[Editor’s Note: this piece, by John Butler from March 2014, is now very relevant again with legal authorities and central banks currently looking at this area closely.]
Created in 2008 by the mysterious ‘Satoshi Nakamoto’, in the past few months bitcoin has gone from a fringe financial technology topic to a mainstream media phenomenon. The debate is now raging as to whether bitcoin is, or is not, a sound form of alternative money. As the Amphora Report has, from inception, focused regularly on monetary theory and the financial market implications of activist central banking, in this edition I survey a handful of prominent, diverging views on bitcoin and then share some of my own thoughts. In brief, I believe that bitcoin’s ‘blockchain’ technology enables a low-cost payments system capable of disintermediating the banking industry, but I do not believe bitcoin presents a viable, alternative store of value on par with gold. In any case, bitcoin serves as a monetary ‘touchstone’ of sorts, distinguishing those who lean toward economic and monetary authoritarianism from those who favour market-based organisation instead.
To understand bitcoin one must first understand money
Satoshi Nakamoto, the initially mysterious and now legendary creator of bitcoin, finally became a mainstream celebrity last week, having been ‘outed’ by US periodical Newsweek. Many who have followed the bitcoin story, however, find Newsweek’s claim rather dubious and instead believe that ‘Satoshi Nakamoto’ is a pseudonym adopted by either a single individual or team responsible for researching and publishing the original 2008 paper describing the specific, ‘blockchain’ algorithm behind bitcoin.
I have no strong opinion on Newsweek’s specific claims, nor on who, or what group, created bitcoin, although I am curious, for reasons that will become apparent. More important is to understand whether bitcoin could function as a sound, alternative money.
To begin, we need first consider why an alternative money would ever be necessary in the first place. Well, repeatedly throughout history, due to financial pressures, governments have chosen to debase their coins or inflate their paper currencies to service or settle their debts, by implication appropriating the wealth of prudent savers in the process. Wars, for example can be expensive and most large debasements in history have occurred either during or following major wars, in particular in those countries on the losing side of the conflict. But even the winners can succumb, as Rome demonstrated in the 3rd century or as the victorious WWI powers did in the 1920s and 1930s.1
Savers fearful of potential future currency debasement or inflation therefore naturally seek alternatives for protection. Gold and silver have historically been the most obvious choices. When governments sought to debase coins passing through the Treasury by clipping or by minting new coins with less gold or silver content, the higher quality coins would be hoarded out of existence by savers, who would subsequently transact using the inferior coins instead.2 In time, this would push up prices, as more and more economic agents became aware that the quality of the coinage had declined.
Another option for savers was to hoard foreign coins, for example, that were not being debased. This could restrict the amount of circulating medium in foreign countries, however, with deflationary effects on prices and possibly on output, something that the foreign governments might then seek to offset with debasement of their own. This could also lead to an aggressive ‘race to debase’, or ‘currency war’, which occurred in the 1930s, for example, and which is also arguably occurring again today, as James Rickards and others have argued.3
Gold and silver hoarding is hardly the only way in which savers can go about trying to store wealth during periods of debasement and inflation. In theory, any goods of value can be hoarded. Wealthy individuals tend to hoard fine art and wine, or prestigious property. Middle-class individuals can purchase a modest home, or perhaps even a second home. Farmers can hoard their harvests for a time rather than release them directly into the marketplace. Producers of energy can do the same with oil and gas. Indeed, practically any business that holds inventory of any kind has the option to hoard some portion of that inventory, not in anticipation of increased real final demand, but merely as a hedge against debasement and inflation. Witholding goods from the marketplace in anticipation of higher prices in future rapidly beomes a self-fulfiling prophecy as it constitutes a negative supply-shock, contributing to ‘stagflation’, such as that of the 1970s in the US, Britain and a handful of other economies.
The problems with hoarding inventory, however, are numerous, and it is far better in the event that confidence in the official money declines for savers to have the option of just switching to an alternative. International businesses have some flexibility in this regard, switching their trading and invoicing between dollars, euros, yen or, increasingly, the yuan.
Unlike physical inventory, major currencies are fungible. Indeed, this is one of the definitions of money, that it is a convenient, efficient medium of exchange. Historically this has most frequently been metallic coinage. Why metallic coinage? Because metals were the most marketable commodities, accepted by everyone, everywhere, subject to a quick check of weight and authenticity in the event they were of dubious provenance.
The desire for an alternative money, therefore, is entirely natural when economic agents become uncertain as to the future purchasing power of any legally-mandated tender. In this regard, we should not be so surprised why bitcoin has skyrocketed from obscurity to prominence in such a short period of time, notwithstanding its tiny market share as a globally-available alternative medium-of-exchange. The context is key, and the current context of unusually high global uncertainly as to the future purchasing power of dollars or other fiat currencies is the ideal environment in which an upstart alternative can have a disproportionate impact. When combined with the perennial technological innovations of modern times, resulting in all but the oldest individuals now being comfortable with digital commerce for all manner of goods and services, why not a truly digital currency, created by computational power itself, to serve as the 21st century alternative medium of exchange?
THE MONETARY TOUCHSTONE
How one feels about bitcoin tells us much of how one feels about money itself, making bitcoin a monetary ‘touchstone’ of sorts. Those who embrace it likely do so out of some combination of uncertainty around existing legal tender and embrace of technological solutions to problems. Those who disparage bitcoin, by contrast, most probably do so either because they trust the legal tender, obviating any perceived need for an alternative currency, and/or because they are distrustful of technology as a solution. This could be due to a general distrust of technology, say in the case of Luddites who would prefer a simpler world absent of much if not all modern technology, or perhaps a distrust of market-based solutions, technological or otherwise.
For example, there are some who oppose the US Federal Reserve on the (entirely justifiable) grounds that its actions appear to favour large financial institutions over other economic actors, including most households; yet rather than replace the Fed with a market-based solution to money creation and interest rate determination, they think that the Fed, a federal agency, should be replaced by another agency instead, say the US Treasury for example.
Several prominent commentators have recently weighed in on this bitcoin debate, spanning the entire range of approval to disapproval. Before we review a broad, representative set of examples, let’s start with the mysterious ‘Satoshi Nakamoto’, whoever he or she or they might be.
Satoshi Nakamoto was not the first to propose a so-called cryptocurrency, an idea that has been occasionally discussed in tech forms for years. However, s/he was the first to publish a practical solution to a problem: that of proof of ownership. The bitcoin algorithm includes a ‘blockchain’ linking bitcoins back to their origin, so that as bitcoins pass from person to person, their ownership remains certain and prevents the possibility of what could be termed ‘crypto-counterfeiting’ in which an individual would fraudulently exchange the same bitcoin with two or more other individuals simultaneously.
The blockchain is thus an objective way to verify ownership comparable in principle to when a physical coin passes from one person’s hand to another in exchange settlement. However, there is an important and controversial difference: When a coin passes between individuals, they can identify one another. When bitcoins pass between individuals, they need never know one another. Indeed, some argue that with a sufficient degree of encryption, bitcoin commerce can be 100% anonymous.
This potential for anonymity became a hot topic of debate around the controversial website ‘Silk Road’, an online marketplace for controlled substances, including various drugs, that transacted in bitcoins. For supporters of anonymity, it was disturbing to learn of the website’s demise when its alleged founder was arrested on various criminal charges. If bitcoin guarantees anonymity, how did the authorities find the perpetrator? More recently, a prominent bitcoin advocate known in the community as ‘Bitcoin Jesus’ has gone into hiding, claiming to be on the run from the US government for some unspecified, presumably bitcoin-related crime.
On the other hand, for those non-Libertarians embracing activist government regulation as an essential form of social protection, the more recent demise of prominent bitcoin exchange Mt Gox has led to the opposite concern, that bitcoin’s anonymous nature enables wholesale fraud without possibility of compensation for victims. It is in this social aspect of the bitcoin debate that it becomes more than just a monetary touchstone: It becomes a social touchstone for how you feel about societal organisation itself, not just the role of money within it. Thus it should be no surprise that Libertarian and non-Libertarian types tend to have quite different views on bitcoin.
