fed’s cheap credit regime, there arose a noxious distortion of the tax code best summarized as ‘leveraged inside buildup’. The linchpin was successive legislative reductions of the tax rate on capital gains that resulted in a wide gap between high rates on ordinary income and negligible taxes on capital gains. This huge tax wedge became a powerful incentive to rearrange capital structures so that ordinary income could be converted into capital gains.
In Stockman’s view there is thus plenty of blame to go around. On a few occasions he even criticises the defence establishment, holding up Eisenhower as the last example of Pentagon budgetary discipline. While he hardly comes across as a dove in foreign policy, he is certainly not as hawkish as recent administrations and he points out a handful of examples of failed defence policies and budgetary largesse past and present.
Beyond left and right
Readers who attempt to understand this book according to any variation of the current economic policy mainstream or through the obsolete left-right narrative of US politics will struggle to understand Stockman’s independent perspective. The Great Deformation is written by an old-school, small-government ‘Eisenhower Republican’ and champion of the free-market who perceives more clearly than most just how far the insidious crony-capitalist rot has spread, whether it be facilitated by purportedly left-leaning ‘regulation’ or encouraged by right-leaning tax-reform. As Stockman repeatedly demonstrates, the concept of ‘capture’ applies equally to both.
Perhaps unsurprisingly given the horrifying state of affairs he so cogently describes, Stockman is not sanguine about America’s future. The US is travelling down Hayek’s fabled ‘Road to Serfdom’ as the government and central bank respond to the damaging effects of failed interventionism with escalating interventionism. Indeed, since at least 2008, the evidence is overwhelming that America has been accelerating down that tragic road.
In closing, Stockman offers some ideas that might help the US to reverse course, although he strongly doubts that they will be adopted. If anything, the political winds from both left and right continue to blow in the other direction. No doubt his polemic will be rebuffed by those in power on both sides of the aisle in Congress and his recommendations for reform will go unheeded. That Stockman knows this, but wrote this book regardless, demonstrates his love for America. Anyone sharing that love should read it.
The Cyprus banking kerfuffle has ignited a blogosphere storm debating the likelihood that depositors elsewhere, perhaps even ‘guaranteed’ ones, may find themselves on the hook for recapitalising their domestic banks. Largely lost in this discussion however is the unpleasant reality that a substantial portion of the international financial sector has been undercapitalised or even insolvent since at least 2008, if not before. Policy responses to the financial crisis have not changed this fact. Indeed, as resource misallocations are the ultimate cause of bankruptcy or insolvency, the exponential increase in price-fixing distortions in the wake of the global financial crisis ensures that depositors in aggregate are now facing far greater losses than they were back in 2008. Someone has to pay for past resource misallocations even when central banks succeed in sweeping these under the rug of monetary inflation. Will it be you?
THE BANKS ARE (STILL) INSOLVENT
You don’t need to live in Cyprus to be aware that banks in numerous countries are woefully undercapitalised, in some cases to the point of insolvency. Sure, regulatory financial accounting conventions allow for a huge amount of smoke-and-mirrors obfuscation, delaying the day of reckoning, but an insolvent bank is insolvent regardless of the regulators’ choices of accounting conventions to apply from one day to the next.
Although the specific distinctions vary from country to country, large banks have multiple sources of capital in their liability structure with varying degrees of seniority. As losses are incurred they are absorbed by this structure, tranche by tranche. First goes the shareholder equity, then the subordinated debt (which includes a great number of interbank derivative positions, about which more later), then the senior debt, then uninsured deposits.
Back in 2008, however, government and central bank officials chose not to follow existing law and apportion losses to banks’ liability structures through appropriate insolvency proceedings. Rather, they chose to go straight to the taxpayers to bail out their respective financial systems, in some cases by outright nationalising institutions. This was done because the institutions in question were deemed ‘too big to fail’ (TBTF) and their insolvency would have threatened to derail the entire financial system.
THE BANKER BAILOUT BACKLASH
This policy (mis)judgement, that socialising bank losses served the interests of society, has been the subject of much dispute, including in previous Amphora Reports and, more recently, in David Stockman’s outstanding new book, The Great Deformation (available on Amazon here). Indeed, as one banker scandal after another has come to light since 2008 there has now been a huge banker bailout backlash. Politicians understand that, in the event another crisis hits and the TBTF banks are at risk of failure yet again, taxpayers may refuse to support another systemic rescue. What to do?
Well, behind the scenes, economic officials the world over have been busy putting together working frameworks for how to deal with future bank failures. One recent, prominent example is a joint paper by the US Federal Deposit Insurance Corporation and the Bank of England, in cooperation with the US Federal Reserve and the Financial Stability Board of the Bank for International Settlements, the international bank supervisory body based in Basle, Switzerland . Given its international character and the prominence of the institutions involved, this paper should be understood as a working template for how large international bank failures will be addressed in future. The paper begins with an explanation of the problem (emphasis added):
The financial crisis that began in late 2007 highlighted the shortcomings of the arrangements for handling the failure of large financial institutions that were in place on either side of the Atlantic. Large banking organizations in both the U.S. and the U.K. had become highly leveraged and complex, with numerous and dispersed financial operations, extensive off-balance-sheet activities, and opaque financial statements. These institutions were managed as single entities, despite their subsidiaries being structured as separate and distinct legal entities. They were highly interconnected through their capital markets activities, interbank lending, payments, and off-balance-sheet arrangements.
