Don’t Shoot The Speculator!

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.


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)


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.


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.


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.


2014: A year of investing dangerously

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.


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…


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.[1]

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.


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.[2]

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.”[3]

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.)


On two occasions in early 2013 I predicted that equity markets were due a correction or even a crash.[4] 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.[5] 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.


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.


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.[6]

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.


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.[7]) But much as astronomers can observe black holes indirectly, by the distortions they create in nearby space, so the remonetisation of gold can be inferred from keen observation of gold flows and economic policy shifts taking place around the world. The strongest such signals may be emanating from China at present, but there are others: in Germany, Russia and Nigeria, for example. (For a more thorough discussion on this topic, please see Cognitive Dollar Dissonance: Why a Global Rebalancing and Deleveraging Requires the De-Rating of the Dollar and Remonetisation of Gold, The Gold Standard Journal, issue 34, October 2013. The link is here.)

Care to comment on this report? Please send me a note:

And if you like you can follow me on twitter: @butlergoldrevo


[1] The link to this FOMC statement is here.

[2] This research from Societe Generale was featured here.

[3] COMPETITION FOR SHADOW BANKING LURKS IN THE SHADOWS, Financial Times, 17 January 2014. The link is here.

[4] The most recent of these predictions was made in March. The link to the relevant report, ASSUME THE BRACE POSITION, is here.

[5] 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.

[6] 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.

[7] 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.


Collateral transformation: the latest, greatest financial weapon of mass destruction

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.[1]


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.) [2]

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. [3]

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.[4]

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.


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.


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?

[1] 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.
[2] The entire paper can be found at the link here (PDF).
[3] This entire speech can be found at the link here.
[4] 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.


Monetisation on steroids

Back in mid-March I made the latest of my somewhat rare specific, near-term market predictions, in this case that a US stock market correction or even a crash was imminent. Now some six weeks and a further 5% rally later, I revisit this view. Why, amid surprisingly weak economic data, corporate profit warnings and continued softness in global commodity prices, has the stock market risen to fresh highs? A key explanation is not one that the bulls are going to like: Central banks are increasingly monetising equities, implying further currency debasement. Investors should thus now begin to deploy idle cash; not in allocations to stocks, however, but to a broad basket of relatively depressed commodities, in particular metals and certain agricultural products.


All investors make mistakes but not all investors learn from them. Those that do make better investors. I like to consider myself in this latter category.

Therefore, the time has come for me to evaluate my most recent prediction, from mid-March, that the US stock market was likely to suffer a serious correction or even a crash over the coming weeks. While there was indeed a slight stumble and loss of momentum in April, this has not prevented a net 5% rally in the S&P500 index to 1,630 this week.

For those not familiar with my prediction, here follow some brief excerpts from the relevant Amphora Report, ASSUME THE BRACE POSITION:

Year to date, both broad money and private sector credit growth are outright negative even through the monetary base is growing at nearly a 70% annualised rate.[1] The Fed is, therefore, pushing harder than ever before, but still pushing on a string.

Corporate insiders… are cashing out at the fastest rate in years. Many companies are raising new capital through either initial or secondary offerings. Such activity is a sign of a market top…

[F]orward earnings growth estimates are in the double-digits, even though profit margins are already at record highs. If history is a guide, profit margins are highly unlikely to remain this wide for long.

[T]he current rally has been characterised by steadily declining volumes. In other words, a relatively small number of transactions have been responsible for pushing up prices. This is in sharp contrast to much research suggesting that a ‘wall of cash’ has been pushing the market higher.[2]

As it happens, each of these cited conditions continues. Alongside a further weakening of broad money and credit growth, leading economic indicators have, on balance, been surprisingly soft. (Remember: jobs data lag, not lead.) By some measures the balance of negative economic data is the worst it has been for over two years.[3]

Second, realised corporate profits and guidance have continued to miss expectations across most sectors. While this had a negative impact on the specific names affected, the rest of the market shrugged it off quickly and, more recently, even the firms that disappointed, including bellwethers such as Caterpillar and FedEx, have rallied to new highs for the year. Corporate insiders, meanwhile, continue to sell holdings and raise new capital.

Finally, turning to trading volumes, these have continued to decline. Daily market turnover in recent weeks has been only a fraction of the average through the entire rally which began in early 2009.

In my opinion, in this last observation lies to key to understanding why the market has continued to post gains when so many negative factors have suggested at a minimum a pause in the rally and possibly the correction or crash that I predicted.

Normally, a steady decline in volume is understood as an indicator that a given trend, bullish or bearish, may be tiring and due a reversal. But we do not live in normal times. We live in an age of unprecedented policymaker activism. Thin volumes, other factors equal, make it even easier for official agents—primarily central banks—to manipulate markets as a policy tool.

There is nothing conspiratorial about this. After all, central banks set short-term interest rates. They also increasingly set long-term interest rates, both via QE purchases and more subtle mechanisms, such as the ‘duration paradox’ phenomenon associated with a zero-rate policy. (For more on this somewhat esoteric topic please see my report linked here.) From time to time they intervene in the foreign exchange markets. Central banks are also active buyers of gold, or sellers for that matter. But did you know that, in recent months, central banks have also been unusually large buyers of… wait for it… equities!

As reported by Bloomberg News and elsewhere, central banks around the world, including the Bank of Japan, the Bank of Korea and the Swiss National Bank have been unusually large buyers of equities:

Among central banks that are buying shares, the SNB has allocated about 12 per cent of assets to passive funds tracking equity indexes. The Bank of Israel has spent about 3 per cent of its $77 billion reserves on U.S. stocks.

In Asia, the BOJ announced plans to put more of its $1.2 trillion of reserves into exchange-traded funds this month as it doubled its stimulus program to help reflate the economy. The Bank of Korea began buying Chinese shares last year, increasing its equity investments to about $18.6 billion, or 5.7 per cent of the total, up from 5.4 per cent in 2011. China’s foreign-exchange regulator said in January it has sought “innovative use” of its $3.4 trillion in assets, the world’s biggest reserves, without specifying a strategy for investing in shares.[4]


These reports may surprise some, but when you line up what amounts to creeping equity monetisation against all the other market-manipulating activities of central banks, including rhetoric expressly supporting rising asset prices as a useful policy tool, then it is just par for the pathological course: central bankers will stop at nothing to reflate their respective economies in order to avoid any meaningful debt deleveraging and restructuring in their respective financial systems. Yes, some in Germany and a handful of other creditor countries may be putting up some resistance around the margins but the general thrust of policy is clear. And while printing money to purchase government bonds is monetisation—unless it is subsequently reversed—printing money to purchase equities is monetisation on steroids: it comes closer to an outright ‘helicopter drop’ of money in that it largely bypasses the financial system by directly supporting equity market valuations, providing corporations with a form of ‘currency’ that can be spent on actual, real expansion, acquisitions and job creation.

(For those sceptical that central bank equity purchases are highly relevant, consider the unusually strong relationship at present between central bank balance sheet expansion and the stock market: the correlation has reached 90%. Correlation is not causation but this is strong circumstantial evidence of an indirect link between central bank asset purchases and equity prices. If central banks are now switching to direct equity purchases then naturally the indirect link becomes direct and presumably more powerful.)

Still, as with money creation generally, there is no guarantee that the beneficiaries will choose to respond as the central banks desire. Indeed, corporations in most of the developed world are highly leveraged on average, face unusually high tax and regulatory regime uncertainty, and thus remain highly reluctant to invest. (As mentioned previously, some are even choosing to raise capital.)

So while there is zero guarantee that the corporate horses being led to water by outright central bank equity purchases and the elevated valuations they support will act as desired and increase investment, central banks are doing their part to repair what they see as a damaged monetary transmission mechanism by leapfrogging the impaired financial intermediaries.

But is the transmission mechanism in fact damaged at all, or does it largely just reflect a shift in the demand function for money? Keynesians and Monetarists argue the former; Austrian economists the latter. Regular readers of this report will know that I side with the Austrians in this matter and in all matters monetary. Indeed, I would go so far as to argue that the Austrian economic school is the only one that has a consistent or even coherent theory of money, notwithstanding the tangled web of abstruse equations proffered by the mainstream PhDs ensconced in the high ivory towers of academia and essentially non-accountable economic policy making.

In my opinion, the shifting demand function for money reflects the private sector’s efforts to rebuild savings following a series of bubbles, busts and the associated realised and as yet unrealised resource misallocations. Central banks wish at a minimum to halt or ideally outright reverse this reckoning process indefinitely. As I have written before, preventing the realisation of resource misallocations by introducing further resource misallocations merely accelerates the deterioration of the economy’s capital stock, leading to outright capital consumption and a permanently reduced standard of living. This is the road we are on.

In any case, as a direct result of unprecedented policymaker activism, the disconnect between lofty stock market valuations and the economic reality on the ground in the US, Europe, Japan and elsewhere grows and grows. Some still dare call this ‘capitalism’ but really, some who do are among those pulling the strings; you’d think they would know better. Perhaps they do and it simply remains their cover story to blame the supposedly ‘free’ market for the escalating failures of interventionism, thereby obfuscating their responsibility for the mess while excusing the next round of Hail-Mary interventionism.

For those who step outside the system and look back at it with unbiased eyes, the dysfunctionality is increasingly apparent. It also goes beyond ordinary politics. As I have written before, the addiction to fiscal deficits and monetary inflationism cross all major party lines in all major economies.

Around the margins, those who do understand the problems are beginning to get themselves organised. The US ‘Tea-Party’ revolt of 2010 was an inchoate example. The ‘Five Star’ movement in Italy has met with considerably greater success. In Germany, the ‘Alternative for Germany’ party has just got off the ground but with much potential. And in the UK, against all expectations, the alternative UKIP party’s support soared in the most recent local elections.

These are observations, not endorsements. None of the parties mentioned above could remotely be called a ‘sound money’ party. But they do demonstrate that the disgust with the inflationist status quo is growing rapidly. The terms of debate are shifting. This is a healthy if at times messy process and is likely to be regarded by future economic historians as an essential part of ending the current economic experiment with unsound, unbacked, manipulated fiat money. As I wrote way back in 2010, “Long may the activism continue.”[5]

[1] To see just how dramatic these money and credit developments are please see the relevant charts from the St Louis Fed’s weekly US financial data publication here.

[2] ASSUME THE BRACE POSITION, Amphora Report vol 3 (March 2013).

[3] For a discussion of this development please see this article from Zerohedge here.

[4] CENTRAL BANKS LOAD UP ON EQUITIES, Bloomberg News, 25 April 2013.

[5] This quote is taken from GUESS WHAT’S COMING TO DINNER: INFLATION! Amphora Report vol. 1 (October 2010).

This article was previously published in The Amphora Report, Vol 4, 8 May 2013.