With that background, let’s now begin exploring the views of a broad, representative handful of prominent bitcoin commentators.
Currently serving as the Executive Director of the Bitcoin Foundation, and having worked for years in e-money research, Jon Matonis was one of if not the earliest (non-pseudonymous) prominent champions of bitcoin. Indeed, he was active in the cryptocurrency debate long before bitcoin arrived on the scene and is thus on the record having anticipated the modern cryptocurrency phenomenon.
Given this background, it should be no surprise that Matonis is a huge fan of bitcoin and sees enormous future potential for a complete transformation of our monetary and financial system. He has a vision of a future in which spontaneous market competition creates competing cryptocurrencies and that perhaps, eventually, only a handful surviveand become the dominant global media of exchange, entirely displacing today’s national fiat currencies. For all intents and purposes, banks as we know them today will disappear, including central banks. The creation of money and the determination of interest rates would be largely unregulated, international and de-politicised. The bitcoin phenomenon is thus comparable or perhaps of even greater historical significance than the original, Lydian invention of coinage; the subsequent invention of deposit banking; and the more recent introduction of the modern, electronic money we all use today in some form, the credit (or debit) card.
Matonis goes even farther, however, envisioning what some detractors might disparagingly call a utopian ‘monetary nirvana’ in which bitcoin enables a comprehensive economic and social evolution to a new stage in civilisation, to the great benefit of humanity generally.
Regardless of whether you share Matonis’ bitcoin enthusiasm and optimism, his website is a treasure trove of information and divergent opinions about bitcoin, not merely his own. As a first step for those genuinely interested in not only a thorough introduction but essentially comprehensive exposure to all things bitcoin, I strongly recommend you visit his website.
As one of the most prominent innovators in the early internet age, Marc Andressen’s view of bitcoin, when published recently in the New York Times, drew much attention from the wider tech community.
As an inventor of a famous disruptive technology in his own right—the Netscape browser—Andressen perceives a similar potential in bitcoin as an ideal internet-based payments system:
Bitcoin is the first Internetwide payment system where transactions either happen with no fees or very low fees (down to fractions of pennies). Existing payment systems charge fees of about 2 to 3 percent – and that’s in the developed world. In lots of other places, there either are no modern payment systems or the rates are significantly higher.4
Even bitcoin’s detractors normally acknowledge as much, as bitcoin does appear to have some promise as a low-cost payments system. We all know how broadband technology sank telecommunications costs to essentially nothing. Why shouldn’t internet payments also cost essentially zero?
Andressen sees much potential for bitcoin and thinks it may catalyse a general transition from e-commerce based in dollars (or other national currencies) to e-commerce based in bitcoin. He is far from as sweeping in his perspective as Matonis, but this could be down to a relative unfamiliarity with the broader social concepts of money. That said, he does share a monetary insight which echoes that of founding Austrian School economist Carl Menger from the late 1800s:
It is perhaps true right at this moment that the value of Bitcoin currency is based more on speculation than actual payment volume, but it is equally true that that speculation is establishing a sufficiently high price for the currency that payments have become practically possible. The Bitcoin currency had to be worth something before it could bear any amount of real-world payment volume. This is the classic “chicken and egg” problem with new technology: new technology is not worth much until it’s worth a lot. And so the fact that Bitcoin has risen in value in part because of speculation is making the reality of its usefulness arrive much faster than it would have otherwise.
Those familiar with the Austrian School will notice immediately in this quote that Andressen has apparently stumbled upon one aspect of the monetary ‘regression-theorem’ concept formalised by Ludwig von Mises in the early 20th century but originally postulated by Menger.
Andressen lists several other reasons to be bullish on bitcoin’s future and his explicit endorsement has almostly certainly influenced a sizeable portion of the tech community, long-since acclimated to the concept of disruptive technologies. As Andressen himself acknowledges, however, his views are less likely to have much influence if any on the mainstream economics community. And so it is to that we now turn.
As one of the best-known mainstream economists of his generation and a Nobel laureate to boot, Robert Shiller’s take on bitcoin has naturally been the subject of much consideration within the academic and financial market community. He also recently published his views in the New York Times. His perspective is that of a mainstream neo-Keynesian economist, albeit one who has spent as much or more time studying financial markets specifically rather than the economy generally. (As an aside, isn’t it curious that the New York Times, hardly an innovative, cutting-edge tech source, seems to have gone on a bitcoin binge of late. One wonders why.)
Shiller is not at all optimistic about bitcoin specifically and in fact thinks that the current level of hype is misguided. The ultimate reason for this view he explains early in his article thus:
The central problem with Bitcoin in its present form…is that it doesn’t really solve any sensible economic problem. Nor should it substitute for banks and the governmental institutions that regulate them. They are reasonably effective institutions, despite their flaws, and should not just be scrapped and replaced by a novel electronic system.
He then goes on to specify that existing currencies work well as both media of exchange and stores of value. Well, if one doesn’t see a problem with state-mandated legal tender in the first place, then naturally one sees little if any value in an alternative, in particular one that has invited a huge degree of pure speculation relative to any current practical use.
Somewhat curiously, perhaps, despite these sentiments, Shiller does see value in the broader debate around bitcoin. He draws particular attention to the concept of money as a unit of account and believes that there is substantial future promise for synthetic units that can serve valuable social functions. As an example, he cites Chile’s inflation-indexed unitado de fundato (UF) or unit of development. This national reference point permits coordinated indexing to domestic price inflation, simplying certain forms of economic calculation in which price inflation is a material risk factor.
Shiller then suggests that price baskets in general could be used as units of account. He thus appears to be drawing from Keynes, who advocated a commodity basket currency he termed a ‘bancor’ and from Prof Jeffrey Frankel, who has done much theoretical work in the commodity-basket-currency area. He then goes one step further, suggesting that a useful electronic unit of account could also reference national account statistics, such as GDP or GNP, which rank among the most complicated economic statistics of all, subject to a large amount of estimation error and other possible flaws.
All of Shiller’s proposed electronic units of account are, therefore, artificial constructs that would need to be specified and subsequently updated by some person or group of persons relying on an agreed statistical sample of certain identifiable and estimable if not precisely measurable variables. He indicates no role whatsoever for a natural, market-based process to determine the units most desired. As such, he is coming from a most different perspective than Andressen or Matonis, one that requires a thick layer of bureaucratic intermediation.
Those distrustful of bureaucrats—always subject to some degree of political influence—to determine monetary convention and set interest rates are likely to reject Shiller’s view from the outset. However, the current academic and policy mainstream, focused as it is on the core Keynesian precept of the necessity of a bureaucratic- rather than market-based money and monetary policy, is likely to consider Shiller’s observations as a potentially useful way to incorporate bitcoin’s technological innovation into their existing economic paradigm.
A highly successful Mexican businessman, Hugo Salinas-Price has been active for decades in the cause of promoting sound money for Mexico. In more recent years he has broadened his activities to promote sound money around the world, drawing up plans for how governments could remonetise gold or, as he would recommend, silver.
Back in early 2012, while on business in Mexico, I conducted an interview with Mr Salinas-Price for publication in a special edition Amphora Report. He explains his silver plan thus:
My focus is on silver, because silver was formerly always the money of the great majority of the population in every country of the world. It has been and can again be money for everyday use and which can be saved by almost everyone. Silver is the ideal medium for ‘micro-savings’, for millions upon millions of savers who can put away small amounts, day by day, and build up a personal or family capital which can be passed on to the next generation.
We have a tragic impoverishment of enormous numbers of humanity whose attempt at savings is continually undermined by the devaluation of paper money – its loss of purchasing power. We have to put a stop to this, out of justice and – self-interest, too: the wider the breach between rich and poor, the more dangerous life becomes for all. (Ed. note: Eminent historians Will and Ariel Durant observed that nearly all revolutions have occurred alongside extreme disparities in wealth.)
