“The co-authors began working on this book in 1974, just after the termination of President Nixon’s controls in the United States. Since that time, we have examined over one hundred cases of wage and price controls in thirty different nations from 2000 BC to AD 1978..
“We have concluded that, while there have been some cases in which controls have at least apparently curtailed the effects of inflation for a short time, they have always failed in the long run. The basic reason for this is that they have not addressed the real cause of inflation which is an increase in the money supply over and above the increase in productivity. Rulers from the earliest times sought to solve their financial problems by debasing the coinage or issuing almost worthless coins at high face values; through modern technology the governments of recent centuries have had printing presses at their disposal. When these measures resulted in inflation, the same rulers then turned to wage and price controls.”
- Robert L Schuettinger and Eamonn F Butler, ‘Forty centuries of wage and price controls: how not to fight inflation’ (The Heritage Foundation, 1979).
It emerged last week that the average asking price for a property in the UK had risen above £250,000. Superficially this sounds like good news for home-owners. In reality, the only benefit goes to government, which enjoys a higher tax take from stamp duty at 3% as opposed to the 1% rate that applies to property purchases below the £250K level – assuming people can be coerced into wanting to move. Unless home-owners are down-sizing, they merely have to pay more for the houses into which they move. And higher house prices make life just that little bit more miserable for a younger generation already plagued by the rising cost of education, the likely burden of student debt, and an increasingly competitive jobs market. And anyone trying to join the long-standing cult that is British property ownership has reason to be wary of the government’s latest attempt to inflate the property bubble by encouraging reckless credit provision via the 5% deposit ‘help to buy’ scheme. It’s almost as if the financial-crisis-triggered-by-a-bursting-property- bubble never happened.
As Schuettinger and Butler point out in their history of wage and price controls, government- provoked inflation is nothing new. The Roman Emperor Nero (AD 54-68) responded to growing economic problems by devaluing the currency. The devaluation started relatively modestly but accelerated under Marcus Aurelius (AD 161-180) when the weights of coins were reduced. “These manipulations were the probable cause of a rise in prices,” wrote Levy. The Emperor Commodus (AD 180-192) turned to price controls and decreed a series of maximum prices, but things deteriorated and the rise in prices became “headlong” under the Emperor Caracalla (AD 211-217).
Egypt was the imperial province most severely affected. During the fourth century, the value of the gold solidus changed from 4,000 to 180 million Egyptian drachmai. Levy also attributes the grotesque rise in prices which followed to the increase of the amount of money in circulation. The price of the same measure of wheat in Egypt rose from 6 drachmai in the first century to 200 in the third century; in AD 314, the price rose to 9,000 drachmai and in AD 334 to 78,000. Shortly after AD 344 the price had reached more than 2 million drachmai. Other provinces endured similar inflations. Levy wrote:
In monetary affairs, ineffectual regulations were decreed to combat Gresham’s Law [bad money drives out good] and domestic speculation in the different kinds of money. It was forbidden to buy or sell coins: they had to be used for payment only. It was even forbidden to hoard them ! It was forbidden to melt them down (to extract the small amount of silver alloyed with the bronze). The punishment for all these offences was death. Controls were set up along roads and at ports, where the police searched traders and travellers. Of course, all these efforts were to no purpose.
Perhaps the most notorious attempt to control wages and prices took place under the Emperor Diocletian. Commodity prices and wages reached “unprecedented heights” shortly after he assumed the throne in AD 284. The Empire’s economic troubles have been attributed to a vast increase in the armed forces (to repel invasions by barbarian tribes); to a huge building programme of questionable value; to the consequent raising of taxes and the employment of ever more government officials; and to the use of forced labour to accomplish much of Diocletian’s public works programme. (Thank goodness the current UK government isn’t intent on squandering over £40 billion it doesn’t actually have on a high speed rail link of dubious utility.)
Diocletian, on the other hand, attributed the inflation entirely to the “avarice” of merchants and speculators. Some things truly never change.
What is undeniable is that as taxes rose, the tax base shrank, and it became increasingly difficult to collect taxes, resulting in a vicious circle. (Happily, the Liberal Democrats in coalition with the current government have a progressive attitude towards soaking the rich.)
Probably the single biggest cause of Diocletian’s inflation was his debasement of the coinage. In the early Empire, the standard Roman coin was the silver denarius. Its value had gradually been reduced in the years leading up to his reign as emperors issued tin-plated copper coins which still kept the name “denarius”. Under Gresham’s Law, silver and gold coins were hoarded and left circulation.