A review of The Great Deformation

David Stockman’s The Great Deformation is a tour de force of historical revisionism that demolishes the conventional economic and political wisdom prevailing both prior to and in the aftermath of the 2008 global financial crisis. Approaching his subject from many different angles, he demonstrates in thorough and specific detail, including much direct personal experience, that the roots of the crisis stretch back many decades. Few if any stones are left unturned; few if any major US political actors escape criticism; and all are subject to healthy scrutiny regardless of their orientation on the left-right spectrum. Indeed, Stockman makes clear that the facile left-right distinction of US politics obscures a deeper crisis of capitalism that spans the breadth of the American economic and political landscape. While he admits he has little hope that America can now change course, in closing he does offer a few specific policy recommendations that might, just might, lay the foundation for a Great American Reformation, were they to be implemented in future.

A most credible source

There is no more credible source for a book detailing the myriad policy failures collectively contributing to America’s decent into crony capitalism than David Stockman. Elected to Congress in the 1970s while still in his 20s, he was selected by President Reagan to be his first budget director at age 31 and was thus the youngest Cabinet-level US official to serve in the entire 20th century.

Bright-eyed and bushy-tailed in comparison to the seasoned older guard dominating the Reagan White House, Stockman became rapidly disillusioned by the striking contrast between Reagan’s lofty rhetoric on the one hand and the reality of White House policies on the other. He left politics in 1985 for the private sector and entered the world of private equity as a partner at the Blackstone Group.

As Stockman himself admits, however, he is not entirely above the criticism he levels repeatedly at others throughout the book. Three prominent examples include his admission of avoiding the Vietnam draft by enrolling in Harvard Divinity School; being repeatedly outmanoeuvred by highly experienced political operatives while serving in the Reagan White House; and bearing at least some responsibility for a handful of poor investment decisions while working at Blackstone.

This honest introspection only serves to make the book more credible. Stockman is an American taking a long look in the mirror and asking the tough questions that few in power will ask, associated as they all are, in some way, with the great tragedy he describes in thorough detail.

The first polemical punch

Stockman wastes no time in landing his first polemical punch: on the first page, he observes that the US ‘Fiscal Cliff’, around which there was such high political drama late last year, is both “permanent and insoluble,” and that the chronic US deficit and debt problem is “the result of capture of the state, especially its central bank, the Federal Reserve, by crony capitalist forces deeply inimical to free markets and democracy.”

What follows is page after page of shocking detail regarding the metastatising crony-capitalist cancer consuming the US economy’s once great potential. While primarily concerned with recent developments, a great strength of the book is that it seeks always to trace the roots of The Great Deformation back to their beginnings, for example, in early 20th century Progressivism; in President Roosevelt’s New Deal; or in the Republican Party’s fateful decision in the 1960s to sever its small-government roots.

Debunking the conventional wisdom

Throughout the book, Stockman relentlessly attacks the economic conventional wisdom. In one instance he reaches back into the Great Depression to demonstrate that numerous policy errors both in the United States and abroad contributed to the 1929 stock market crash and subsequent banking crises of the early 1930s. Moreover, he demonstrates convincingly that it was not the military Keynesianism of the 1940s that ended the Depression but rather a severe and prolonged household and corporate deleveraging facilitated by a combination of women entering the workforce en masse, a general shortage or outright absence of many consumption goods and the associated, unusually high national savings rate.

This goes directly against the mainstream interpretation that increased rates of savings only serve to make financial crises even worse. But Stockman does not stop there. He shows how the rapid public sector deficit reduction in the immediate postwar period and the general fiscal prudence of the Truman and Eisenhower years enabled the rapid, healthy, sustainable growth of the 1950s and 1960s to proceed absent any material increase in the public debt and absent inflationary pressures on prices.

This began to change during the Kennedy administration but it was under Johnson and Nixon that traditional American fiscal convervatism was shown the door for good. From this point forward, the tone of the book changes dramatically as Stockman initiates a devastating assault on the conventional wisdom: The entire left-right narrative of US politics is demonstrated to be a great charade. Even the early Reagan years in which Stockman was a direct policy participant are shown to be an exercise in the relentless growth of government, associated deficits and debt. As he explains it, “Rather than a permanent era of robust free market growth, the Reagan Revolution ushered in two spells of massive statist policy stimulation.” Indeed, Stockman characterises the Reagan and Bush years as a ‘Keynesian Boom’.

As Stockman explains, for all the talk to this day of Reagan’s fiscal conservatism, the only meaningful conservative policy victory of the time was achieved by the Fed, not the government. Paul Volcker did what was required to stabilise the dollar and bring down inflation following the disastrous stagflationary 1970s, the inevitable consequence of Johnson’s and Nixon’s fiscal largesse, the hugely expensive Vietnam war, soaring government deficits, de-pegging the dollar’s link to gold and the Fed’s accommodation of, among other associated phenomena, higher crude oil prices via OPEC.

As is the consistently the case throughout the book, however, Stockman highlights the links between failed economic policies and their unfortunate social consequences: The relentless growth of moral hazard and crony capitalism. Once Volker had left the stage, replaced by Alan ‘Bubbles’ Greenspan (sic), he explains how the Fed began de facto to target asset prices, in particular the stock and housing markets, and that “Under the Fed’s new prosperity management regime … the buildup of wealth did not require sacrifice or deferred consumption. Instead, it would be obtained from a perpetual windfall of capital gains arising from the financial casinos.” Wow.

That’s right, for decades the stock market has been a financial casino, rigged as desired by the Fed to (mis)manage the economy, and now all that is left is a “bull market culture” that has “totally deformed the free market.”

Stockman also points out how the decades leading up to 2008 were replete with ‘foreshocks’ of the eventual financial earthquake. For example, there was the S&L crisis of the late-1980s and early 1990s. There was the Long-Term-Capital debacle. And each and every time that the Fed’s economic management led, either directly or not, to near-calamity, the bailout beneficiaries were enriched anew.

With most of Stockman’s criticism is directed at Washington, Wall Street and the Fed, he nevertheless reserves some for the non-financial corporate sector. As he explains:

Alongside the Fed’s cheap credit regime, there arose a noxious distortion of the tax code best summarized as ‘leveraged inside buildup’. The linchpin was successive legislative reductions of the tax rate on capital gains that resulted in a wide gap between high rates on ordinary income and negligible taxes on capital gains. This huge tax wedge became a powerful incentive to rearrange capital structures so that ordinary income could be converted into capital gains.

In Stockman’s view there is thus plenty of blame to go around. On a few occasions he even criticises the defence establishment, holding up Eisenhower as the last example of Pentagon budgetary discipline. While he hardly comes across as a dove in foreign policy, he is certainly not as hawkish as recent administrations and he points out a handful of examples of failed defence policies and budgetary largesse past and present. 

Beyond left and right

Readers who attempt to understand this book according to any variation of the current economic policy mainstream or through the obsolete left-right narrative of US politics will struggle to understand Stockman’s independent perspective. The Great Deformation is written by an old-school, small-government ‘Eisenhower Republican’ and champion of the free-market who perceives more clearly than most just how far the insidious crony-capitalist rot has spread, whether it be facilitated by purportedly left-leaning ‘regulation’ or encouraged by right-leaning tax-reform. As Stockman repeatedly demonstrates, the concept of ‘capture’ applies equally to both.

Perhaps unsurprisingly given the horrifying state of affairs he so cogently describes, Stockman is not sanguine about America’s future. The US is travelling down Hayek’s fabled ‘Road to Serfdom’ as the government and central bank respond to the damaging effects of failed interventionism with escalating interventionism. Indeed, since at least 2008, the evidence is overwhelming that America has been accelerating down that tragic road.

In closing, Stockman offers some ideas that might help the US to reverse course, although he strongly doubts that they will be adopted. If anything, the political winds from both left and right continue to blow in the other direction. No doubt his polemic will be rebuffed by those in power on both sides of the aisle in Congress and his recommendations for reform will go unheeded. That Stockman knows this, but wrote this book regardless, demonstrates his love for America. Anyone sharing that love should read it.


Someone has to pay – will it be you?

The Cyprus banking kerfuffle has ignited a blogosphere storm debating the likelihood that depositors elsewhere, perhaps even ‘guaranteed’ ones, may find themselves on the hook for recapitalising their domestic banks. Largely lost in this discussion however is the unpleasant reality that a substantial portion of the international financial sector has been undercapitalised or even insolvent since at least 2008, if not before. Policy responses to the financial crisis have not changed this fact. Indeed, as resource misallocations are the ultimate cause of bankruptcy or insolvency, the exponential increase in price-fixing distortions in the wake of the global financial crisis ensures that depositors in aggregate are now facing far greater losses than they were back in 2008. Someone has to pay for past resource misallocations even when central banks succeed in sweeping these under the rug of monetary inflation. Will it be you?


You don’t need to live in Cyprus to be aware that banks in numerous countries are woefully undercapitalised, in some cases to the point of insolvency. Sure, regulatory financial accounting conventions allow for a huge amount of smoke-and-mirrors obfuscation, delaying the day of reckoning, but an insolvent bank is insolvent regardless of the regulators’ choices of accounting conventions to apply from one day to the next.

Although the specific distinctions vary from country to country, large banks have multiple sources of capital in their liability structure with varying degrees of seniority. As losses are incurred they are absorbed by this structure, tranche by tranche. First goes the shareholder equity, then the subordinated debt (which includes a great number of interbank derivative positions, about which more later), then the senior debt, then uninsured deposits.

Back in 2008, however, government and central bank officials chose not to follow existing law and apportion losses to banks’ liability structures through appropriate insolvency proceedings. Rather, they chose to go straight to the taxpayers to bail out their respective financial systems, in some cases by outright nationalising institutions. This was done because the institutions in question were deemed ‘too big to fail’ (TBTF) and their insolvency would have threatened to derail the entire financial system.


This policy (mis)judgement, that socialising bank losses served the interests of society, has been the subject of much dispute, including in previous Amphora Reports[1] and, more recently, in David Stockman’s outstanding new book, The Great Deformation (available on Amazon here). Indeed, as one banker scandal after another has come to light since 2008 there has now been a huge banker bailout backlash. Politicians understand that, in the event another crisis hits and the TBTF banks are at risk of failure yet again, taxpayers may refuse to support another systemic rescue. What to do?

Well, behind the scenes, economic officials the world over have been busy putting together working frameworks for how to deal with future bank failures. One recent, prominent example is a joint paper by the US Federal Deposit Insurance Corporation and the Bank of England, in cooperation with the US Federal Reserve and the Financial Stability Board of the Bank for International Settlements, the international bank supervisory body based in Basle, Switzerland [2]. Given its international character and the prominence of the institutions involved, this paper should be understood as a working template for how large international bank failures will be addressed in future. The paper begins with an explanation of the problem (emphasis added):

The financial crisis that began in late 2007 highlighted the shortcomings of the arrangements for handling the failure of large financial institutions that were in place on either side of the Atlantic. Large banking organizations in both the U.S. and the U.K. had become highly leveraged and complex, with numerous and dispersed financial operations, extensive off-balance-sheet activities, and opaque financial statements. These institutions were managed as single entities, despite their subsidiaries being structured as separate and distinct legal entities. They were highly interconnected through their capital markets activities, interbank lending, payments, and off-balance-sheet arrangements.