The above quote should make clear why, in principle, Mr Salinas-Price is a strong advocate of a monetary alternative to the national fiat currencies of today. QE and related stimulus policies have coincided with a tremendous surge in wealth disparity across most of the developed world, as money has flowed primarily towards those who already held substantial assets when the global financial crisis arrived in 2008.
However, as he has made clear in a recent comment, bitcoin is not a satisfactory monetary alternative. Indeed, he argues that bitcoin is not money at all, nor is there any realistic chance of it becoming so:
An interesting point about the Bitcoin is that it is so important for it to have a price in dollars; it has had various prices, all totally speculative.
I should like to point out that when real money – gold – was in use in the world, it had no price. All national currencies were only certain various amounts of gold, with various national names.
The Bitcoin as a “digital currency” is an example of the enormous confusion which reigns in the world, regarding what money is and must be. Money – authentic money – must be the most marketable of all commodities. This is why gold is money! Silver follows in second place. The Bitcoin cannot be money because it is digital. Since it is merely a digit, which is as close to nothing as one can get, it cannot settle any debt.5
Well that is a rather categorical critique of bitcoin and I think it would be difficult to convince Hugo Salinas-Price or anyone dismissing the entire concept of intangible money that bitcoin has any future as a monetary alternative. As it happens, there are many prominent economists of the Austrian School who completely agree and insist that, were money determination left to the marketplace, rather than imposed by governments from above, gold and silver would invariably be chosen as money, as indeed they have been since the beginning of recorded history.6
There are prominent Austrian School economists, however, who do not dismiss bitcoin out of hand but rather see it as something that, in key respects, satisfies the core Austrian School requirements for sound money.
In a recent article, BITCOIN HAS THEORY AND HISTORY ON IT’S SIDE, Detlev Schlichter lays out what I believe is the correct framework for considering the prospects for bitcoin and for cryptocurrency technology generally:
Any proper analysis has to distinguish clearly between the following layers of the Bitcoin phenomenon: 1) the concept itself, that is, the idea of a hard crypto-currency (digital currency) with no issuing authority behind it, 2) the core technology behind Bitcoin, in particular its specific algorithm and the ‘mining process’…
Before we look at recent events and recent newspaper attacks on Bitcoin, we should be clear about a few things upfront: If 1) does not hold, that is, if the underlying theoretical concept of an inelastic, nation-less, apolitical, and international medium of exchange is baseless, or, as some propose, structurally inferior to established state-fiat money, then the whole thing has no future. It would then not matter how clever the algorithm is or how smart the use of cryptographic technology. If you do not believe in 1) – and evidently many economists don’t (wrongly, in my view) – then you can forget about Bitcoin and ignore it.
If 2) does not hold, that is, if there is a terminal flaw in the specific Bitcoin algorithm, this would not by itself repudiate 1). It is then to be expected that a superior crypto-currency will sooner or later take Bitcoin’s place. That is all. The basic idea would survive.7
We can use Schlichter’s framework, (1) and (2), to summarise the previous bitcoin advocates and detractors:
- Jon Matonis clearly sees the need for a monetary alternative and believes that both the concept of cryptocurrencies generally (1) and the specific properties of bitcoin are solid and have a bright future (2);
- Marc Andressen sees vast potential for bitcoin as a disruptive financial technology (2). He is agnostic, however, as to whether there is a need for an alternative money (1);
- Robert Shiller sees no need for an alternative money (1) but does see a role for widespread use of price- and other index algorithms in facilitating the use of existing state-fiat media of exchange (2);
- Hugo Salinas-Price sees a vital need for an alternative to state-fiat but dismisses the entire idea of intangible money (1), thus the specific qualities of the bitcoin algorithm (2) are irrelevant to any monetary application.
Schlichter then goes on to offer his own thoughts on bitcoin’s potential. First, he observes that several recent attacks on the bitcoin concept are essentially baseless in that they assume that the existing monetary order is functioning well. This assertion is increasingly tenous post-2008 even though the economic mainstream continues to defend it. Robert Shiller falls into this category but he did leave open a door to algorithms augmenting the core of what he believes is a robust monetary system.
Second, as is the case with Salinas-Price, Schlichter points out that our current monetary system is quite young and that some historical perspective is in order. Unbacked state fiat money has existed for only about 40 years, a mere bat of the historical eyelash. Indeed, the human eye has regarded gold (or silver) as money for 99% of history, and all previous experiements with unbacked fiat, without exception, have ended in failure and a subsequent de jure or de facto remonetisation of gold and silver. Contemporary economists, including Shiller, who claim that state fiat is a robust system, have scant historical evidence at their disposal. Indeed, any objective look at the evidence strongly implies the opposite is true.
Third, and this is really the key point, Schlichter cogently argues that bitcoin far more closely resembles gold than state fiat money, subject as the latter is to state manipulation and control:
Bitcoin – just like a proper gold standard – does not allow for discretionary manipulation of the monetary base. There was no ‘monetary policy’ under a gold standard, and there is no ‘monetary policy’ in the Bitcoin economy. That is precisely the strength of these concepts, and this is why they will ultimately succeed, and replace fiat money.
It should be no surprise that Schlichter sees through all the rhetoric and hyperbole on all sides of the bitcoin debate. His first book, PAPER MONEY COLLAPSE, begins with the theoretical observation that what separates paper money from gold or silver is the elastic nature of its supply. This opens up paper money to political manipulation and, sadly, corruption. As discussed above, the historical record on this is as clear as can be.
Regardless of how one feels about an intangible money, you can’t deny that the bitcoin algorithm strictly determines its supply according to an inviolable and entirely transparent rule whereby new bitcoins are ‘mined’ into existence. Applying Schlichter’s approach, the entire bitcoin debate thus reduces quickly, to those like Shiller, who simply regard bureaucratic money as superior, and those like Matonis or Salinas-Price, who would prefer to do away with the monetary bureaucracy completely.
Schlichter does not go so far in his article as to advocate bitcoin specifically as a preferred monetary alternative (although over lunch a few weeks back he did refer to bitcoin as ‘ingenious’). But is appears that he would in principle prefer a bitcoin-centric monetary system over that we currently have.8
By ‘in principle’ I refer to another key point on which I completely agree: If you hold, as Schlichter and other economists of the Austrian School do, that the ideal money is that determined spontaneously by market-driven exchange processes, rather than by state edict, then it becomes not just presumptuous but even theoretically inconsistent to claim precisely what that money should be.
If the market chooses gold, fine. If both gold and silver, fine. If cocoa beans, peppercorns or seashells, fine. And if bitcoin or another cryptocurrency, well that’s fine too. If it so happens that a given money isn’t performing adequately, well then the market will sort that out in short order, just as it does with uneconomic activities generally, rendering inefficient firms bankrupt, reordering the capital and labour stock, and moving on via creative destruction to more efficient production and innovation. Money is no exception to the fundamental laws of human action and free exchange: As with all economic goods, it is best provided by the marketplace itself, not by a government agency.
NOW, IT’S MY TURN
Having evaluated these various pro-, anti- and maybe-bitcoin arguments, it is now my turn to weigh in. Although I do agree with Detlev that fiat money is flawed and that a non-manipulable, non-state money is highly desirable, I strongly believe that, when one goes one step farther and directly evaluates bitcoin and gold as potential monetary rivals, a free society, absent legal tender laws or other restrictions on money, would favour gold (or silver) over bitcoin and cryptocurrencies generally.