During the 50 years ending in AD 268, the silver content of the denarius fell to one five- thousandth of its original level. Trade was reduced to barter and economic activity stagnated. The middle class was almost obliterated. To overcome the baleful influence of his bureaucracy, Diocletian introduced a system of taxes based on payments in kind, which had the effect of destroying the freedom of the lower classes and tying them to the land. Then came currency reform, and the Edict on prices and wages. Historian Roland Kent:
Diocletian took the bull by the horns and issued a new denarius which was frankly of copper and made no pretence of being anything else; in doing this he established a new standard of value. The effect of this on prices needs no explanation; there was a readjustment upward, and very much upward.
Diocletian had the option of either inflating – minting increasingly worthless denarii, or to deflate – in the form of cutting government expenditures. He chose to inflate. He also chose to fix the prices of goods and services and suspend the freedom of the people to decide what the currency was actually worth. He fixed the maximum prices at which beef, grain, eggs and clothing could be sold, and the wages that workers could receive, and prescribed the death penalty for anyone who disposed of his wares at a higher figure.
Less than four years after the currency reform associated with the Edict, the price of gold in terms of the denarius had risen by 250%. By AD 305 the process of currency debasement began again. Levy:
State intervention and a crushing fiscal policy made the whole empire groan under the yoke; more than once, both poor men and rich prayed that the barbarians would deliver them from it. In AD 378, the Balkan miners went over en masse to the Visigoth invaders, and just prior to AD 500 the priest Salvian expressed the universal resignation to barbarian domination.
David Meiselman, in a foreword to ‘Forty centuries..’ writes as follows:
What, then, have price controls achieved in the recurrent struggle to restrain inflation and overcome shortages ? The historical record is a grimly uniform sequence of repeated failure. Indeed, there is not a single episode where price controls have worked to stop inflation or cure shortages. Instead of curbing inflation, price controls add other complications to the inflation disease, such as black markets and shortages that reflect the waste and misallocation of resources caused by the price controls themselves. Instead of eliminating shortages, price controls cause or worsen shortages. By giving producers and consumers the wrong signals because “low” prices to producers limit supply and “low” prices to consumers stimulate demand, price controls widen the gap between supply and demand.
Despite the clear lessons of history, many governments and public officials still hold the erroneous belief that price controls can and do control inflation. They thereby pursue monetary and fiscal policies that cause inflation, convinced that the inevitable cannot happen. When the inevitable does happen, public policy fails and hopes are dashed. Blunders mount, and faith in governments and government officials whose policies caused the mess declines. Political and economic freedoms are impaired and general civility suffers.
The chart below, courtesy of Church House, shows the history of the most important price in the UK economy – the price of money, as set by the central bank (as opposed to the market):
The chart below, courtesy of the St Louis Federal Reserve and Incrementum AG, shows the expansion of the US monetary base since 1918; the three separate iterations of QE are marked:
- The (government-sanctioned) price of money hasn’t been this low in 300 years.
- The US monetary base has exploded. (We concede the role of private banks in money creation too, so we watch the velocity of money carefully.)
- As Robert Louis Stevenson once said, “Sooner or later everyone sits down to a banquet of consequences.”
- We hold gold.
This article was previously published at The price of everything.
“The Fed insists on saving us from ‘everyday low prices’ – they call it deflation. I submit that in a world of technological wonder, prices ought to be weakening: it costs less to buy things because it costs less to make them. This benign tendency the Fed resists at every turn. It wants the price level (as it defines it) to rise by two percent a year, plus or minus. In so doing, it creates redundant credit that finds its way into other things. These excess dollars do mischief. On Wall Street we call this mischief a bull market and we’re generally all in favour of it..
“The Fed, in substance if not in name, is [still] engaged in a massive experiment in price control. (They don’t call it that.) But they fix the Fed Funds rate, they manipulate the yield curve.. they talk up the stock market. They have their fingers and their thumbs on the scale of finance. To change the metaphor, we all live to a degree in a valuation ‘hall of mirrors’. Who knows what value is when the Fed fixes the determining interest rate at zero? So I said “experiment in price control” but there is no real suspense about how price control turns out. It turns out, invariably, badly.”
- James Grant, recently interviewed on CNBC.
Consider the following table. It comes by way of iShares by Blackrock (not a fragrance), via Barry Ritholtz and Absolute Return Partners. It shows the recommended positioning of Wall Street’s finest with regard to bond markets and equities. (This exercise may well show that when everyone is thinking the same, nobody is really thinking at all.)
As far as the sell side was concerned, brash individualism and bold contrarianism died some time during 2013. By the start of 2014, all that remained on Wall Street was the hive mind of the Borg – a rather bland consensus that bonds were bad and equities were good. Astonishing that stockbrokers might possibly nurse such bias. So January’s primary trends (bonds rallying, and equities tanking), if sustained, may serve to remind us all that unsolicited sell side research, being to all intents and purposes free, is worth precisely what folk pay for it.