The paper then proposes what appears, at first glance, to be an entirely reasonable way to deal with a possible future failure of such an institution:

[R]esolution strategies should maintain systemically important operations and contain threats to financial stability. They should also assign losses to shareholders and unsecured creditors in the group, thereby avoiding the need for a bailout by taxpayers. These strategies should be sufficiently robust to manage the challenges of cross-border implementation and to the operational challenges of execution.

Fair enough. How reasonable to actually have a framework in place that allows banks to fail without placing taxpayers on the hook. But as with many apparently reasonable policy initiatives, the devil lurks in the details, specifically in paragraph 13 (an appropriate number perhaps?):

An efficient path for returning the sound operations of the [bank] to the private sector would be provided by exchanging or converting a sufficient amount of the unsecured debt from the original creditors of the failed company into equity. In the U.S., the new equity would become capital in one or more newly formed operating entities. In the U.K., the same approach could be used, or the equity could be used to recapitalize the failing financial company itself—thus, the highest layer of surviving bailed-in creditors would become the owners of the resolved firm. In either country, the new equity holders would take on the corresponding risk of being shareholders in a financial institution. Throughout, subsidiaries (domestic and foreign) carrying out critical activities would be kept open and operating, thereby limiting contagion effects. Such a resolution strategy would ensure market discipline and maintain financial stability without cost to taxpayers.

What this amounts to is a debt-for-equity swap arrangement for the “highest layer of surviving bailed-in creditors.” While in some cases the ‘highest layer’ might be that of the bondholders, in others it would include depositors, as is the case in Cyprus for example. Yet this is to be done while “subsidiaries carrying out critical activities would be kept open and operating, thereby limiting contagion effects.” So what, exactly, are these ‘critical activities’? And what is meant by ‘contagion effects’?

What the authors are referring to here is the interbank market, not only for wholesale lending in the money markets but also for all manner of financial derivatives and the underlying collateral on which they are, in some way, secured. This is what caught regulators by surprise in 2008: following the collapse of Lehman Brothers a fire-sale slump in collateral values led to a cascade of interbank margin calls and the market seized up, threatening relatively well-capitalised firms that had appeared previously not to be at risk. The paper thus implies that the way to prevent contagion in future is to prevent a sudden contraction in the interbank lending+derivatives market.

Think about this for a moment: The interbank market, a leveraged, inverted pyramid of subordinated debt built on top of a comparatively limited amount of senior debt collateral, is to be held intact by regulatory fiat while depositors are ‘bailed-in’ via a debt-for-equity swap. Do you see the sleight-of-hand at work here? Under the guise of protecting taxpayers, depositors of failing institutions are to be arbitrarily, de-facto subordinated to interbank claims, when in fact they are legally senior to those claims!

In other words, regulators are laying the operational groundwork for a new type of banker bailout deemed politically acceptable. The last time around, they went straight to the taxpayers. The next time around, they are going straight to the depositors.

Now it so happens that depositors are never explicity mentioned in the paper. They are always referred to as ‘unsecured creditors’. But the effective meaning of this term is belied by the fact that the proposal assigns the FDIC the job of resolving US-based institutions via the debt-for-equity swap mechanism mentioned earlier. Were the bondholders rather than depositors in primary focus this would not be the case as the FDIC has no direct responsibility for the wholesale, non-depositor sources of credit to US financial institutions.

Finally, consider the brutal, unjust irony of the entire proposal. Remember, its stated purpose is to solve the problem revealed in 2008, namely the existence of insolvent TBTF institutions that were “highly leveraged and complex, with numerous and dispersed financial operations, extensive off-balance-sheet activities, and opaque financial statements.” Yet what is being proposed is a framework sacrificing depositors in order to maintain precisely this complex, opaque, leverage-laden financial edifice!

If you believe that what has happened recently in Cyprus is unlikely to happen elsewhere, think again. Economic policy officials in the US, UK and other countries are preparing for it. Remember, someone has to pay. Will it be you? If you are a depositor, the answer is yes.


What if your deposits are ‘guaranteed’? Does this mean that you will be excluded from abribtrary subordination? Perhaps. Perhaps not. Once officials start changing the rules they have a naughty tendency to keep right on going. That said, perhaps ‘guaranteed’ deposits are indeed sacrosanct in certain countries, if not in Cyprus. (To clarify, ‘guaranteed’ depositors in Cyprus are not participating in the debt-for-equity swap arrangement being implemented there, but they are subject to strict and indefinite capital controls. At best this is a huge inconvenience; at worst, a holding pattern prior to a subsequent future bail-in in the event that the unguaranteed deposits are insufficient to recapitalise the banks. A distinct possibility in my opinion.)

But step back for a moment. What, exactly, is a deposit guarantee? Who provides it? Why, the taxpayer of course. So to the extent that guaranteed depositors do not directly recapitalise failing banks, they do so indirectly as taxpayers. Remember, someone has to pay.

Recall, however, that the entire shift in focus from taxpayer-funded bail-outs to depositor bail-ins originates in the political backlash against the banks. Taxpayers don’t like being on the hook for corrupt bankers’ past mistakes. That said, they don’t much like being on the hook for anything. Take a look around at those large and growing public sector deficits and debts. Guess how they came about. They exist because countries have been resorting to inflation to finance their bloated welfare states as well as banker bailouts.

Economic officials may not care to call this debt-financing inflation, but inflation it is. Those debts are being financed, directly and indirectly, by rapidly expanding central bank balance sheets and associated broad money and credit creation. At some point in future, this monetary inflation will show up in consumer prices. It is just a question of time [3].

So in the end, depositors, guaranteed or not, taxpayers, and anyone not benefiting from inflation is paying for the resource misallocations that caused the insolvency of much of the global financial system. Unless you work for a leveraged financial institution or a government that spends money it doesn’t have, that ‘someone’ who pays probably includes you.


Common sense informs us that real risks can only be insured with real savings. This is one explanation for why countries with low savings rates tend to inflate their way out of economic recessions, rather than to restructure and resume healthy growth through Schumpeterian creative destruction. History suggests that the inflationary process becomes a vicious cycle as inflation further disincentivises savings, resulting in an even lower savings rate, followed by even more counter-cyclical inflation down the road.

As it erodes wealth, however, inflation is not a form of insurance. It is merely a means of reducing the real burden of unserviceable debts by transferring economic resources from savers to borrowers. A nasty side effect of inflation is that it causes resource misallocations and subsequent crises. Neo-Keynesian economic models refuse to acknowledge this but economists of many stripes including Richard Cantillon, Hume, Marx, Lenin, von Mises, von Hayek, Alan Greenspan and even Keynes himself were aware of it. With the notable exceptions of Marx and Lenin they also warned of these hidden dangers. (Marx and Lenin actually encouraged inflation as a means to confiscate wealth from the capitalists and concentrate it in a central bank owned and run by the state. The establishment of a central bank was plank 5 of Marx’s Communist Manifesto.)

To expand on a previous point, to the extent that it is applied to an entire financial system, deposit ‘insurance’ is therefore a misnomer. The only way depositors system-wide can possibly be made whole is by the state issuing a sufficient amount of debt in order to raise the necessary funds from the central bank. But as this is inflation, the very depositors being bailed out are the depositors whose wealth is being confiscated through inflation! System-wide deposit insurance is robbing Peter to pay Peter, so to speak. But if Peter doesn’t notice, will he object?

Sadly, whether we notice or not, the result of this game of robbing ourselves is not zero-sum but rather negative-sum: a ‘dead-weight-loss’ in the economic jargon. This is because the financial system is a huge consumer of misallocated resources that could otherwise be directed toward fulfilling the actual needs and wants of consumers. That’s right: alongside bloated governments, the greatest resource misallocation in the world today is that of the financial system itself, which has grown like a cancer ever since central banks wrestled control of the money supply away from the ‘golden anchor’ that, prior to 1971, largely kept it in check.

In numerous countries there is now much evidence that depositors are re-evaluating their trust in their respective financial systems and voting with their wire transfers. This is entirely understandable. Indeed, although it may go against the conventional wisdom, I would argue that the threat of a bank run is a healthy thing. How else to keep bankers in check, when the present system gives them every incentive to leverage up as much as possible, thereby concentrating profits in their hands yet socialising losses on the depositors and taxpayers via bail-outs, bail-ins and inflation?

How refreshing it would be to see banks competing on claims of depositor security for a change, as opposed to which bank has the friendliest image, the most fashionable logo, is the ‘greenest’, or occupies the tallest building in London or New York? Indeed, such faux competition highlights that banking is an industry sorely lacking in real competition.

Notwithstanding all the evidence to the contrary, some still call the bankers ‘capitalists’. While they’re at it, they might as well call the Communist Manifesto a capitalist work.

[1] The Amphora Report has tackled this issue on multiple occasions. Probably the most extensive discussion was in A TALE OF TWO CRISES, Amphora Report vol. 2 (December 2011). The link is here.

[2] The entire proposal is worth reader can be found at the link here.

[3] For a more thorough discussion of this deflation-into-inflation tangent please see FROM DEFLATION PUSH TO INFLATION SHOVE, Amphora Report vol. 3 (June 2012). The link is here.


Assume the brace position

On rare occasions I make specific, near-term market predictions, most recently in Q3 last year, when I called for a modest equity market correction. As it happened, only a tiny correction occurred, followed by a large subsequent rally taking the S&P500 index to 1,550 this week. Now I am making a similar if bolder prediction: A larger correction, possibly a crash (20%+), appears imminent. There are various fundamental and market technical reasons for this view but these all follow from the same ultimate cause: policymaker activism. The Fed and other major central banks ‘own’ this rally. If a crash occurs, and takes the global economy down with it, let’s place blame where it belongs.

The road to record highs

The old adage, “Don’t fight the Fed,” is one that many investors learn first-hand by taking losses. The printing press can be a powerful thing. But like most if not all powerful things, it has its limits. Think of a chess player able to choose which piece goes where. That might seem quite a power until faced with checkmate, when no further moves are possible.

Having stimulated a large increase in money and credit growth through QE in the second half of last year, the Fed now faces checkmate. Why is this so? Because the surge has now reversed as velocity has plummeted. Year to date, both broad money and private sector credit growth are zero even through the monetary base is growing at nearly a 70% annualised rate [1]. The Fed is, therefore, pushing as hard as ever, but still pushing on a string. Moreover, following on by far the largest amount of artificial fiscal and monetary stimulus ever thrown at the US economy, including during the Great Depression, the string is far longer than that which existed back in 2008.



Although they will not admit this, the Fed is now essentially out of options. Recent talk about negative interest rates is just that: talk. As the NY Fed research staff have already noted, they could not work in practice [2]. Some will argue that there remains an arrow in the quiver, namely the power to outright monetise debt, public and private, and pro-actively debase the dollar. But this would end the dollar’s reserve currency status, something that would greatly reduce the Fed’s power in any case, and it would most probably lead quickly back to some form of global gold standard [3]. (While I and many other sound money advocates would endorse such a policy, I am well aware that the current Fed leadership abhors the thought of wearing a monetary straightjacket.)