First, I think it is important to distinguish clearly between the medium-of-exchange and store-of-value roles of money. Indeed, this was one of the first topics I covered in the Amphora Report back in 2010.9 There can be no doubt that bitcoin is an innovative medium-of-exchange that, in principle, can bypass the existing payments system. In this sense, bitcoin is a disruptive technology that, if so allowed by regulators, would render a huge portion of transactional banking unprofitable, ranging from credit cards to bank transfers. Unless your bank charges you for making deposits and withdrawals, how could it make money from your future transactions if you first withdraw funds, purchase bitcoins and transfer them instead? And if the counterparty, on receipt of the bitcoins, sells them and deposits the currency proceeds in the bank, then their bank can’t earn any transactional fees either.
It is highly likely that some smart people working in strategic planning at banks are already aware of this danger. They are probably also aware that, if banks can’t make money from processing transactions, they will have to make more money from idle deposits. But with interest rates on most types of accounts already near zero, how are banks going to do that, absent charging depositors to keep their money? And if banks start charging depositors, what are depositors going to do? Why, they will look for alternatives to traditional banking, such as using bitcoins or other cryptocurrencies instead!
Do you see the vicious circle here? Absent regulatory action to impede or prohibit cryptocurrency use, or to somehow subsidise the banks, cryptocurrency-based payments services are going to disintermediate the existing, bank-centric payments system. And it doesn’t really matter which services gain market share. Indeed, the fact that bitcoin has invited as much competition as it has, as fast as it has, is strong evidence that those entrepreneurs familiar with the economics of disruptive technologies are now behaving like sharks that smell blood (profit).
For all their promise as highly efficient means of payment, however, I am unconvinced of cryptocurrencies’ collective role as a store of value. In fact, it is precisely their suitability for use as an inexpensive, alternative payments system that, in my opinion, undermines their ability to provide a store of value.
Why should that be? Although bitcoin and other cryptocurrencies are based on entirely transparent algorithms that strictly regulate their supply, there is nothing that regulates their replication. There might be only one blockchain for each currency, but there is no limit on the number of blockchains that can be created at will to satisfy growing demand. As one blockchain is preferred and gains market share, speculators may enter and drive the price higher. But beyond a certain point, around the speculative margins that exist in all markets, substitution effects will kick in and some will switch into a rival cryptocurrency, programmed into existence at minimal cost, then another, then another… in a process that need never end.
This process, if market-driven, can be entirely self-regulating, providing for an endlessly growing supply of nearly costless-to-create, competing media of exchange, based on replicate algorithms, each with its own blockchain. But do you now see the problem? A dynamic aggregate of replicate, competing blockchains would have a highly ELASTIC supply, not one strictly limited. In fact, the supply is theoretically infinite, more infinite than grains of sand, drops of water, molecules of oxygen or, indeed, any other substance on earth or, for those who think even more broadly, in the entire universe. The cyber ‘universe’ is, by its very nature as a creation of the human mind rather than a naturally occurring substance, infinitely larger than the physical universe, vast as it is.
Gold or silver, by contrast, are strictly limited in supply, regardless of price, and cannot be replicated. Sure, they can be exchanged for one another and also for other substances, such as copper or nickel, to use two real-world coinage examples. But regardless of which of these are used, note what they all have in common: They have a production cost. Indeed, they are expensive to locate, pull out of the ground, refine and cast. Only when their market prices are sufficiently high does their production expand and, as supply rises to meet demand, their prices then stabilise. In other words, metallic monetary systems are also self-regulating, but in a context of real-world physical supply constraints and associated costs, rather than a cyber-world of no theoretical supply constraints and the minimal costs associated with a few strokes on a keyboard and the imagination to conceive a new crypto ‘brand’.10
A second theoretical problem I have with cryptocurrencies as stores of value is that of physical security. I’m not talking here about the potential for fraud and abuse, which exists and will always exist where human exchanges take place. Rather, I’m talking about the ability of an authority of some sort, say one with the ability to operate entirely in secret, to trace blockchains as desired, from place to place, and to hack in to systems as required to effectively confiscate these in the event that the authority deems their use to be criminal or politically undesirable. While I don’t in any way condone criminal behaviour, I appreciate why criminals prefer physical over electronic cash, or physical gold or silver for that matter, as these exchanges are anonymous vis-à-vis third parties, even if not at all anonymous between the two parties involved in the transaction.
Some claim that encrypted bitcoin ensures complete anonymity vis-à-vis not only the parties to a transaction but also third parties. In my opinion the opposite is true. The blockchain, if traced by sufficient computing power, provides a complete record of all transactions that can then be used or abused as desired by the authorities, who most probably could also covertly confiscate bitcoins or render them effectively unusable.
However, if the authorities want to confiscate your gold, for whatever reason, they are going to have to make a rather public matter out of it. If you keep some gold in a safe at home, they are going to have to break into your house. If you have it buried in your garden, they are going to have to trespass on your property in order to dig it up. Physical gold stored in a neutral jurisdiction, such as Singapore or Switzerland, will not be released to foreign authorities without extensive, public evidence of criminal wrongdoing. And even then, it might only be released following public trials in public courts. In this sense, gold is a sort of monetary habeus corpus: There is no easy way for authorities to confiscate physical gold short of extensive, public legal action, including a presentation of the specific charges. Bitcoins, however, can be electronically ‘reassigned’.
Finally, I believe that there is a third important reason why gold and silver are likely to win out over bitcoin in the marketplace for money, namely culture and religion. Cultures don’t change overnight, they evolve through the generations. The same could be said of major religions, each of which has a core canon of beliefs but one that, around the edges, can change over long spans of time. As Hugo Salinas-Price observes correctly, you don’t just convince people overnight to use something new as money. Referring to Austrian School economist Ludwig von Mises, he writes that:
[N]o fiat currency has ever been successfully introduced into circulation without a monetary value ultimately derived from when that currency was gold or silver money. Bitcoin does not fill the bill; it cannot circulate along with the established fiat currencies of the world because it has no history, no ancestry reaching back to its parent, gold or silver.
The late Roy Jastram, who’s magnum opus THE GOLDEN CONSTANT is regarded as a modern classic amongst the gold investment community, opined that the reason why of all substances gold came to be money went beyond any purely rational explanation as to gold’s unique physical properties.
I believe that Jastram was on to something. And I believe that Hugo Salinas-Price, Detlev Schlichter and Austrian School economists generally are on to something too. That something is human nature. As Lord Acton observed, power tends to corrupt; absolute power corrupts absolutely. By corollary, monetary power tends to corrupt; absolute monetary power corrupts absolutely. So now I lay my monetary cards on the table: As I write in THE GOLDEN REVOLUTION, no form of money “can possibly replace that which transcends all government, all laws, and, indeed, all things created by man.”
CONCLUSION: TOWARDS A
While I fully acknowledge bitcoin’s vast potential as an alternative payments system to disintermediate much of the increasingly archaic, dysfunctional, ‘too-big-to-fail’ banking system, I have also described several reasons why I do not believe that it will displace gold or precious metals generally as the preferred alternative stores of value, at least not on a relevant time horizon. This raises the question, therefore, of whether it might be possible to somehow combine the two in a way that instantaneously ‘sweeps’ cryptocurrency proceeds directly into allocated gold, at some market-determined exchange rate. That is, if you would like to transact in bitcoin but save in physical gold, is there a way in which to do so without using a fiat currency as an intermediate step?
While the technology to provide for some form of ‘gold-backed’ bitcoin almost certainly already exists—or if it does not, a patent application is probably pending—the question is whether the legal-tender authorities would ever allow this. After all, payments systems compete with banks but don’t compete with purely monetary power, at least not directly. Gold does. It will be interesting to see what happens when the first ‘crypto-gold’ service is launched, perhaps in a friendly monetary jurisdiction such as Singapore or Switzerland. If the local authorities allow it to go ahead, will residents of other countries adopt the service? If they do, will their domestic authorities try to prevent them in some way?
From the perspective of the state, the power to inflate is the power to tax. States do not take kindly to a reduction in their power to tax. Arguably, blockchain technology, if employed as state-mandated legal tender, would in fact increase the power of the state to tax, as taxes could be automatically withheld from the blockchain for each and every transaction according to some algorithm; or alternatively the blockchain authority could earn seignorage income as the supply grew.