If the last investor is already loaded up to the gills on stocks, where is the greater fool to whom those stocks can then be sold? January may have given us an answer. Pimco’s Bill Gross comes to a similar conclusion in his latest investment outlook, from which the following is taken:
..be “careful.” Bull markets are either caused by or accompanied by credit expansion. With credit growth slowing due in part to lower government deficits, and QE now tapering which will slow velocity, the U.S. and other similarly credit-based economies may find that future growth is not as robust as the IMF and other model-driven forecasters might assume. Perhaps the whisper word of “deflation” at Davos these past few weeks was a reflection of that. If so, high quality bonds will continue to be well bid and risk assets may lose some lustre.
Astonishing, too, that the world’s largest bond manager might possibly nurse such bias in favour of “high quality bonds”. Especially when they’re not (high quality, that is) – there just happen to be oodles of them. But the fact remains that investors seem to have been spooked by the final arrival of Fed tapering, and those in emerging markets doubly so. But since we’re all trapped in what James Grant calls that valuation ‘hall of mirrors’, courtesy of central banks endlessly tinkering with asset prices via the most aggressive monetary stimulus in world history, it’s not remotely easy trying to foresee the outlook for either bonds, or stocks, or anything else. Rather than just abandon the field and sit disgruntled on the sidelines in cash, our response is to seek solace in the most compelling examples of deep value we can find, both in the credit market and in stocks.
Tim Lee of Pi Economics also sees evidence of a growing deflation shock. His chart below shows that a proxy for global broad money growth (a simple weighted average of money growth rates for the US, the Eurozone, the UK and Japan) peaked in 2011 and now appears to be rolling over.
Tim now expects major equity markets to continue to decline as the crisis in the ‘Fragile Five’ economies accelerates. “At some stage the dollar will then begin to appreciate more broadly and Eurozone yield spreads will begin to blow out. Treasury yields will, of course, continue to decline.” If this comes to pass, Wall Street will have managed to get its asset allocation advice for 2014 precisely wrong on both counts. Developed equities will fall, while fixed income (notably US Treasuries) will rally further.
Macro hypothesizing is all very well, but it at least partly assumes that the hypothesizer is benchmarked and in our case, we’re not. We don’t currently have significant exposure to developed world equities since we see much more compelling value (in classic Graham & Dodd terms) in certain pockets of the Asian markets. And we currently have no exposure to US Treasuries because we can access higher real yields with objectively superior credit quality elsewhere. That is, of course, a raging anomaly, but we never said markets were entirely or even necessarily remotely rational.
We always thought that markets (in both the debt and equity spheres) were overly complacent about the risks associated with Fed tapering. Last year, for example, the Fed printed and bought $500 billion-worth of US Treasuries – and the Treasury market still went down. The idea that the Treasury market would shrug off the determined departure of its biggest buyer in 2014 always seemed nonsensical. Now, however, there is increasing reason to fear deflationary forces at work throughout most of the developed markets other than Japan, so the price dynamic for Treasuries has changed markedly. Similarly for developed world equities, where the gyrations of January indicate – to us – a market that is coming to the slow realisation that it has already stepped over the cliff edge. Unfortunately many investors, with central banks having slashed deposit rates to de minimis levels, have gone ‘all-in’ with regard to risk assets in the desperate pursuit of yield. Be careful what you wish for. It is quite clear that central banks will do literally anything within their power to attempt to avert deflation – to ensure that “it cannot happen here”. That does not mean they will succeed – but they may end up destroying fiat currencies in the process (one of the reasons we have consistently held gold).
Tim Lee believes it is “quite obvious” what the Fed will ultimately do:
They will expand their balance sheet dramatically further by doing QE in outright risk assets – junk debt, equities, etc. They will swap money for risk assets, not money for safe assets.
The problem is that this would be a very big step; a further violation of the ‘rules’ of central banking. And we have a new Fed chairman, who has only just taken office. It is likely that things will have to get very bad before that very big step can be taken.
Six years into this crisis, and in the words of Lily Tomlin, things are going to get a lot worse before they get worse. From our perspective as asset managers, it comes down to a simple mantra: continually question precisely what you own, and why you own it.
This article was previously published at The price of everything.
“We know Carney is blagging us, he knows we know but he has to keep a straight face and essentially say – look chaps no fundamental reason to keep rates at zero – in fact none whatsoever – but I need a couple of years to offload all our Gilts back onto you chumps.”