It would not be accurate to claim, however, that the previous surge in money and credit growth did not impact the economy. Most probably it prevented the H2 2012 global growth slowdown from being larger than it was. More obvious is that strong growth in money and credit balances changed investors’ risk preferences, such that they decided to hold proportionately more equities than bonds. This has pushed up valuations for the former. Rotation out of bonds has had relatively little impact on prices, however, as the Fed has been buying large amounts of Treasuries and, importantly, primarily in longer maturities, where their buying activities have a much greater price impact as this compresses term premia. (Short-maturity bond prices are primarily a function of short-term interest rates, which are set by the Fed and which have been essentially zero since 2008.)

Celebration on Liberty Street?

So notwithstanding the slowing economy, the Fed has engineered a large stock market rally. No doubt Fed officials are celebrating. Some investors might also be pleased, but it primarily benefits those who want to cash out at high valuations. Corporate insiders, for example, are selling at the fastest rate in years. Many companies are raising capital through either initial or secondary offerings. Such activity is a sign of a market top, however, and should concern the far larger ‘buy-and-hold’ crowd seeking to increase their wealth through a sustained rally.

There are several other reasons to be seriously concerned. First, consider valuations. Naturally a crash is more likely from elevated valuations than from depressed ones. Where are we now? Well, at 1,550, the S&P500 index is valued at around 14x forward earnings. That is not far above the post-1980 average, so may not appear lofty to some, but consider: This historical period includes many years of bubble-like valuations, including 1987, 1997-2000 and 2005-07. Depressed years, such as 1981-82 are less well represented in this sample.

Second, relying on forward earnings may be problematic as they are notoriously overstated relative to realised reality. In the present instance, forward earnings growth estimates are in the double-digits, even though profit margins are already at record highs. If history is a guide, profit margins are highly unlikely to remain this wide for long [4].


Third, the current rally has been characterised by steadily declining volumes. In other words, a relatively small number of transactions have been responsible for pushing up prices. This is in sharp contrast to some research suggesting that a ‘wall of cash’ has been pushing the market higher. (In any case, cash cannot directly push prices higher as for every cash buyer there is also a seller.)

Finally, let’s return to our starting point: Money and credit growth were strong in H2 2012 but this got little traction in actual economic activity. So what has this money and credit been used for? There is much evidence that it has been used as leverage to purchase shares. For example, margin interest on the NYSE is unusually high, at a level associated with previous market crashes.

What credit giveth, it can take away

Applying a little logic, if it is true that, courtesy of activist central bankers, the money and credit growth surge last year is behind the ongoing if increasingly low-volume rally in equities, then a sharp slowing or contraction of money and credit growth should trigger a sharp reversal. If accompanied by corporate profit warnings or other negative headlines, it could precipitate a crash.

As discussed, profit warnings are highly likely to continue in the current environment. Given that there has been nearly zero US household disposable income growth over the past year—in part due to the recent increase in payroll+Obamacare taxes—it is difficult to see how forward earnings expectations of 10%+ can possibly be met. Yes, the foreign sector might be doing better but recent dollar strength will depress those profits when accounted for in dollar terms. Slowing or contracting money and credit plus profit warnings could crash the market. Soon.

The bulls counter these arguments in various ways. Perhaps the most common bullish argument at present is that interest rates are low and will stay low as long as US unemployment remains elevated. After all, this is explicit Fed policy and I began this edition with “Don’t fight the Fed”. But if I’m right and the Fed and other central banks now face checkmate, it makes no difference. The Fed may try to stop a crash but short of trashing the dollar I doubt it can succeed. Of course, if the Fed does intervene and the dollar falls sharply, equity investors will still lose wealth in real if not nominal terms. Checkmate is checkmate.

At this point, the risk/reward for owning equities is tilted in favour of cash. Better still, if you believe that the Fed would at least try to arrest or reverse a crash with additional stimulus measures, would be to acquire safe haven real assets and liquid commodities that cannot be arbitrarily devalued by desperate central banks, including of course gold.

Speaking of gold, it has performed poorly of late. In my view the decline in the gold price is the mirror image of the decline in the equity risk premium. Once risk preferences shifted in favour of equities, yet money and credit growth slowed abruptly, it was absolutely necessary that certain other prices would decline. Not only gold, but copper, crude oil and most agricultural products have also fallen in price. By contrast, the Fed has directly prevented a material decline in bond prices through increased intervention.

Central banks probably have continued buying gold however, just as they were buying at a record pace last year. But as with all things, just because one sector of the market is buying doesn’t mean that prices can’t decline. For example, there are numerous recent reports of commodity hedge fund redemptions, implying forced liquidations of commodity positions. While some commodity hedge funds purport to be ‘market-neutral’, in my experience advising and working with such funds, I can assure you that most retain a long bias. Fund liquidations therefore imply net selling, not net buying.

I don’t disparage holding a commodity long bias, however. Regular readers of the Amphora Report know why: A long position in commodities is in effect a short position in currencies at risk of devaluation: Not just the dollar, but the euro, yen, sterling … you name it. Excessive debts and currency devaluation go hand in hand historically and I see no reason why this time should be different, other than devaluations will be more global than at any time since the 1930s. Indeed, there are reasons to believe they may be larger. Poor demographics and large public sectors in the developed economies imply unusually low productivity growth. This does not bode well for these economies’ abilities to service their vast accumulated debts without resort to large devaluations [5].

In closing, whether or not I am proven right by events, I would encourage my readers to ponder what, exactly, a rising stock market implies when it decouples from the real economy. In my view it is yet more evidence that resource misallocations are widespread; that investment decisions are being heavily distorted via manipulated interest rates and bond markets; that fundamental, value-driven investment is being ‘crowded out’ by raw, undisciplined speculation [6]. This is not the way to grow a healthy economy, although it can, and clearly has, provided short-term stimulus from time to time.

Investors think longer-term than speculators. They also think longer-term than politicians. What is happening now is that the short-termism for which politicians are frequently and rightly criticised has come to dominate the financial markets, the economy and, quite possibly, society generally. History is not kind to societies that operate in an arbitrary, risk-it-all and get-rich-quick way. Long-term investment, savings, thrift and the rule of law tend to result in better outcomes. Central banks are doing far, far greater damage than they realise.

[1] To see just how dramatic these money and credit developments are please see the relevant charts from the St Louis Fed’s weekly US financial data publication here.

[2] For a thorough discussion of the NY Fed paper on negative interest rates please see PAR FOR THE PATHOLOGICAL COURSE, Amphora Report vol. 3 (September 2012). The link is here.

[3] This is, in fact, the central thesis of my 2012 book, THE GOLDEN REVOLUTION, available on Amazon here.

[4] For an excellent discussion of the dangers of relying on forward earnings estimates please see this article by John Hussman here.

[5] The US devalued the dollar vs gold by some 60% in 1934.

[6] This topic was explored at length in a previous Amphora Report, THE ASSET PRICING IMPLICATIONS OF THE GREAT BAILOUT, linked here.

This article was previously published in The Amphora Report, Vol 4, 13 March 2013.


Cooperation breakdown

The evidence of a major breakdown in global economic and monetary cooperation continues to mount. Just yesterday, the G7 released a statement regarding foreign exchange policies, only to be followed by a corrective statement that the market reaction was undesirable. This indicates escalating tensions within the G7. But if the G7 cannot cooperate, how on earth will the G20 do so? Or other countries? We are witnessing in real time a descent into economic nationalism that increasingly resembles the 1920s and 1930s. Then, as now, such nationalism resulted in major economic damage, with every single currency devaluing sharply versus gold, and with every single stock market underperforming gold. History is rhyming, loud and clear.


On several occasions I have predicted a breakdown in international economic and monetary cooperation, most extensively in my book, The Golden Revolution (link here), but also in the pages of this report and in several TV interviews, including an appearance on the Keiser Report just last week (watch here). But I must admit even I was taken by surprise by the astonishing behaviour of G7 officials yesterday.

To much anticipation, the G7 countries (US, Canada, UK, Germany, France, Italy and Japan) released an official communique early in the morning European time regarding their foreign exchange policies. Among other things the statement said that the G7 “will not target exchange rates.”[1]

So far, so clear. The entire statement was also entirely consistent with the previous G7 communique from September 2011, which read in part that “We reaffirmed…our support for market-determined exchange rates.”

Given this degree of consistency between the two statements and lack of any specific mention of the yen, the foreign exchange markets determined that the G7 was giving tacit approval for Japan to continue to weaken the yen, which has declined by 10-15% versus all major global currencies in the past few months. The yen declined by another 1% versus the dollar and euro in the hours following the release of the statement.

Apparently, however, this was not the reaction all G7 members in fact desired. As the yen continued its decline, an unidentified G7 official came out with a highly unusual (and possibly unprecedented) qualifying statement, saying that:

The G7 statement signaled concern about excess moves in the yen. The G7 is concerned about unilateral guidance on the yen. Japan will be in the spotlight at the G20 in Moscow this weekend.[2]

Whoa! Well G7 members are either concerned specifically about the yen or they are not. So it would seem that certain members of the G7 desired to include a specific comment on the yen but that certain other members vetoed this. Now who might that have been? Japan itself comes to mind and, given that Japan has been the biggest single purchaser of US Treasury securities over the past year, it seems reasonable to assume that the US supported Japan with the veto. The UK and Canada have now both said they made no such comment.

Taking the other side would logically have been the euro-area countries. While Germany is widely known to compete with Japan in a broad range of global export markets, there is also a degree of such competition with France and Italy. Indeed, on a per-capita basis, northern Italy is as large a world exporter as Germany, producing a huge range of manufactured goods, including precision machinery vital to many global industries. There are also such pockets in France, including around Paris, Lyon, Lille and Strasbourg. (I am excluding agricultural products here, although both Italy and France are wine and cheese export powerhouses.)

Yesterday’s unusual G7 drama thus appears to confirm what I claimed in my last report, COUNTDOWN TO THE COLLAPSE (link here), that Japan broke a temporary ‘cease-fire’ in the ‘currency wars’ with the sharp weakening of the yen in Q4 last year. In that report I also indicated that the UK was likely the next country to join hostilities.

Sure enough, in a press conference earlier today, Bank of England Governor Mervyn King said that “it’s very important to allow exchange rates to move,” and that “when countries take measures to use monetary stimulus to support growth in their economy, then there will be exchange rate consequences, and they should be allowed to flow through.”[3] These bold comments could be interpreted as embracing rather than eschewing the escalating currency wars. They also indicate that the UK desires a weaker sterling.

If even the relatively closely-knit G7 can’t cooperate in foreign exchange matters, why should we be confident that the G20 can? Well, we shouldn’t be. Quite the opposite.