Aspiring totalitarian regimes (and science fiction writers) take note: Use of physical cash or any unauthorised form of electronic exchange can simply be criminalised with severe penalties and replaced by ‘PatriotCoin’. The PatriotCoin withholding algorithm can be modified so as to exempt favoured individuals or qualifying transactions. State employees can share out any seignorage income, as befits their privileged status. Children can be assigned personalised PatriotCoin serial numbers at birth and retain these until death, when they pass to their children…
Is this where we are going? Who knows? As is the case with gold and silver on the one hand, and debasement and fiat on the other, the war between economic liberty and authoritarianism never ends. And it certainly won’t end with bitcoin.
1 There are those who fail to draw the connection between WWI and the currency debasements which followed. While it is easy to understand why the defeated powers ended up hyperinflating in the period 1919-1924—they were broke and had reparations payments to make—it is harder to see how WWI contributed to the devaluations of sterling and the dollar in the 1930s. However, a close look at the 1920s reveals that inflationary policies, including the fractionally-reserved ‘gold exchange standard’ were implemented to soften the economic blow of the immediate post-war period. However, these led to asset bubbles, in particular in the US, which burst in the early 1930s, inaugurating the Great Depression. FDR finally succumbed to the urge to debase the dollar in 1933.
2 This was observed in practice by Sir Thomas Gresham and became the basis for his eponymous ‘Law’, that bad money drives good money out of circulation and into hoards.
3 James Rickards, author of CURRENCY WARS, also has a much-anticipated new book coming out, THE DEATH OF MONEY.
4 Please see Andressen’s NYT article here.
5 OF PAPER MONEY, DIGITAL MONEY AND GOLD, by Hugo Salinas-Price, 7 March 2014. The link is here.
6 It is true that there is much evidence of relatively primitive socieities using local commodities as a form of money, in particular agricultural products such as carob, cocoa or soyabeans. Seashells have also served. However it should be noted that in every single historical instance in which these societies came into commercial contact with other societies, they quickly adopted gold and silver as the preferred stores of value, even if they continued to employ the domestic commodity for day-to-day domestic trade.
7 This article can be found at www.detlevschlichter.com.
8 I should disclose at this point that Detlev is a personal friend with whom I maintain a regular correspondence. The reader is free to determine whether my comments here are in any way so biased in his favour.
9 Please see IS MONEY A STORE OF VALUE? Amphora Report vol. 1 (March 2010). The link is here.
10 For those familiar with the concept of elasticity in economics, gold and silver supply are demonstrably highly price inelastic, whereas theoretical blockchain supply is highly price elastic. As stability of supply is an essential feature of sound money, this factor alone argues strongly in favour of precious metals generally vis-à-vis blockchain technology as an alternative store of value.
A former RAF aviation engineer and software engineer in the financial sector, Steve Baker has been the Conservative MP for Wycombe, Buckinghamshire since 2010. Recently he was elected by his colleagues to the Treasury Select Committee, where he has put questions to Bank of England Governor Mark Carney, and he has also sponsored a Parliamentary debate on ‘Money Creation and Society’. He is an outspoken follower of the Austrian Economic School, and is an advocate of ‘free banking’ and the de-nationalisation of money. In this interview, Steve shares his views on money, banking and economics generally; why he chose to enter into politics; his plans for the next Parliament; and the prospects for sound money and banking in the UK and around the world.
BY WAY OF BACKGROUND…
Steve Baker has been fascinated by machines since his youth growing up in Cornwall. He studied Aerospace Engineering at Southampton University through a University Cadetship programme, entering the RAF on graduation, and served his country in multiple international locations for 10 years.
Also fascinated by information technology, on leaving the RAF in 1999 he studied towards a degree in Computer Science at St Cross College, Oxford. He then worked in a number of IT roles, including at Lehman Brothers in 2006-08, leading into the global financial crisis. His personal website (here) makes plain that, “My work at Lehman Brothers particularly informs my present work on reforming the financial system.” He decided to enter politics in 2007 and was elected to Parliament on his first attempt in 2010.
Steve is hardly the only sitting MP to focus on financial and banking issues. But he is the only Conservative MP to openly advocate for fundamental reform of not just banking, but of money itself. This is due to his outspoken belief in the key tenets of the Austrian Economic School, which teaches that activist monetary and fiscal policies undermine long-term economic health. To begin our discussion, we explore how Steve experienced the 2008 financial crisis and the impression it made.
JB: Steve, you had been working at Lehman Brothers for about two years when the financial crisis hit in 2008. Did you ever have a sense that the firm was dangerously exposed to a potential crisis? That the firm’s high leverage and a reliance on short-term financing could bring it down? That the financial system in general was as fragile as it demonstrably was?
SB: Back when Lehman was posting record quarter after record quarter, I was focussed on delivering value through software and I still believed our masters understood the institutional superstructure of the economy. It was only when the bust came that I realised the Austrian School had crucial insights to offer which were missing from the mainstream.
JB: How exactly did you come to believe that the Austrian Economic School provided the best explanation for the 2008 financial crisis and also for understanding economics more generally? Was this a gradual process or rather something more like a sudden epiphany?
SB: It was a long process. I first read Mises’ The Causes of the Economic Crisis and Hayek’s Monetary Theory and the Trade Cycle in 2000 during my MSc in Computer Science. I was planning to make my fortune in software, but then the dot-com bust happened. I wanted an explanation and found it in these books. However, my priority was business and I didn’t have the confidence to start telling economists where they were going wrong. It was only after working for banks and their regulators that I realised key insights about epistemology and method were absent from mainstream economics in important ways. That caused me to read more deeply, co-found The Cobden Centre with Toby Baxendale and then use my Parliamentary position to promote better economic policies.
JB: Please describe what it is you mean by free banking and money. Most people just take national fiat money and heavily-regulated banking for granted. Of course this was not always the case. But then have free banking and money really ever been the norm? Why is this topic of such importance to you?
SB: By ‘free-banking’ I mean money and a banking system produced by the spontaneous co-operation of free individuals in markets. It is what Hayek proposed in his Denationalisation of Money and HM Treasury briefly worked in that direction as an alternative to the euro. Usually, free banking means gold (or silver) as the base money and banking conducted under the ordinary commercial law, usually with unlimited strict liability. Canada and Scotland historically came closest to free banking. In a future free-banking system, cryptocurrencies or blockchain technologies of some sort are likely to have a role. Sound money is crucial to the justice of social processes.
JB: When and how did it occur to you that, by entering politics, you could contribute to changing the terms of debate around money and banking, when neither major UK party seemed to have any interest in doing so?
SB: Originally, it was the scandal of the Lisbon Treaty – the mangled EU Constitution – which prompted me to seek election to deliver an in/out referendum. It seems I may have played my part in reaching that objective but that decision was reached in 2007, before the crash. Once the crash came, when I had no realistic expectation of being elected, I decided to establish an Austrian School think tank. My surprise selection for a Conservative-held seat and election to Parliament changed everything.
JB: Please describe your experience in Parliament to date. What is it like to be something of a ‘maverick’ MP on the issues of money and banking? Is it encouraging? Discouraging?
SB: It’s hugely encouraging but hard work and I always appreciate support. As far as I am aware, I have no original ideas in this field and, being wary of the fringes of debate, I keep close to established literature. As a result, I seem to be attracting colleagues to at least consider the possibility that the Austrian School has a better answer to the question—famously asked by HM the Queen—of how the financial crisis could have happened. People know I am unorthodox but they also know I am grounded in credible literature. They also recognise the call for lower taxes, balanced budgets and sound money as distinctively Conservative. I suppose the difference is I really mean it; I don’t just say such things in hope of being elected.
JB: You recently sponsored a Parliamentary debate on ‘Money Creation and Society’? What was the purpose of the debate and do you believe that it achieved your objectives?