The paper then proposes what appears, at first glance, to be an entirely reasonable way to deal with a possible future failure of such an institution:
[R]esolution strategies should maintain systemically important operations and contain threats to financial stability. They should also assign losses to shareholders and unsecured creditors in the group, thereby avoiding the need for a bailout by taxpayers. These strategies should be sufficiently robust to manage the challenges of cross-border implementation and to the operational challenges of execution.
Fair enough. How reasonable to actually have a framework in place that allows banks to fail without placing taxpayers on the hook. But as with many apparently reasonable policy initiatives, the devil lurks in the details, specifically in paragraph 13 (an appropriate number perhaps?):
An efficient path for returning the sound operations of the [bank] to the private sector would be provided by exchanging or converting a sufficient amount of the unsecured debt from the original creditors of the failed company into equity. In the U.S., the new equity would become capital in one or more newly formed operating entities. In the U.K., the same approach could be used, or the equity could be used to recapitalize the failing financial company itself—thus, the highest layer of surviving bailed-in creditors would become the owners of the resolved firm. In either country, the new equity holders would take on the corresponding risk of being shareholders in a financial institution. Throughout, subsidiaries (domestic and foreign) carrying out critical activities would be kept open and operating, thereby limiting contagion effects. Such a resolution strategy would ensure market discipline and maintain financial stability without cost to taxpayers.
What this amounts to is a debt-for-equity swap arrangement for the “highest layer of surviving bailed-in creditors.” While in some cases the ‘highest layer’ might be that of the bondholders, in others it would include depositors, as is the case in Cyprus for example. Yet this is to be done while “subsidiaries carrying out critical activities would be kept open and operating, thereby limiting contagion effects.” So what, exactly, are these ‘critical activities’? And what is meant by ‘contagion effects’?
What the authors are referring to here is the interbank market, not only for wholesale lending in the money markets but also for all manner of financial derivatives and the underlying collateral on which they are, in some way, secured. This is what caught regulators by surprise in 2008: following the collapse of Lehman Brothers a fire-sale slump in collateral values led to a cascade of interbank margin calls and the market seized up, threatening relatively well-capitalised firms that had appeared previously not to be at risk. The paper thus implies that the way to prevent contagion in future is to prevent a sudden contraction in the interbank lending+derivatives market.
Think about this for a moment: The interbank market, a leveraged, inverted pyramid of subordinated debt built on top of a comparatively limited amount of senior debt collateral, is to be held intact by regulatory fiat while depositors are ‘bailed-in’ via a debt-for-equity swap. Do you see the sleight-of-hand at work here? Under the guise of protecting taxpayers, depositors of failing institutions are to be arbitrarily, de-facto subordinated to interbank claims, when in fact they are legally senior to those claims!
In other words, regulators are laying the operational groundwork for a new type of banker bailout deemed politically acceptable. The last time around, they went straight to the taxpayers. The next time around, they are going straight to the depositors.
Now it so happens that depositors are never explicity mentioned in the paper. They are always referred to as ‘unsecured creditors’. But the effective meaning of this term is belied by the fact that the proposal assigns the FDIC the job of resolving US-based institutions via the debt-for-equity swap mechanism mentioned earlier. Were the bondholders rather than depositors in primary focus this would not be the case as the FDIC has no direct responsibility for the wholesale, non-depositor sources of credit to US financial institutions.
Finally, consider the brutal, unjust irony of the entire proposal. Remember, its stated purpose is to solve the problem revealed in 2008, namely the existence of insolvent TBTF institutions that were “highly leveraged and complex, with numerous and dispersed financial operations, extensive off-balance-sheet activities, and opaque financial statements.” Yet what is being proposed is a framework sacrificing depositors in order to maintain precisely this complex, opaque, leverage-laden financial edifice!
If you believe that what has happened recently in Cyprus is unlikely to happen elsewhere, think again. Economic policy officials in the US, UK and other countries are preparing for it. Remember, someone has to pay. Will it be you? If you are a depositor, the answer is yes.
WHAT ABOUT GUARANTEED DEPOSITS?
What if your deposits are ‘guaranteed’? Does this mean that you will be excluded from abribtrary subordination? Perhaps. Perhaps not. Once officials start changing the rules they have a naughty tendency to keep right on going. That said, perhaps ‘guaranteed’ deposits are indeed sacrosanct in certain countries, if not in Cyprus. (To clarify, ‘guaranteed’ depositors in Cyprus are not participating in the debt-for-equity swap arrangement being implemented there, but they are subject to strict and indefinite capital controls. At best this is a huge inconvenience; at worst, a holding pattern prior to a subsequent future bail-in in the event that the unguaranteed deposits are insufficient to recapitalise the banks. A distinct possibility in my opinion.)