The G20 is arguably the most important forum when it comes to maintaining international economic cooperation, or potentially revealing the lack thereof. I also mentioned in my last report that a key event to watch will be the upcoming BRIC summit held on March 26-27 in Durban, South Africa. Now as with all such international diplomatic gatherings, discussions and negotiations around key topics and issues begin many weeks or even months in advance. By the time the G20 meet in Moscow this weekend, you can be confident that the official BRIC position on foreign exchange matters is already under discussion.

It is therefore possible that, in one or more statements by BRIC member countries at the G20, we receive a hint or two as to the evolving BRIC position. But what is it likely to be? How do the BRICs feel about the weaker yen, for example? About the fact that the South Korean won and Taiwan dollar have recently weakened and, just this week, have been joined by the Malaysian ringitt? China, for one, finds itself suddenly surrounded by sharply weaker currencies. China is also embroiled in some escalating territorial disputes with Japan and other neighbours regarding sovereignty over the South China Sea. (Note the name!) In this context, should we be surprised that China appears to have ceased allowing the yuan to rise versus the dollar of late?

If China ceases to allow the yuan to rise, what are the chances that the other BRICs fall in line with China in the ‘currency wars’ and do the same? And if so, how is the US likely to respond? With the labour market still very weak and yet president Obama is now pushing for a rise in the minimum wage to $9/hr, is the US going to tolerate a strong dollar? The combination of higher payroll and ‘Obamacare’ taxes, a higher minimum wage and a stronger dollar would go a long way toward reversing the modest decline in the unemployment rate over the past year.

The euro-area may have even more immediate issues with the strong euro. With Greece, Spain and Portugal still mired in a deep recession, Italy teetering on the edge and France and Germany now entering at a minimum a mild recession and possibly something worse, further euro strength will be considered unwelcome.

(The German Bundesbank is an important exception here. President Weidmann said earlier this week that, “If more and more countries try to depress their currency, it will end in a depreciation competition, which will only produce losers.”[4] He also specifically criticised politicians for weighing in on currency policy, saying that “politicians should hold on to the established division of labour.”)

Now the issue of whether euro-area politicians or the ECB should be in charge of currency policy has long been in dispute. Even before the euro came into existence it was hotly contested. As it happens, the ECB has intervened in the foreign exchange markets before, back in 2000, but to strengthen the euro. The ECB has never intervened to weaken it.

This unwillingness to intervene to weaken the euro is understandable given that, since the introduction of the euro in 1999, the rate of euro-area CPI has only once strayed materially below the ECB’s 2% reference level for any period of time.[5] It would seem at odds with the ECBs mandate to maintain price stability were the ECB to intervene to weaken the euro unless the rate of CPI fell well below 2% and policy rates were already very low, implying a limited ability to prevent a further decline. As the chart of euro-area CPI below shows, there has been only one such period and, it so happens, this was primarily a base effect resulting from a previous spike. At present, the rate is 2.2%.



So where does this leave us? We have ample evidence that what is happening is not just a failure to communicate but a failure to cooperate. What are the implications for the financial markets?

First, foreign exchange markets are likely to become unusually volatile. This may present a headache for policymakers but when markets sense that major policy disputes are escalating they begin to force the issue by building positions.

Second, if FX volatility becomes severe enough policymakers may resort to extreme actions that spill over into other markets. For example, following a huge surge in the Swiss franc on safe-haven buying in 2011, the Swiss National Bank (SNB) chose to put in a floor of 1.20 on the EUR/CHF exchange rate, committing to ‘unlimited’ purchases of euro assets if so needed. This has resulted in an explosion of the SNB balance sheet, something that could become hugely inflationary under certain circumstances.

More dramatic would be for countries to raise trade barriers in an effort to protect domestic industries and jobs. For all the talk of ‘free-trade’ in the world, the reality is far different. A great many industries and products are subject to various kinds of frequently minor trade barriers, some of which are quite well hidden to those not involved in a particular industry or product. A political response to currency devaluations by competitors could well be to increase existing barriers or erect entirely new ones.

As I have written before, trade barriers can be hugely damaging to corporate profitability. Imagine if all of a sudden euro-area countries or US states sought to protect domestic firms and jobs by charging a 10% tariff on any goods crossing the border. With few exceptions, corporate profit expectations would collapse and the stock markets would immediately follow suit. Now extrapolate this to the global level and imagine what a trade war would do to the multinational companies that comprise the vast bulk of major world stock market capitalisation. It would make the crash of 2008 seem tame by comparison.

Third, countries might enact capital controls to stabilise their exchange rates but at the expense of preventing capital from moving efficiently across borders. Capital controls are to capital flows what trade barriers are to exports and imports and would also crush corporate profitability. Imagine trying to raise capital, rollover debt, or redeem multinational corporate debt or shares in a world of capital controls. Global financial markets in general would largely seize up. Risk premia would soar. Valuations would collapse.

Were the US itself to take the lead in any one of these extreme actions, the dollar would from that day forward cease to enjoy its long-held dominant reserve currency status and the comparatively low borrowing costs this confers. Given the huge, escalating federal, state and municipal debts, even small increases in debt servicing costs could spiral into a public debt crisis. The Fed would no doubt come under pressure to buy the bonds required to bring such a crisis under control but with global savers less able to absorb these new dollars due to capital controls, the dollars would circulate primarily domestically, leading to a potentially huge surge in price inflation.



The colossal global debt problem, associated currency wars, looming trade wars and possible capital controls collectively threaten the real value of financial assets generally through some combination of devaluation, default and inflation. In this unusual and unfortunate situation, commodities provide a form of insurance. They cannot be ‘printed’ or otherwise arbitrarily devalued. They cannot default. They will always find some demand. Indeed, amid trade barriers and capital controls some basic commodities taken for granted today may command a large premium due to supply shocks.

As it stands now, however, commodities appear cheap relative to financial assets. Equity markets have risen strongly of late, leaving commodities the most undervalued in relative terms since 2008. Bond markets may have sold off slightly in recent weeks but in any reasonable historical comparison remain extremely expensive as a result of unprecedented and unsustainable central bank buying.

It is impossible to know just which commodities are most likely to rise in price. As a form of alternative money, gold and silver are likely to rise, in particular if there is even a partial official remonetisation of these metals as a replacement for highly unstable fiat currencies.[6] But trade barriers could restrict the flow of oil and foodstuffs, pushing up their prices to unprecedented levels.

The best action investors can take is to diversify their exposure across a broad range of essential commodities and those companies that produce them domestically and abroad. These companies are likely to retain their pricing power amid trade wars, although they may be subject to nationalisation in extreme cases.

This article was previously published in The Amphora Report, Vol 4, 12 February 2013.

[1] For more details please see this Bloomberg News story here.

[2] This was reported by Bloomberg News here.

[3] These statements were reported here.

[4] President Weidmann’s comments were reported by Bloomberg News in the article linked here.

[5] I use the term ‘reference’ here because the ECB lacks a formal target. The ECB’s mandate is to maintain price stability as the ECB so defines it. The ECB has long held that a rate of 2% is consistent with price stability and so 2% is a reference only, not a target.

[6] There is still much nonsense out there about how there is “too little gold or silver” in the world to serve as money. As I am fond of pointing out, the amount of gold and silver may be relatively fixed by weight and volume but not by price, which need only rise sufficiently.


Countdown to the collapse

On multiple fronts there appears to have been a resumption of hostilities in the global currency wars. A subtle indication of this is the recently released report, ‘Gold, the Renminbi and the Multi-Currency Reserve System’ (PDF), which I believe is highly significant for two reasons: First, it demonstrates that major global actors are now keenly aware and frightened of the possibility of a major breakdown in international monetary relations. Second, it suggests that these same actors are trying to contain the growing demand for gold as an alternative reserve asset and pre-empt an uncontrolled gold remonetisation. These efforts will fail. A collapse of the current, unstable global monetary equilibrium is inevitable. Recent events indicate that the countdown has begun.


Curiously, in the second half of 2011 and through most of 2012, notwithstanding the escalating euro-crisis, US ratings downgrade, Japan’s protracted nuclear disaster and sharply divergent global growth rates, there was surprisingly little volatility in foreign exchange markets. EUR/USD traded mostly in the historically narrow range of 1.40-1.25. USD/JPY was in a range of from 76-82. The Chinese renminbi held between 6.4 and 6.2. GBP/USD moved within 1.54-162. The Swiss franc was also steady at around 1.20 versus the euro, although this was the result of an explicit Swiss policy of capping the franc at that level.

In retrospect, it appears that this period was characterised by a general ‘cease-fire’ in the global currency wars ignited by the global financial crisis of 2008.[1] Rather than attempt directly to devalue currencies to stimulate exports at trading partners’ expense, the focus during this period was primarily on measures to support domestic demand.

There has now been a resumption of hostilities. The first shots were fired by the Japanese, where national elections were held in December. The victorious LDP party campaigned on a platform that, if elected, they would increase the powers of the Ministry of Finance to force the Bank of Japan into more aggressive monetary easing. The LDP also has voiced support for either a higher BoJ inflation target or a nominal GDP growth target.

Combined with poor economic data, this had a dramatic impact on the yen, which has subsequently declined by about 10% versus the dollar and 15% versus the euro. This is the weakest the yen has been in broad, trade-weighted terms since 2011.

Now it is understandable that Japan should desire a weaker yen. Japan is no longer running a trade surplus, in part because it is importing a record amount of energy following the decision to scale back the production of nuclear energy. Moreover, demographics are such that the proportion of retired Japanese is growing rapidly. As Japan’s ageing population draws down its savings to fund retirement, this implies that Japan will be saving less and consuming more relative to the rest of the world.

But while Japan has an interest in a weaker yen, many other countries have an interest in weaker currencies too. Much of Asia has been following a classic, mercantilist growth model ever since the Asian credit/currency crises of 1997-98, seeking to export more than they import. They are still inclined to follow this model, as it has succeeded in the past.

Of course it is impossible for all countries to be net exporters. The US is by far the world’s biggest importer. But given structural economic problems and associated high unemployment, US policymakers also have reasons to desire a weaker currency to stimulate exports and jobs. Much the same is true of the UK, arguably the leading candidate for the next big devaluation. Then there is the euro-area, which is suffering under a huge debt burden and desires to stimulate exports abroad to offset ‘austerity’ at home.

The BRICs (Brazil, Russia, India, China, South Africa) and other developing economies are well aware of mature economies’ problems and do not want to be the ones that pay for what they perceive, quite justifiably, as economic hypocrisy. Just who has been living beyond their means? Who has been borrowing and consuming, rather than saving?

It does, of course, take two to tango. The BRICs have been financing mature economies’ largesse—including financial bailouts—with their surpluses. But as the BRICs have stated on multiple occasions, they would far prefer for the developed economies to take their necessary economic medicine at the local, structural, supply-side level rather than to try and pass the pain of adjustment off on them.