SB: Prominent Constitutional fiat money advocates Positive Money were agitating for a debate and they have strong national support. Despite disagreeing on many things, I am one of their best contacts in Parliament. The timing of the debate corresponded with their campaigning activity. However, of course I have spoken many times in the same vein, beginning with my maiden speech. Positive Money had created sufficient support for a debate in the main chamber to be possible and I was glad to lead it. We meant to move the debate forward and we did: I have received messages of support from around the world.
JB: Having recently achieved selection to the Treasury Select Committee, you have now had the opportunity to engage with Bank of England governor Mark Carney on multiple occasions. While he is obliged to answer your questions, do you find his answers satisfactory? Or evasive? Does it seem to you that the Bank of England is properly accountable to Parliament? Or is it able more or less to set policy on its own? If you could change anything about the existing governance of the Bank of England—other than abolishing it—what would that be?
SB: It is always a huge pleasure and privilege to ask questions of the Governor, who also chairs the G20 Financial Stability Board. Mark Carney is undoubtedly the central banker of his generation, full of talent and statesmanship. He knows where I stand. Perhaps our good-natured jousting can sometimes be seen in the sessions. His answers are mainstream and remember he has a dreadful power to shift markets with every word. He is sometimes breathtakingly honest—for example in relation to the shortcomings of mathematical models—but it is right that he has regard to the potential for his words to reverberate through markets. This factor has no place in a free society, of course, but we are where we are. The Bank is accountable to Parliament and the officials evidently take this seriously. The Bank operates within its mandate and that means it reaches policy decisions independently of politicians.
Given that, like Walter Bagehot [ed. note- Bagehot was Editor-in-Chief of The Economist from 1860 to 1877 and wrote extensively on fundamental economic and financial issues], I think the ideal system would not include central banks, your last question is hard to answer. I would have the Bank produce research that questions their groupthink and they are doing so. It will be a long time yet before we win the argument but having the Bank itself challenge orthodoxy may be an important breakthrough.
JB: Assuming that you and the Conservatives are re-elected in the coming months, what plans do you have for the next Parliament? What goals are realistic? And if you’re optimistic, what might be achieved over the next five years?
SB: Nationally, we must balance the budget. In all the circumstances, this will remain a tough problem. Personally, I would like to be re-elected by my colleagues to the Treasury Committee so I can continue to work on changing the terms of debate.
JB: How do you feel about the growing UK independence movement? Do you believe that the UK is more likely to fundamentally reform money and banking inside or outside the EU?
SB: People across the political spectrum are awakening to the reality that state power has escaped democratic control and that awakening is a good thing. The challenge is to hold politics together while a coalition for democracy and liberty is built, especially bearing in mind that it is the classical liberal and conservative family that is awakening first. A further fragmentation of the centre-right would be bad news for democrats and advocates of liberty.
Realistically, monetary reform is likely to come from either spontaneous market action or global reform of the post Bretton-Woods system. I don’t think the UK is likely to reform sterling unilaterally but this could happen provided we retain our own currency. I imagine Switzerland is culturally better-placed to reform independently, especially now they have decoupled from the euro. Maybe Russia will dramatically disrupt geopolitics with the reform you describe in your book. [Ed. note- I have suggested that Russia might respond to escalating international tensions by backing the rouble with gold. See here.]
JB: Do you regard the government’s ‘austerity’ policies to have been a success? How would you define ‘success’?
SB: Success would be a balanced budget. More work is required and the longer I spend in politics, the clearer it becomes that turning around a democracy is not like turning around a private company. The Chancellor has been more successful than most other finance ministers. I will continue to support him in so far as I can.
JB: To expand on the above, you are more aware than most about the deteriorating state of UK public finances and of the large imbalances in the economy more generally, such as the excessive reliance on property and financial services, and the chronic trade deficit with the rest of the world. Is it hard to be optimistic for the future when history suggests that the UK economy is going to remain weak for many years even in a relatively benign, non-crisis scenario in which these imbalances and excesses are worked off?
SB: In truth, it is often hard to be optimistic when you have “taken the red pill” of Austrian School economics. On the one hand, I am glad so many more people are now in private sector employment but on the other, as I have explained many times, the trajectory of debt and the continuing abuse of currencies is of grave concern. The future of our civilisation may be at stake.
JB: You co-founded the Cobden Centre, the leading sound money and banking think-tank in the UK. What do you see as the CC’s core mission? How exactly do you see the CC making a difference in future? Through education? Practical policy recommendations?
SB: The Cobden Centre’s core mission is to promote classical liberalism and specifically the Austrian School, that is, social progress through honest money, free trade and peace. It does not do politics but ideas and education. There is much more to do. Those interested in learning more can visit the website at www.cobdencentre.org and potential donors are welcome to send an email to email@example.com!
JB: Thanks so much for your time Steve. Before we conclude, are there any other thoughts you would like to share with our readers, many of whom work in the financial industry and would be profoundly affected by the sort of money and banking policies you advocate. What sort of impression would you hope they would take away from our discussion today?
SB: I hope readers will read your reports and your book, The Golden Revolution, and Detlev Schlichter’s complimentary work Paper Money Collapse. I hope they will read Mises and Hayek. If financial professionals cease opposing honest money and banking will we achieve the greatest institutional reform of our age: money and banking subject to competition and free of ruinous state control.
JB: Thank you so much Steve for your time.
POST-SCRIPT: REAL REFORMS REQUIRE
The value of Steve’s prominent role in promoting sound money and banking cannot be overstated. His leadership is an inspiration to all who would seek a better economic future. The best hope for real reform is to pressure the system both from within and from without. I encourage all readers to support Steve in his efforts in Parliament; through the educational resources of the Cobden Centre; and through their own private initiatives, whatever they might be.
Care to comment on this Report? Please contact me at firstname.lastname@example.org.
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Recent dollar strength has been a surprise to many but a strong dollar was also a key component of the Asian currency crises of 1997-98. These contributed to sharply lower oil prices, which in turn helped to trigger the 1998 Russian debt default, European bond spread de-convergence and spectacular blowup of hedge-fund Long Term Capital Management (LTCM). It is worth recalling that, when LTCM failed, the dollar abruptly gave up a full year of gains. While history rhymes rather than repeats, I suspect something comparable is likely in 2015, although with US total economy debt much higher, the potential for a sharp decline in the dollar is that much greater.
Back when I managed macro strategy teams at investment banks, I had a simple set of guidelines that I required junior strategists to follow when making investment recommendations, that is, in addition to those required by the firm or the regulators. These included:
- Recommendations must be supported by a broad range of fact-checked evidence, rather than one or two ‘cherry-picked’ pieces;
- Recommendations must be ‘actionable’ in a practical way by the target clients and one or more of these must be specified;
- Recommendations must not only provide a specific price (or return) target, but also an estimate of risk (or volatility) and reference to a specific time horizon;
- Recommendations must include one or more conditions under which the particular investment would no longer be as attractive, if at all.
In practice, most analysts managed in their initial draft recommendations to follow the first two but struggled when it came to the third and fourth. The reason for this is most probably the inclination that many if not all quantitative-analytical types have for expecting that financial assets be priced ‘correctly’, according to whatever analytical framework is applied. If something is out of line, so the thinking goes, it should start correcting as soon as the analysis in question is complete and should completely correct over the short-to-medium term time horizon of primary importance to the bulk of those active in the investment management industry.
While that might seem reasonable, the problem is that, notwithstanding claims to the contrary, investors are not rational. Indeed, I would hold that no economic actors are rational in any meaningful, measurable way. This is due in part to my view of human nature and modern psychology seems to uncover new ways in which our minds are biased and irrational with each passing day. But if all investment opinions are biased and irrational to some degree, the sum of all such opinions—the financial markets—is most probably also biased and irrational.