- Analysis of UK central bank policy from an anonymous but well-respected City source.
So farewell then, forward guidance. We barely knew you. We were never fans of this policy and said as much. Here, for example, is what we wrote in ‘The Spectator’ last October:
The financial crisis of 2007-8 was caused in large part by unsustainable property markets in the US, the UK and elsewhere. Credulous borrowers took on too much debt and credulous bankers encouraged them. The sudden abatement of that frenzy meant that governments had to step in to bail out otherwise insolvent banks. In the process, government finances disintegrated, hence the uneasy half-steps toward austerity undertaken throughout the indebted West. Yet central bankers now seem to believe the best medicine for a financial meltdown triggered by a housing bubble is a new housing bubble. George Osborne’s sudden urge to tinker with his own Help to Buy scheme is an indication of Downing Street’s nervousness about this trend.
But there is only so far central banks can go in the cause of economic stimulus. Traditionally, cutting base rates has always provided a ‘coup de whisky’ for jaded markets. So when base rates are stuck around zero, unorthodox stimulus is required. The Bank of England has provided it, in the form of its quantitative easing programme. For QE, read printing money. We’ve had £375 billion so far and not a whole lot of obvious economic recovery to show for it, other than in the property markets of Mayfair, Chelsea and Belgravia.
Five years on from the collapse of Lehman Brothers, which threatened a second Great Depression, our central bankers are treated as gods. Since there is no counterfactual, we will never know what might have happened if western governments had pursued free market policies and allowed a few bankrupt banks to fail (or be wholly nationalised, rather than perpetuate the illusion of a healthy financial sector). What’s clear is that central bank stimulus has entered hitherto uncharted territory: historically unprecedented base rates; trillions of dollars, pounds and yen conjured up to reconstruct bank balance sheets and support monstrous government borrowing; hyper-aggressive reflationary tendencies that have driven millions of investors into high-risk assets. If economic health could be measured in property values alone, the stimulus has been a success. In terms of maintaining sound currencies or encouraging a climate of confident business investment, central bank stimulus has been a disaster.
It’s time to ask whose interests the central banks really serve. While they pay lip service to the interests of embattled savers, it is clear that their primary function today is to act as lenders and stimulators of last resort to a venal banking system — Danegeld, if you prefer, paid by savers through artificially low deposit rates and channelled to a narrow financial elite. But it will be a pyrrhic victory for Carney and his peers if our banks have been ‘saved’ at the expense of everybody else.
The base rate — the fundamental reference rate for the price of money — is under the control of the Bank of England’s monetary policy committee. What the Bank of England cannot entirely control, however, is the gilt market, which dictates how cheaply or expensively the UK government can borrow money over various terms. Alarmingly for Carney, gilt investors have already voted with their feet. His much heralded ‘forward guidance’ — flashy central bank jargon for keeping interest rates on hold until there is tangible evidence of economic recovery in falling unemployment numbers — has been revealed as farce by rising gilt yields. The market, in other words, does not believe the governor’s pledge. In vowing to keep back the tide, Mark Carney is acting like a latter-day Cnut.
Longstanding readers will also appreciate that we feel toward central bankers the way lamp-posts would feel toward dogs – if they were capable of feeling anything at all. It’s a sad thought that there is apparently nobody better qualified than Mark Carney from within this sceptered isle’s native population of 63 million – but then we must accept that there are only so many Goldman Sachs alumni out there, let alone those that must squeak by on a housing allowance of just £250,000. If it were down to us, we would replace more or less the entire executive staff of the Bank of England (and the Fed, and the ECB..) with an old sock. With a nod to the democratic impulse, we could perhaps be allowed to vote for our favourite old sock from a roster of different socks, as opposed to suffer the economic indignity of unelected bureaucrats manipulating interest rates, and much else besides, in the cause of bailing out their buddies at otherwise insolvent banks (and governments).
But there’s the world as we might like it, and there’s the world as is. In the world as is, a popular January pastime for economists, fund managers and financial analysts is to issue unsolicited predictions about how the balance of the year will shape up, investment-wise. We have to assume that these are always self-interested and conflicted: Chinese equity managers will mysteriously forecast extraordinarily strong economic growth in China (and no blow-up of the shadow banking system); Gilt investors will mysteriously foresee strong performance from UK government bonds despite the fact that real yields are non-existent and Mark Carney is caught between a rock and a hard place (see above) when it comes to exiting from now unnecessary monetary stimulus; etc. etc. ad infinitum for all the different asset classes and their respective managers.