A recent sign of such concern includes some rather provocative statements by Russian central banker Alexyi Ulyukayev. Russia is currently the Chair of the G-20 countries who seek to cooperate on global economic matters. Back in 2009 the G-20 agreed not to engage in competitive currency devaluations. Well they’re not exactly cooperating at present according to Mr Ulyukayev, who has specifically accused Japan of breaking the cease-fire: “Japan is weakening the yen and other countries may follow,” he said recently. South Korea, one of Japan’s closest competitors in several major industries, has warned of possible retaliation for the weaker yen and both South Korea’s and Taiwan’s currencies weakened sharply this week. Even Norway, with a healthy economy at present, has recently indicated that it is concerned by the strength of the krone.[2]

The sad fact of the matter is, currency wars (ie competitive devaluations) are ‘zero-sum’ at best. At worst, they severely distort global price signals, thereby misallocating resources, and eventually morph into trade wars, in which economic protectionism destroys the international division of labour and capital, making economic regression all but certain. The 1920s/1930s are a classic case in point but there were similar such episodes in the 18th-19th centuries, the era of mercantilist economic policy debunked by, among others, Adam Smith and David Ricardo. (While the classicists were right about mercantilism, it should be noted that classical economic theory is deeply flawed in key respects.)

Given the destructive power of currency and trade wars, it should come as no surprise that policymakers in the developed economies are increasingly desperate to find a way to de-escalate and contain the conflict. But is this possible?


Perhaps the best indication of growing policymaker desperation is a recent report prepared by the Official Monetary and Financial Institutions Forum (OMFIF), on behalf of the World Gold Council. In the report, the OMFIF argues that the international monetary system is approaching a transformation from a mostly ‘unipolar’ system centred around the dollar, to a ‘multipolar’ one of multiple reserve currencies, including the Chinese renminbi, which at present comprises only a tiny fraction of global FX reserves.

Most important, the report recognises that monetary regime change is fraught with uncertainty. History is clear on this point. Also clear is that, historically, periods of global monetary uncertainty have been associated with central bank (and private) accumulation of gold reserves and, by association, a rising price of gold.

According to the OMFIF, this is the explanation for why central banks are accumulating gold today. It boils down to increasing uncertainty or, if you prefer, decreasing trust between countries, a natural consequence of the currency wars. OMFIF assumes that, in the coming years, uncertainty and associated gold accumulation will continue to increase, placing further upward pressure on the gold price.

It is difficult to argue with any of that. Indeed, in my book, The Golden Revolution (available here), I illustrate how the 2008 global financial crisis critically destabilised the international monetary system. In particular, the dollar is losing its dominant reserve currency status, yet there is no other existing fiat currency that can replace it. The euro has issues, the yen has issues and the renminbi has issues, although it is the ‘rising star’ in this group.

The OMFIF report then makes a recommendation that the best way to reduce the unavoidable monetary uncertainty ahead is to acknowledge that there should be a more formal role for gold to play in the international monetary order, in particular, that it should be included in the Special Drawing Rights (SDR) basket as calculated by the International Monetary Fund (IMF). The SDR is a global reference point for currency valuation and IMF member countries’ capital shares are denominated in SDRs.

This is a formalisation of what was first proposed by World Bank president Robert Zoellick back in 2010. In a Financial Times article that I believe will be noted by monetary historians in future, he wrote that gold was already being treated as an “alternative monetary asset,” and that the international monetary system “should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values.”[3]

The OMFIF report also suggests expanding the SDR basket to include all the ‘r’ currencies, not only the renminbi but also the Indian rupee, the Russian rouble, the Brazilian real and the South African rand. This would be a formal recognision of the rising economic power of all the BRICs, not just China, and pave the way for their currencies’ use as reserves.


Bureaucrats are naturally drawn to bureaucratic ‘solutions’ to problems. But cooperative solutions become unworkable when cooperation breaks down, as is increasingly the case in global monetary relations. In this context, the OMFIF report, while it sounds nice on paper, is a futile attempt to hold an unstable equilibrium together. The fact is the BRICs no longer trust the mature economies in monetary affairs.[4] Lacking such trust, the only viable way forward is to ‘de-nationalise’ money for international trade, thereby disarming those who would opportunistically engage in currency wars.

Gold is the only such non-national money, a currency that cannot be printed or otherwise manipulated by one country at the expense of another. Its supply is strictly limited by that which can be got out of the ground at economic cost within a given period of time. Thus gold stands in sharp contrast to all unbacked fiat currencies, the weapons of the currency wars. The OMFIF report dances around this fundamental difference between the two but ultimately stumbles. Yes, the OMFIF report recognises that:

[T]he previously dominant western economies have attempted to dismantle the yellow metal’s monetary role, and – for a variety of reasons – this has comprehensively failed. Gold thus stands ready to fill the vacuum created by the evident failings of the dollar and the euro, and the not-yet requited ambitions of the renminbi.

But notwithstanding the recognised failings of fiat currencies and persistence of gold, the report then moves on to recommend that gold and the major fiat currencies be treated as equals in the future monetary order, specifically, by:

…extending the SDR to include the R-currencies – the renminbi, rupee, real, rand and rouble – with the addition of gold. This would be a form of indexation to add to the SDR’s attractiveness. Gold would not need to be paid out, but its dollar or renminbi or rouble equivalent would be if the SDR had a gold content. By moving counter-cyclically to the dollar, gold could improve the stabilising properties of the SDR. Particularly if the threats to the dollar and the euro worsen, a large SDR issue improved by some gold content and the R-currencies may be urgently required. (Emphasis added.)[5]

From ‘dance’ to ‘stumble’ may be the wrong metaphor here, unless the stumble is meant to serve as a distraction for some slight-of-hand on the stage. Did you catch the subtle trick of logic in the above?

Allow me to explain. The “failings of the dollar and the euro” vis-à-vis gold are indeed “evident”: This is why central banks everywhere are in a scramble to acquire more gold and, in some cases (eg Germany, Venezuela, Turkey) to strengthen their custody of it through repatriation and changes in regulations. The dollar and the euro are no longer trusted as stores of value, at least not to anywhere near the degree that they were in years past.

But if your agenda is to try and contain the scramble for gold and prevent it from further displacing fiat currencies in reserves, how convenient if you implemented an international monetary system that would limit, through official, global arrangements, the degree to which gold could compete as an international money while still allowing for whatever amount of fiat inflation policymakers believe is required to devalue their excessive debts.

If gold “need not be paid out” then, as the price of gold rises, you just print more paper currencies as required to make up the difference! In other words, gold would be unable to serve as a brake on a general global monetary inflation. And “if the threats to the dollar and the euro indeed worsen”, then yes, just print more of those SDRs—a basket of dollars, euros, renminbi, etc—and who cares if the price of gold rises in tandem? You’re still inflating!

In context of the changed global economic landscape, the OMFIF report thus reads as a desperate attempt to sue for a compromise peace in the currency wars, to find a basis for agreement between the US, euro-area, Japan, and China and the other BRICs, to inflate in coordinated fashion thorugh SDR issuance, while at the same time keeping the golden genie in the bottle where, according to central-planning inflationists, it belongs.

Of course, just because an olive branch is extended does not mean it will be accepted. Is it really in China’s or the BRICs’ interest to participate in such an arrangement? Does China really want the ‘failing’ dollar and euro to keep depreciating? Or might China want to get paid for its exports in hard currency for a change?

Again, it all comes down to trust. Currency basket arrangements such as the euro or, as the OMFIF proposes, a global SDR with a token role for gold, only hold together as long as all the major players perceive that they serve their interest. The moment a player perceives otherwise, the system, lacking sound money foundations, falls apart. If the OMFIF report is indicative of the next step in the evolution of the global monetary system, then the past and current failures of the dollar and euro are destined to become the future failures of the SDR.

China must know this. I suspect the other BRICs do too. And numerous small countries, hardly irrelevant in the matter, are watching intently to see where this goes, while accumulating gold in the meantime, unsure of the outcome.


If the developments discussed above seem unprecedented, think again. We have been here before, namely, in the mid- to late 1960s, when the US and other Bretton Woods participating countries were struggling to maintain the gold price at $35/oz. There was lots of monetary inflation in the US and elsewhere by the mid-1960s and it was assumed by many that this would lead to price inflation in time.

European central banks, most of whom had accumulated substantial dollar reserves, were beginning to swap these for gold. Private investors sought to protect themselves with gold purchases. By 1967, while the official price for gold remained $35/oz, there was steady upward pressure on the market price in London. ‘Two-tier’ markets create arbitrage opportunities and, as more speculators got in on the game, the upward pressure on the gold price intensified.

In 1967, France, already having indicated from early 1965 that it was dissatisfied with the dollar-centric Bretton Woods system, abruptly withdrew from the pool. While this was a clear message to all that the official $35/oz gold price was unsustainable, encouraging yet more speculation, at the same time it meant that the remaining London gold pool participants had to cover for France’s significant absence by making even more gold available to the growing number of buyers.

This unsustainable arrangement lasted less than a year, with the pool collapsing entirely in 1968. The situation was now critical as the monetary system was without solid foundation. The upward pressure on the price of gold intensified yet again. The Federal Reserve was now frightened that a run on the dollar was imminent, with the pound sterling already under renewed attack. At one Fed meeting that year it was claimed that, “the international financial system was moving toward a crisis more dangerous than any since 1931.”[6]

By 1971 the day of reckoning had arrived. The US had continued to sell gold into the market to suppress the price and to convert foreign reserves on demand into gold since 1968 but when even the UK was asking for a substantial portion of its gold back in summer 1971, it was clear that this effort was futile. Either the US would run out of gold or it would allow the gold price to rise and the dollar to ‘float’, that is, to devalue substantially.

President Nixon opted for the latter course, as he announced to the world on 15 August that year. The dollar was devalued and gold convertibility suspended indefinitely as a ‘temporary’ measure. But why did the world continue to use dollars as reserves when these were unbacked by gold? Because the US was still by far the largest economy in the world, the biggest importer and exporter. And while US finances were deteriorating at the time, they were in far, far better shape than they are today, with trade and budget deficits tiny as a percentage of GDP. Today, the picture is the complete opposite. US finances are in a far worse state than those of the BRICs.

The US and the other developed economies are thus no longer in a position to dictate terms in international monetary matters. The BRICs have made the point clear. They are going to begin to demand hard currency in exchange for their exports. A plan to this effect could be announced as early as their annual spring summit, held this year in Durban, South Africa, on March 26-27.


If the recommendation to accumulate gold in advance of its remonetisation for use as an international money seems obvious, perhaps less obvious is to reduce holdings of bonds. Why should a remonetisation of gold lead to higher bond yields/falling bond prices? After all, the economic dislocations associated with international monetary regime change could well tip the world into yet another recession as the associated economic rebalancing takes place.

While we have come to associate rising yields with economic recoveries and falling yields with recessions, in fact, on a sound money foundation this relationship does not hold. Back when the world was on the gold standard, for example, yields sometimes rose in recessions and declined in recoveries. This is because the central bank was unable to manipulate the bond market with monetary policy.