So-called ‘behavioural investing’ tries to address these biases in a systematic way in order generate excess investment returns over time with acceptably low risk. However, the problem with any such ‘fight the irrational herd’ approach is, to paraphrase Keynes, “The herd can remain irrational longer than the rational investor can remain solvent.” On top of this there is the added complexity of the so-called ‘beauty contest’, also mentioned by Keynes, in which investors constantly try to out-guess each others’ intentions, irrational, behavioural or otherwise, so what in fact is ultimately decisive in price determination at any point in time arguably has little if anything to do with any underlying, fundamental, rational investment process.
Having been an active investor for many years, I have experienced a number of profit and loss events across a broad range of assets and strategies. In the end, while idea generation, however rudimentary, is necessary to active trading or investing, it is ultimately some aspect of risk management, of knowing when NOT to trade or invest, that often tips the balance between success and failure. Sure, anyone can be ‘smart’ or ‘lucky’ for a time but the irrational herd is far more dangerous to the unusually smart than to the lucky, even though many in the latter category no doubt consider themselves also (or perhaps exclusively) in the former camp.
The fight against irrationality, if one wishes to call it that, is thus one that is overwhelming more likely to be won in the longer-term, over which most investors have only little or no interest. In the economic jargon, investors have high ‘time preference’ to front-load investment returns, by implication taking irrationally large longer-term risks. For institutional investors managing other peoples’ money, it is often a losing business proposition to fight the herd so aggressively as to risk losing clients, even if the investment views implemented ultimately work out longer-term. Holding on to client money month after month, quarter after quarter, year after year, when an apparently irrational market chooses to become ever more irrational is a potentially career-limiting move in the extreme. Thus herd-following, rather than fighting, becomes the industry norm, and those who rise to the top of large asset management organisations do so not because they are great investors but because they are skilled at retaining client assets regardless of the direction in which the irrational herd is travelling.
This natural (if irrational) herding tendency is further exaggerated when economic or monetary officials intervene in order to ‘stabilise’ asset markets, which at least since 1987 has meant to prevent them from correcting violently to the downside. 1. When the herd believes that officials have their backs, they tend to ignore the risks closing in on their backsides for far longer than they ought to. And so the inevitable bubbles that form can continue to grow and grow, yet concern about them fades and fades, as normalcy bias and policy goals converge in a world of ever-rising or at least not falling asset prices.
In this world, biased by policy towards steadily rising asset prices, returns beget leverage, and leveraged returns beget greater leverage. Regulators pretend as if they can manage this and its probable future effects on the financial system and economy, but 2008 and many other manias, panics and crashes that have come and gone before inform us otherwise. Sure, a new regulatory effort is rolled out now and again, to much fanfare: Note the central bankers’ ‘macroprudential’ PR campaign over the past two years. The ivory-tower academic folk who originally propose such measures—or so they claim—applaud on the sidelines while taking implied, self-serving credit. (These academics are equally quick to blame the ‘private sector’ whenever anything goes wrong, as their ideas can’t possibly be at fault.)
I’ve been around long enough to see this dynamic play out on multiple occasions. I also witnessed first-hand the spectacular events of 1997-98, a period with strong parallels to today. Back then, the dollar rose on the false view that the US could decouple from crises abroad. When events abruptly proved otherwise, the dollar gave up a full year’s gains in just two weeks. The same could happen in 2015.
POOR-QUALITY GROWTH, RISING IMBALANCES
Following six years of zero interest rates and QE, the US economy has still failed to resume healthy, sustainable growth. Yes, the economy is growing at present and there have been some pockets of deleveraging. But this amounts to ‘cherry picking’ the range of available evidence and thus fails to adhere to even the first of my guidelines for investment recommendations. Looking behind the numbers in more detail, as I prefer to do, one sees an unbalanced economy that is re-leveraging amid the growth of yet another asset bubble.
Now my mainstream economic critics will scoff at this, pointing to the recently-released Q3 GDP report, for example, as demonstrating that healthy US growth has resumed. But when you look behind the numbers at the composition, the quality of the growth, it remains poor. One way to do this is to strip out the volatile inventory cycle and see what remains of ‘core’ GDP growth, referred to as ‘real final sales’. US real final sales growth has been positive over the past few years but, notwithstanding massive policy stimulus, has barely managed to rise above 2% year-over-year. Past recoveries have seen rates two to three times higher.
‘CORE’ GDP GROWTH STUCK AROUND 2% Y/Y
If you go one step further and strip out population growth, what remains is a per-capita core growth rate of little more than zero. And what has it taken to achieve this near zero rate of per-capita growth? Why, huge government deficits which have not been spent on long-term infrastructure investment but rather programmes designed to promote current consumption. Moreover, households have been re-leveraging following a period of sharp retrenchment in 2008-9. The savings rate, averaging about 4.5% over the past few years, is only marginally higher than it was in the bubble years of 2004-7.
HOUSEHOLD LEVERAGE HAS SOARED AGAIN…
…AS THE SAVINGS RATE HAS DECLINED ANEW
There was some material deleveraging of corporate balance sheets in 2009-12 but that has now given way to re-leveraging. Much of this is occurring via share buy-backs, which were all the rage in 2014, perhaps because without them, earnings per share would not have risen by much, if at all, given now-negative US corporate profit growth.
Now this may be the first you have heard about ‘negative’ US corporate profit growth. But if you look at profits not in the ‘pro-forma’ way that corporations present them to shareholders but in how they actually report them for official pourposes according to the methodology used in the national accounts, this is precisely what you see.
CORPORATE PROFIT GROWTH NOW NEGATIVE
This is not to say that the huge monetary and fiscal stimulus in the wake of the GFC had no effect. No, it had a huge effect. But that effect was primarily to bring future consumption artificially forward and thereby to reduce the savings available to provide for investment and future consumption. Eminent Austrian Economist Ludwig von Mises famously claimed that this was akin to “burning the furniture to heat the home.” (The pernicious effects of capital consumption are discussed in greater detail here.)
The fact is that the US is not saving enough to provide for current much less future consumption and thus must continue to borrow from the rest of the world. While the US trade deficit is not as large today as it was back in the bubble years of 2004-7—in large part due to increased domestic energy production—it remains sizeable in a historical comparison and, of course, adds to the enormous cumulative deficit that already exists.
US STILL DEPENDENT ON FOREIGN CAPITAL
So not only is US growth not on a sustainable path; to the extent there is growth, much of it is being financed with US-issued IOUs (ie dollars). The dollar may be strong at present due to flows out of various underperforming emerging markets. But this should not disguise the fact that the US economy cannot possibly decouple from the rest of the world when it is in fact highly dependent on the rest of the world as a source of financing.
DECLINING OIL PRICES ARE A KEY MECHANISM OF AN INEVITABLE RECOUPLING
Much us external financing is in the form of recycled ‘petrodollars’ from the larger oil-exporting countries such as Saudi Arabia, who take oil revenues and invest them in US assets such as Treasury bonds. This has two inter-related effects, supporting demand for the US dollar and helping to hold down US interest rates. As oil prices decline, however, so do oil revenues, in particular if global demand is declining, as it appears to be doing. This implies less recycling of petrodollars.
While in theory declining oil prices are supportive of growth, this is true only to the point that the financial system is not leveraged to oil revenues. Russia’s 1998 default on its external debt is a classic case in point. All of a sudden what appeared a benign development for the US economy was anything but, as through various financial linkages, the US financial system was in fact exposed to a sharp decline in global oil revenues.
Global liquidity, sloshing as it does from place to place, is much like the tides of the oceans. Local observers in different locations might not notice or care that a high tide in one place implies a low tide in another. But the global observer knows better: An extreme high tide in one part of the world will correspond to an extreme low tide elsewhere. But these need not occur simultaneously, as the flow from high to low between locations can take time.