But step back for a moment. What, exactly, is a deposit guarantee? Who provides it? Why, the taxpayer of course. So to the extent that guaranteed depositors do not directly recapitalise failing banks, they do so indirectly as taxpayers. Remember, someone has to pay.
Recall, however, that the entire shift in focus from taxpayer-funded bail-outs to depositor bail-ins originates in the political backlash against the banks. Taxpayers don’t like being on the hook for corrupt bankers’ past mistakes. That said, they don’t much like being on the hook for anything. Take a look around at those large and growing public sector deficits and debts. Guess how they came about. They exist because countries have been resorting to inflation to finance their bloated welfare states as well as banker bailouts.
Economic officials may not care to call this debt-financing inflation, but inflation it is. Those debts are being financed, directly and indirectly, by rapidly expanding central bank balance sheets and associated broad money and credit creation. At some point in future, this monetary inflation will show up in consumer prices. It is just a question of time .
So in the end, depositors, guaranteed or not, taxpayers, and anyone not benefiting from inflation is paying for the resource misallocations that caused the insolvency of much of the global financial system. Unless you work for a leveraged financial institution or a government that spends money it doesn’t have, that ‘someone’ who pays probably includes you.
DEPOSIT ‘INSURANCE’ IS JUST PART OF THE NEGATIVE-SUM GAME
Common sense informs us that real risks can only be insured with real savings. This is one explanation for why countries with low savings rates tend to inflate their way out of economic recessions, rather than to restructure and resume healthy growth through Schumpeterian creative destruction. History suggests that the inflationary process becomes a vicious cycle as inflation further disincentivises savings, resulting in an even lower savings rate, followed by even more counter-cyclical inflation down the road.
As it erodes wealth, however, inflation is not a form of insurance. It is merely a means of reducing the real burden of unserviceable debts by transferring economic resources from savers to borrowers. A nasty side effect of inflation is that it causes resource misallocations and subsequent crises. Neo-Keynesian economic models refuse to acknowledge this but economists of many stripes including Richard Cantillon, Hume, Marx, Lenin, von Mises, von Hayek, Alan Greenspan and even Keynes himself were aware of it. With the notable exceptions of Marx and Lenin they also warned of these hidden dangers. (Marx and Lenin actually encouraged inflation as a means to confiscate wealth from the capitalists and concentrate it in a central bank owned and run by the state. The establishment of a central bank was plank 5 of Marx’s Communist Manifesto.)
To expand on a previous point, to the extent that it is applied to an entire financial system, deposit ‘insurance’ is therefore a misnomer. The only way depositors system-wide can possibly be made whole is by the state issuing a sufficient amount of debt in order to raise the necessary funds from the central bank. But as this is inflation, the very depositors being bailed out are the depositors whose wealth is being confiscated through inflation! System-wide deposit insurance is robbing Peter to pay Peter, so to speak. But if Peter doesn’t notice, will he object?
Sadly, whether we notice or not, the result of this game of robbing ourselves is not zero-sum but rather negative-sum: a ‘dead-weight-loss’ in the economic jargon. This is because the financial system is a huge consumer of misallocated resources that could otherwise be directed toward fulfilling the actual needs and wants of consumers. That’s right: alongside bloated governments, the greatest resource misallocation in the world today is that of the financial system itself, which has grown like a cancer ever since central banks wrestled control of the money supply away from the ‘golden anchor’ that, prior to 1971, largely kept it in check.
In numerous countries there is now much evidence that depositors are re-evaluating their trust in their respective financial systems and voting with their wire transfers. This is entirely understandable. Indeed, although it may go against the conventional wisdom, I would argue that the threat of a bank run is a healthy thing. How else to keep bankers in check, when the present system gives them every incentive to leverage up as much as possible, thereby concentrating profits in their hands yet socialising losses on the depositors and taxpayers via bail-outs, bail-ins and inflation?
How refreshing it would be to see banks competing on claims of depositor security for a change, as opposed to which bank has the friendliest image, the most fashionable logo, is the ‘greenest’, or occupies the tallest building in London or New York? Indeed, such faux competition highlights that banking is an industry sorely lacking in real competition.
Notwithstanding all the evidence to the contrary, some still call the bankers ‘capitalists’. While they’re at it, they might as well call the Communist Manifesto a capitalist work.
 The Amphora Report has tackled this issue on multiple occasions. Probably the most extensive discussion was in A TALE OF TWO CRISES, Amphora Report vol. 2 (December 2011). The link is here.
 The entire proposal is worth reader can be found at the link here.
 For a more thorough discussion of this deflation-into-inflation tangent please see FROM DEFLATION PUSH TO INFLATION SHOVE, Amphora Report vol. 3 (June 2012). The link is here.