Take the euro-area today as a contemporary case in point. As Greece, Portugal and Spain have tipped into deep recessions, their bond yields have risen as they lack national central banks which can buy their bonds with printed money. And investors have a choice whether to hold these bonds, or to hold the bonds of sounder euro-area governments, such as Germany, hence the wide spreads that investors demand in compensation.

A return to gold-backed international money will have much the same effect but at the global level. US Treasuries and other bonds will need to compete more directly with gold itself as a store of value or as official reserves. Interest rates will therefore need to rise to compensate investors for the very real possibility that the supply of bonds will just keep on growing to finance endless government deficits while the supply of gold remains essentially fixed.

Now I am under no illusions here. If the US, euro-area, UK and Japan face sharply higher borrowing costs in future, they are going to have debt crises similar to those faced by Greece, Portugal and Spain today. Indeed, with no one willing or able to bail them out, the associated crises may be more severe. The US and other indebted countries may resort to capital controls and even to selective default on their debt, such as that held by foreigners abroad.

If so, this will be another major escalation in the currency wars, one that will begin to resemble the 1920s and 1930s in its intensity. Those were sad decades, to be sure, in which much of the global middle class saw its savings wiped out at least once and, in some cases, twice. They didn’t care whether this occurred via inflation/devaluation or via deflation/default. Investors today shouldn’t care either. They should accumulate gold and certain other real assets in limited supply. These are the ultimate insurance policy against inflation, deflation, devaluation, currency and trade wars, financial crises, monetary collapse … you name it. The time to do so is running out.

[1] In the Amphora Report I have long followed the ‘currency wars’. My first take on the subject, BEGUN, THE CURRENCY WARS HAVE, dates from September 2010. The link is here.

[2] These various statements were reported in this Bloomberg News article that can be found here.

[3] Robert Zoellick, “The G20 Must Look Beyond Bretton Woods II,” Financial Times, 7 November 2010.

[4] Please see THE BUCK STOPS HERE: A BRIC WALL, Amphora Report vol. 3 (April 2012). The link is here.


[6] Amateur historians take note: Federal Reserve Open Market (FOMC) minutes may be tedious for the most part but occasionally there are real gems to unearth, as is the case here. However, the transcripts are only released with a five-year lag. It will be interesting to see what was discussed—and not redacted—from transcripts from 2008 and 2009, when the Fed was involved in bailing out the bulk of the US financial system.

This article was previously published in The Amphora Report, Vol 4, 30 January 2013.


A conversation with John Llewellyn

Not your typical Cobden Centre interview, but hopefully thought-provoking …

John Llewellyn is one of the most highly regarded economists in Europe, having worked in the private sector, academia, and national and supranational policy institutions. He now runs his own consultancy, advising governments, multinational corporations, and institutional and private investors. He was educated in the neo-Keynesian tradition but, on becoming an applied economist, he became what he terms “an evidence-based eclectic”. As such John recognises the potential explanatory limitations of the Keynesian paradigm for a world of excessive debt and unprecedented policy activism. At present, he is concerned about what appears to be an unfolding, synchronised global cyclical downturn amidst what remains a structurally weak growth environment. The consensus is in his view too complacent in believing that recent policy stimulus actions will either lift growth rates or reduce debt burdens meaningfully over the coming 1-2 years.


Born in England, but raised in New Zealand, John Llewellyn attended The Victoria University of Wellington for his BA (Hons) degree and then Oxford University, where he obtained his DPhil. He then researched and taught at Cambridge University for nearly ten years, and was a Fellow of St John’s College. Thereafter, he moved to Paris to the Organisation for Economic Cooperation and Development (OECD), the supranational economic policy analysis and forecasting organisation, where he rose from Head of Economic Forecasting to Deputy Director for Employment, and finally Chef de Cabinet to the Secretary General. In 1995 he moved to London, where he was Global Chief Economist for Lehman Brothers until 2005, when he became the firm’s Senior Economic Policy Adviser. Following the bankruptcy of Lehman Brothers he set up his own firm in 2009, Llewellyn Consulting, which specialises in thematic macro research (e.g. demographics, technological innovation, climate change) and economic risk assessment.

I came to know John during my time at Lehman Brothers in the mid-2000s, where I was the European Head of Interest Rate Strategy. We worked closely together to link economic forecasts and risks with practical, implementable strategies for the global interest rate and currency markets.

We both became deeply concerned by developments in global housing and credit markets in the mid-2000s, in particular in the US, agreeing that a dangerous bubble was forming in association with global trade and capital flow imbalances. On numerous occasions we presented our counterparts and other colleagues in New York with this view. It was not well received.

When the crisis began to unfold in 2007, and then intensified in 2008, neither of us was particularly
surprised. We did not, however, predict that not only Lehman Brothers but also a number of major financial institutions would fail. The intensity of the crisis and the aftermath of tepid growth, together with lingering structural problems and global imbalances, have caused both of us, each in our own way, to change the way we think about the world, and question some core assumptions. In general, this process has led us to become decidedly less optimistic in how we see the economic future.

John and I continue to speak on a weekly basis, and get together at least once a month to review global economic developments and assess the risks, as we see them. Recently, John identified an associated set of economic risks that could well result in a much sharper downturn in global growth over the coming year than the consensus expects. What follows below is a rough amalgamation of several informal, recent conversations between us about how John came to this view; about the risks associated with excessive debts and so-called ‘financial repression’; the future of the euro and possible alternatives to the current set of national economic policy choices. The conversation then turns to the financial markets.


JB: John, in your most recent economic risks publication, you write that, in 2013, economic activity in nearly every part of the world is likely to slow. That is highly unusual. Normally there are at least a few pockets of strength that support demand for weaker economies. If that is not going to be the case, does this raise the risk of a generally sharper downturn across the world?

JL: It does. Conventional, single-economy, economic models assume stable and reasonably large fiscal and monetary multipliers. These are derived from historical observation. But there is little evidence about synchronised global downturns, so most of the data are irrelevant, or at least potentially misleading: policymakers are therefore likely to underestimate the size of the coming slowdown. This analytic point used to be one of the major reasons for, and messages from, the OECD; but the message is heard less these days. Were the US, the EU, or China to get traction with new stimulus in the near-term, then the slowdown would be less likely to be synchronised, and the consensus, as best I can tell, would be more likely to be correct that 2013 growth will be similar to 2012. On the other hand, if there is a further move toward outright tightening of policy, say due to the fiscal cliff in the US, or enhanced austerity in Europe, things could get worse.

JB: Let’s step back for a moment. Neither the fiscal cliff nor austerity would be an issue if debt burdens were lower, or growth higher, or both. Manageable debts are a nonissue. How did the developed world get into this mess? Is it purely a result of the financial crisis, or were there longer-term, structural forces at work, largely unseen by the policy mainstream?

JL: To some extent the answer differs from country to country. Some, like Greece and Portugal, were simply consuming beyond their means, and had to rein in total expenditure. Others, like Spain and Ireland, as well as the UK and the US, let leverage in their financial systems build up to such an extent that, when assets prices collapsed, the authorities had little option but, in effect, to nationalise the resulting private sector debt in order to keep the financial system functioning. But overlaying this in virtually all economies was, and is, a set of promises made by generations of politicians that they will be unable to meet, not least given the ageing of populations.

JB: Doesn’t this bring a central tenet of Keynesian economics into doubt, that you can borrow your way to prosperity? While countercyclical government borrowing and spending seems reasonable on paper, we now have quite a bit of empirical evidence that these debt burdens accumulate over time, that governments embrace deficit spending but eschew the offsetting surpluses required to keep finances in balance. Going forward, should we have faith that policy can be more responsible?

JL: The central tenet of Keynesianism is subtler than the bastardised version that came to be taught later. I was taught what I would term ‘classical Keynesianism’ in New Zealand, and had it reinforced at Cambridge by former colleagues of Keynes, such as Joan Robinson, Austin Robinson, Richard Kahn, Nicholas Kaldor, as well as more recent luminaries, such as Geoff Harcourt and John Eatwell. This central tenet is that borrowing works if it takes GDP back towards full employment, and fairly quickly, and if it kindles, or re-kindles, Keynes’ ‘animal spirits’ – the entrepreneur’s intrinsic faith such that he or she is willing to incur the certain cost of borrowing now in the expectation that he or she will earn a return in an unavoidably uncertain future. In other words, as Robin Matthews pointed out in the 1960s, Keynesianism works only if people believe it will work. Or, as Keynes observed, economies are held up by their own bootstraps.


JB: Returning to the fix we appear to be in, I know you have thought extensively about policies that limit financial freedom in order to subsidise government debt service and reduction, collectively termed in the jargon as ‘financial repression’. Could you elaborate on this and how you see it developing going forward?

JL: Basically in such circumstances, governments do four things: they encourage inflation; they instruct the central bank to keep short rates and bond yields along the curve low; they oblige savers (including pension companies and insurance companies) to hold an increased proportion of their assets in government bonds; and they impose capital controls to prevent savers from taking their capital abroad in search of higher real yields.

JB: But does it work? Recall that Carmen Reinhart made explicit that ‘financial repression’ is historically associated with failing third-world governments desperate for public revenue. What does this imply about the developed world today? Are you troubled by this? Does it not seem, potentially, to be a road to ‘financial tyranny’? A road to Argentina, to name an obvious case in point?

JL: It does work; but of course it is troubling. The West has used these policies before. The UK, the US, and France amongst others did exactly what I have summarised to reduce public debt as a proportion of GDP after WWII. But there was a difference then: As various people of that generation have told me, they were completely aware at the time that the war bonds that they were buying would not be worth much, if anything, after the War. But they bought them nevertheless, because that was the price for having a chance to defeat tyranny. I am not sure that the younger generation will be so tolerant today with politicians and political parties who made promises only to get elected, and which they knew they could not fulfil.


JB: You were, to use a colloquial term, present at the creation of the euro. You knew some of the architects. You observed, indeed contributed to, some of the planning, as well as the implementation. And now you have observed the crisis unfolding. You have always held that the euro is a political project, and remains so. You are also on record as having more confidence than most that the euro will not only survive but that it will in time prove its detractors wrong, that it will enhance European economic performance through greater stability and integration.

Given recent developments, this seems a bold view to some. Would you care to elaborate?

JL: All economists involved in the creation of the euro knew that its initial institutional arrangements contained a number of important flaws. But those ‘present at the creation’ also knew that Chancellor Kohl and President Mitterrand knew this too. The Kohl / Mitterrand calculation was that they were the last generation fully able to appreciate the enormity of war in Europe; that they would bind their two economies together by ‘a thousand silken threads’; and that they would hope that when, in the future, the project ran into problems, their successors would choose to fix them rather than allow the union to break up. So far, the gamble has paid off. Of course, the British do not see it that way. They were told by Edward Heath that this was an economic union, and they believed him. And British economists in turn analyse the union purely in economic terms. That is a generalisation: but you get the point.

JB: You also hold, and rightly so I believe, that there is far too much focus on the troubles of the euro-area and not enough on those elsewhere. As a case in point, consider Japan, which has comparatively larger demographic issues with which to deal and which is, following a multi-decade period of sub-par growth, slipping out of trade surplus and into deficit. In my opinion, this is an issue not only for Japan but for the entire world. How do you feel about Japan?