Collapsing oil revenues were the proximate trigger for Russia’s 1998 decision to default on its external debt. European banks were among Russia’s primary creditors and thus they had to liquidate holdings of peripheral EU debt in order to raise capital. This pushed peripheral bond spreads sharply wider, reversing the trend in leveraged euro ‘convergence trades’ in the run-up to European monetary union. LTCM was one of the largest, most highly-leveraged followers of this strategy and found it suddenly faced huge losses potentially exceeding its capital. LTCMs creditors—primarily bulge-bracket Wall Street banks—demanded additional collateral be posted immediately. But there wasn’t enough high-quality collateral to go around and so the price of the highest-quality collateral—US Treasury bonds—soared to records in the scramble.
The Fed soon realised the scale of the potential danger: A default cascading through the heart of Wall Street. It thus placed pressure on all LTCM’s creditors to agree to a plan to ease off on collateral calls, allowing for an orderly unwind of positions. In return, the Fed would lower interest rates, to the benefit of all participants.
While these actions succeeded in containing the damage, they signalled to the world that the US financial system was in fact highly leveraged to the international financial markets and thus exposed indirectly to the serial crises elsewhere. Moreover, the Fed was willing to lower interest rates as required to bail out the US financial system. Hence the dollar was not the safe-haven it was previously thought to be and suddenly plunged in value, wiping out an entire year’s gains in a violent, two-week selloff.
A YEAR’S DOLLAR GAINS ERASED IN WEEKS
The US stock market also took notice, falling sharply as the re-coupling of the US to global reality set in. It was not until the Fed announced the LTCM bail out and rate cuts that the stock market began to recover.
Over the next two years, it did more than merely recover. With Fed policy actions having stimulated aggressive herd buying of equities, the NASDAQ crack-up boom took place, followed by the inevitable bust of 2001-03.
…AND A MAJOR STOCK MARKET CORRECTION
DE-CONVERGENCE HAS RUN A LONG WAY; RE-CONVERGENCE COULD OCCUR AT ANY TIME
The parallels with 1997-98 are increasingly clear. Currencies, asset markets and growth have slumped across Asia and Europe, yet US financial markets have been largely unaffected, happily continuing to climb. The dollar has strengthened steadily. Yet in the sharp decline in oil and other commodity prices we see a mechanism in motion that, in some way yet unseen, will eventually choke off the flow of liquidity into US financial markets. While I don’t anticipate that Russia will default this time round—Russia’s external government debt is tiny—there are a number of other countries out there highly dependent on commodity exports for external debt service.
Indonesia and Malaysia are two cases in point, the former being a relatively large emerging market economy. Sharp weakness in these countries’ currencies of late is an indication of growing stress eerily similar to 1997. Either or both of these countries could soon find they are unable to prevent large withdrawals of foreign capital. But devaluing a currency to deal with a balance-of-payments crisis doesn’t work as the problem is external debt denominated in a foreign currency, in this case dollars. The International Monetary Fund might try to come to the rescue, as it did in 1997-98, but the scale of the problem is far larger this time round.
Also worth mentioning here is something rather closer to home. The US shale industry is hugely dependent on leveraged financing from the US banking and shadow banking systems. (The latter uses structured financing vehicles of various kinds. By some estimates as much as a quarter of the entire US high yield debt market is related to the shale industry in some way.) With crude oil prices now plunging below $50/bbl, a huge portion of shale oil production has become unprofitable. Yet with debt to service, producers have no choice but to continue producing as much oil as they can. This will help to keep a lid on prices but will also bleed the most poorly financed producers to the point of insolvency and default, with potentially grave implications for the US financial system. (Some readers may recall the Texas oil, property and savings and loan collapse of the late 1980s, a key contributor to the eventual federal bail out of the entire US savings and loan industry.)
There are thus several ways in which today’s commodity price bust could turn into a more general financial crisis, as in 1997-98. It is impossible to know. But in my opinion, unless commodity prices soon recover, it is only a matter of time before a wave of balance-of-payment crises and/or corporate insolvences begin to dissolve the pillars of sand on which the strong dollar currently stands.
STRATEGIES FOR A DOLLAR REVERSAL
Those investors who agree that dollar strength is likely to reverse, perhaps abruptly, in 2015, should consider now those strategies that will perform well in that sort of environment.
There are various ways to speculate on a weaker dollar, the most straightforward of which is to short the dollar against other currencies in the foreign exchange markets. The difficultly with this, however, is that investors then need to take a view regarding which currencies are most likely to re-strengthen versus the dollar. Given that many countries would oppose currency strength at present, investors should take care. A diversified approach is probably best, and there are various vehicles that exist for this purpose, including the Merk currency funds. (Disclosure: Axel Merk is a personal friend I have known for many years. However I have no financial interest in his funds, nor do I receive commissions or compensation of any sort for recommending them.)
However, given that many countries might resist currency strength, the case can be made that gold has more upside potential in a dollar reversal. Moreover, if the environment turns decidedly risk-averse, as it did in 1998 for example, gold can benefit two-fold. Last year, Axel Merk launched the Merk Gold Trust (NYSE: OUNZ), a vehicle that allows for investors to take physical delivery of their gold, if desired, without this qualifying as a taxable event.
Gold’s poor sister silver is arguably better value at present, although in a risk-off environment it would be normal for gold to outperform silver. A simple diversification compromise would be to allocate 2/3 to gold and 1/3 to silver. This is because silver is normally about twice as volatile as gold. From a risk perspective, this implies an equal risk weighting in each of these two monetary metals. There are ETFs available that can be rebalanced periodically to keep holdings from drifting too far from the target 2/3 and 1/3 allocations.
Finally, a quick word on oil. While I have written above about the potentially negative financial market consequences of the recent, sharp decline in oil prices, there is of course much underlying demand for oil that is not particularly cyclical in nature but will occur even in a weak or zero-growth environment. Here I note that, even in the depths of the 2008 crisis, the oil price (WTI) found support around $40/bbl before recovering. At just under $50/bbl at time of writing, that is still a 20% decline from here, but the eventual upside recovery potential is probably far greater than 20%. For investors willing to take a risk amid what admittedly appears to be a ‘blood on the streets’ environment for oil at present, I’d recommend building a position here, either through an ETF or just by buying shares of upstream oil producers.
In relative terms, oil looks even better value, for example relative to industrial metals such as copper or aluminium. Yes, the latter have also seen prices come off but not to anywhere near the same extent. Platinum group metals may be precious but they are used overwhelmingly in industrial applications, in particular autocatalysts, and in the event that automobile demand should slow, there is much potential for these to decline relative to the price of oil. Palladium is considerably more exposed than platinum to this scenario and is thus the better short.
The really brave might even take a look at the debt of distressed shale producers, although I have no particular expertise in that area. A distressed industry is one that will likely be restructured in some way, such as by private equity firms swooping in, taking viable companies private, and restructuring them for the longer-term, out of the public spotlight.
1. There is in fact a far longer history of such interventions. In the US these include the devaluation of the US dollar by executive fiat in 1934 and abrogation of Bretton-Woods treaty obligations in 1971.
“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.)
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 The link to this FOMC statement is here.
 This research from Societe Generale was featured here.
 COMPETITION FOR SHADOW BANKING LURKS IN THE SHADOWS, Financial Times, 17 January 2014. The link is here.
 The most recent of these predictions was made in March. The link to the relevant report, ASSUME THE BRACE POSITION, is here.
 For a more thorough discussion of this episode from last year, please see my previous report, WILL THE FED RE-ARM THE BOND MARKET VIGILANTES? Amphora Report vol. 4 (July 2013). The link is here.
 George Gilder is hardly the first to have made this point, however. Among others, Friedrich von Hayek, Immanuel Kant, Confucius and innumerable quantum physicists have also explored the necessary limits to knowledge, in their various ways. One particularly poignant example is Leonard Read’s famous assay, I, PENCIL.
 The article, by veteran FT columnist Gillian Tett, can be found at the link here.
This article was previously published in The Amphora Report, Vol 5, 07 February 2014.
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.