JL: Under US guidance, Japan did a brilliant job after WWII in adapting its manufacturing sector to the Western (initially US) market which the US opened to it, and then widened further by admitting Japan to the OECD. But Japan’s policymakers drew a wrong conclusion: That the only way to grow was to sell goods to foreigners. As a result they never allowed any real competition, nor any structural reform, to take place in the service sector: They did not realise that they could get rich also by selling to themselves. To this day, they have not learned that lesson.

JB: It is so easy to forget that no single economy is a closed system. Especially today, given how globalised the world has become. Even the US, which has a comparatively small external sector, is today far more widely integrated into the global economy that it has ever been. There is also the non-trivial matter of the US providing the world’s reserve currency. Some argue that this ‘exorbitant privilege’, to use a term coined by former French President Valery Giscard d’Estaing, is not at risk. I know you disagree that the US is a ‘safe-haven’ in the way normally portrayed in the financial press. Could you please elaborate?

JL: A country is a safe haven right up until the moment when investors decide that it is not. The US economy produces a vast array of goods and services. If since WWII one had to hold monetary assets denominated in any currency, that currency would be the US dollar. Dollars can be converted into anything that one might conceivably want. But alternatives are emerging: The euro. The renminbi. At the least, investors will want to diversify; and indeed they are so doing. And if the US does not deal with its fiscal problem, the move away from the dollar will likely accelerate.

JB: But that is precisely the point: The US is not a safe haven. A safe haven cannot be a country that is at risk of devaluation, default, or some combination of the two. But that does leave a rather small list of countries, and I would suggest that none of them is realistically the provider of a dominant reserve currency, or the provider of sufficient additional aggregate demand to provide for Keynesian stimulus to bail the world out of its excessive debts. If this is the road we’re on, where does it lead? Can the economics profession continue to act as if the policy tools and actions that got us into this mess can get us out? Or does the solution lie elsewhere?

JL: Just as reflating one’s own economy requires that entrepreneurs and investors have faith in the future, so does reflating the world economy require that entrepreneurs and investors have faith in the currency or currencies that are attempting the reflating. I shudder to think what the world economy will look like of investors’ faith in the dollar declines, rather than revives.


JB: When a debt crisis becomes a currency crisis you have a problem that is an order of magnitude greater, because at that point you are not only distorting macro price signals via ‘financial repression’ but as there is now so little confidence in the stability of the currency, and households and businesses no longer have confidence in their ability to manage their time preferences effectively. Austrian economists would argue that this is so damaging that, if sustained, it will destroy an economy’s capital stock through severe resource misallocation. Do you have some sympathy with this view or is it too pessimistic?

JL: I have some sympathy, but also some humility. When economies are so far away from where they have even been in modern economic history; when the structure of our economies, with their much, much larger government sectors, is so unprecedented; and when we have been told so confidently what will happen by economists who engage in a priori theorising only to be proved wrong later, I am, I confess, rather more humble.

JB: The alternative to printing your way out of a debt burden is to allow for bankruptcy, restructuring and reorganisation of the capital stock to take place instead. Josef Schumpeter called this ‘creative destruction’, and he believed that it was not only helpful but in fact essential for economic progress. Might a severe recession be exactly the bitter medicine required at this point to save the patient, rather than more of the palliative to date that appears not to be working, or perhaps even making the problems worse? Would you argue that Britain’s basket case economy of the 1970s could only have been turned around in this way? Or could there have been a more mainstream, Keynesian way to go about it, such as an even larger currency devaluation?

JL: I have never liked ‘severe recession’ as the cure for anything. The spectre of all that lost output always appalls me. It smacks of the same mentality that advocated bloodletting and leeches. It has always seemed to me that more useful things could be done with potential output than just letting it flow out to sea. The state could build toll roads, harbours, airports, even certain types of housing, and sell them off later to the private sector when confidence returned. Surely that ought to be possible.

JB: Let’s move a bit closer to your current home. What about the UK of today? Does the UK need to undergo another Thatcher-like experience, something beyond timid ‘austerity’, including more meaningful structural reforms to make it more competitive internationally in exports? If so, would that be easier to accomplish were the UK to leave the EU? You have said that there is a distinct possibility of that in the coming few years.

JL: I think that leaving the EU is a distraction from the real issue, which is that UK companies are sitting on a pile of cash and are so uncertain about the future that they will not invest. Meanwhile households are trying to reduce their borrowing; and so is the government. The only thing to be done, in my view, would have been for the government to have undertaken the type of investment that companies otherwise would have done, and sell it on later. But that idea ran straight up against political dogma.

JB: But if the UK economy needs to rebalance, doesn’t the US need to as well? And on the other side of these trade deficits are trade surpluses elsewhere. Can the world continue to grow without first correcting these imbalances to at least some degree? And doesn’t history suggest that imbalances this large are ultimately corrected only in periods of unusually weak growth?

JL: Here you are putting your finger on a problem that Keynes highlighted at the end of WWII, but which Harry Dexter White, the senior US Treasury official at the 1944 Bretton Woods conference, refused to acknowledge. Surpluses and deficits are mirror images of one another. Two sides of the same coin. There cannot be one without the other. Hence being in surplus is just as contributory to imbalances as being in deficit. In a properly run global world, policies would bear down on surplus economies and deficit economies equally. But they never do.


JB: Taking into account our discussion so far, I think there are ample reasons why the stock market should appear ‘undervalued’ to many. P/E ratios may not be particularly high, even if profit margins are. The fact is, however, revenues simply cannot grow rapidly in this environment, at least not in real terms. And record profit margins cannot survive a proper global rebalancing as the cheap labour of emerging markets converges on the developed world. In my opinion, given the structural macroeconomic headwinds we have discussed, stock market valuations should, in fact, be at generational lows, perhaps below where they were in the early 1980s or early 1960s. Your thoughts?

JL: I think that that argument is correct as far as it goes. But given that investors are starting to lose confidence in paper assets, and particularly government paper, they want to hold something real: and that includes shares in companies. And it is not as if there is a stock market bubble – so far at least. PEs in the US and the UK are not far from their historical averages.

JB: But if stock market valuations need to adjust even lower from here, perhaps much lower if policymakers don’t embrace more meaningful structural reforms, and if bond markets are overvalued due to the risks of currency devaluations, where, exactly, is an investor to hide? I lean toward a diversified exposure to real assets, including raw commodities. Could you perhaps share your thoughts on that?

JL: Clearly, commodities, industrial, food, and of course gold, are obvious contenders.

JB: Speaking of gold, you are aware that I believe that there has now been so much global economic confidence lost that it will not be properly restored absent a return to some form of gold standard, if only for international rather than domestic commerce. While I know you are sceptical, you don’t disregard the idea entirely. You have mentioned before the possibility of an international pricing convention based on a ‘bancor’, a currency based on a fixed basket price of globally traded commodities. How might that work? And are you confident that there would be sufficient support for such a regime, given that global economic cooperation is endangered by the threat of competitive devaluation, trade wars and the rise of economic nationalism generally?

JL: It would work by governments setting fixed rates for converting currencies into a basket of commodities. I think that it makes logical sense; and it could help in spurring the production of commodities that would later be in demand as activity picked up. Kaldor thought a lot about this, and we discussed it when I worked under him. But equally, I am sure that it is a non-starter. Two decades of life in the OECD has shown me just how hard it is for countries to agree about anything so fundamental.

JB: Some economists simply dismiss the idea of a gold standard as archaic and unworkable. I don’t think you hold that strong an opinion. But what would you see as the primary disadvantages of a gold standard, or relative advantages of the current dollar reserve standard. Does it come down to how much confidence you have in policymakers?

JL: It is possible to have confidence in individual policymakers at the national level, while nevertheless having little confidence about their ability to agree to reforms to the international system as a whole. And that is where I come from. In any international negotiation of this sort, two types of country have disproportionate influence: the biggest; and those in current account surplus. Today, that would mean the US and China: and I doubt that they would agree on any reform that proved to be in the global interest.


JB: Now I’m really going to put you on the spot. An economist of your stature must always be considered a potential candidate for a senior policy role, say as a senior advisor to a finance minister, or a member of a central bank policy committee. Were you to be appointed to a role in which you had a broad mandate to design and implement fiscal and monetary policy, say for the euro-area or the UK, what would you do? If hard choices need to be made and if you had the mandate to make them, what would these be?

JL: In the UK, about which I thought particularly as an adviser to the Treasury from 2009 to 2012, I would have “thrown everything at the 2008 crisis, including the kitchen sink” as my friend William Keegan put it and as, in fact, Alistair Darling did. And I would thereafter have set out on much the same course of fiscal consolidation as Darling did, and Osborne continued. I think that Paul Krugman and Ed Balls understate the risk that would attach to the government borrowing substantially more. But, as I indicated above, I would also have embarked on finding ways to support private-sector-like investment. My proposition throughout has been that the government should have been willing to underwrite, or undertake, investment that produces marketable output – ports; airports; toll roads; certain types of housing, etc. These could be valued and entered as an explicit, verifiable, line in the National Accounts, and could later be sold to the private sector. The ratings agencies would, on my understanding, have been open to such a plan being explained to them.

JB: I’m pleased to hear that there are things that might yet be done within the existing policy framework to help, at least if people listen to you a bit more! Thanks so much for your time; I’m certain that Amphora Report readers will appreciate it.

JL: Thank you John.

JB: Perhaps we can do this again in a year or so to see how things are panning out?

JL: It would be my pleasure. Perhaps you will even eventually win our bet that Greece withdraws from the euro-area.

JB: Well as you recall that bet expires on 31 December. It appears I will need to treat you to dinner in the New Year.

JL: Ah yes. Well as you strategists sometimes say, all views are potentially correct; the timing, however, is always uncertain.

JB: Indeed. Well Happy Holidays!

JL: To you too John.


My many conversations with John, including those recent ones merged into the transcript above, were an important input into my 2012 Amphora Reports. While the primary purpose of these reports is to interpret contemporary economic and financial market developments through the lens of Austrian economics (and occasional, plain common sense), it is essential to continuously check assumptions, however strongly held. As I’m certain is clear from the conversation(s) above, John has provided an invaluable source of such checking.

This is not to say that we agree on most things. Far from it. For example, as alluded to briefly in closing, I am of the opinion that the euro-area cannot survive in its current form. John believes that it is indeed salvageable, although he does doubt the willingness of policymakers to do what is necessary.
This brings us, I believe, to the crux of the risks the lie ahead. Policymaker activism continues to escalate across economies. This is not going to change in the near-term, nor absent another crisis that clearly and plainly discredits economic central planning generally, be it in fiscal or monetary matters. As has increasingly been the case in recent years, future risks are going to originate primarily from policy decisions. They will, in other words, be qualitative rather than quantitative in nature.

This article was previously published in The Amphora Report, Vol 3, 09 January 2013.