Well, we don’t see the point. What’s more interesting to those of us not sufficiently self-important to be wining and dining at Davos this year (Matt Damon? Really?) is to get an assessment of consensus expectations from the City, and then consider those. Helpfully, this is exactly what Espirito Santo’s Marcus Ashworth has done. Here is his Top Ten summary of ‘Street consensus’ for 2014:
- Equities to continue to grind higher, an up year but not as strong as 2013. Despite the fact that earnings are anaemic and buy-backs are the only response.
- Bonds might be doing a bit better now, led by credit, but bond yields must go up substantially at some point this year.
- Dollar to go higher, Yen lower, Euro to crack at some point surely.
- Nikkei to put in another banner year, ahead of the pack as Yen weakens.
- Oil lower as US supply alters the world dynamic, Iran and others become less pressing with supply snafus dissipating.
- China to struggle to keep growth pace up, Government forced to prevent bankruptcies.
- Gold to wallow as risk on makes it ever less of a hedge fund toy but gold bugs will continue to fret about the Bundesbank’s gold and China buying it all.
- Bank of England to be the first to raise rates but not before the ECB takes them negative. Fed will be all tapered out by the summer, November latest.
- Credit [i.e. corporate debt] is about as tight as it can possibly get, in the trough, only a muppet would buy it down here.
- Emerging markets are so, like, 2013; current account deficits and currency weakness will force slow money back to the major markets. Europe the new (only) alpha source?
Of course, one response to apparently consensus positions is to take the other side of the trade. But contrarianism for contrarianism’s sake is also a dangerous game. More to the point, while any of us can state a market forecast with a degree of confidence, nobody really knows. From our own perspective, Marcus’ Top Ten feels intuitively correct – these seem to us to represent a fair reflection of many investors’ hopes / fears / biases / portfolios. So what could be the shockers?
- Equities don’t necessarily grind higher for FY2014 as a whole, but mean revert on the basis of some exogenous shock that no-one saw coming; or for that matter in response to one of the many problems that are already well flagged.
- Bond yields “go Japanese” to low levels well below consensus.
- Fears / flows over (Fed) tapering cause currency markets to go mental.
- Japanese stocks disappoint.
- Some or other Middle Eastern black comedy in the making goes full Strangelove.
- China fails to crash. (Or Renminbi fails to appreciate.)
- Gold goes sharply higher in response to 3.
- Gilt yields collapse as economic growth is revealed to be a fantasy conjured up by a central London property bubble.
- Credit spreads remain tight (they are clearly poor value).
- Emerging markets outperform.
So far, so entertaining. A harmless enough diversion. Mostly irrelevant to us, since we spend more time avoiding obvious flashpoints than flirting with them. We’re positioned in
- Creditworthy sovereign and quasi-sovereign bonds, with a growing allocation to floating rate exposure.
- Deep value equities, concentrated in Asia and Japan (with currency selectively hedged).
- Systematic trend-followers, which are nothing if not consistently uncorrelated to stocks and bonds.
- Real assets, notably the monetary metals, gold and silver. This was obviously a pain trade last year, but for us it wasn’t a trade at all, rather a conscious decision not to play in paper currency conflagrations-to-come.
It strikes us, in the light of Mr Carney’s awkward gyrations over forward guidance, and anticipating a less than smooth tapering process from Janet Yellen at the Fed, that 2014 will be the year in which the central banking emperors’ new clothes are revealed to be from Primark rather than Prada.
 Mixed metaphors, of a sort. We know that the emperor’s new clothes consisted of his birthday suit and nothing else. Perhaps we should have said, after Warren Buffett, that 2014 will be the year when we get to see, from a universe comprising governments and investors, just who’s been swimming naked.
This article was previously published at The price of everything.
“It is no longer a secret that stocks, like bonds, do poorly in an inflationary environment.”
- Warren Buffett, ‘How inflation swindles the equity investor’, May 1977.
A happy new year to all readers.
On December 31st, 1964, the Dow Jones Industrial Average stood at 874. On December 31st, 1981, it stood at 875. In Buffett’s words,
I’m known as a long term investor and a patient guy, but that is not my idea of a big move.
To see in stark black and white how the US stock market could spend 17 years going nowhere – even when the GDP of the US rose by 370% and Fortune 500 company sales went up by a factor of six times during the same period – the price chart for the Dow is shown below.
17 years and not much to show for it: Dow Jones Industrial Average, 1964-1981
So the US stock market suffered a Japan-style lost decade, and then some. Back to Buffett, again.
To understand why that happened, we need first to look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line..
In the 1964-81 period, there was a tremendous increase in the rates on long-term government bonds, which moved from just over 4% at year-end 1964 to more than 15% by late 1981. That rise in rates had a huge depressing effect on the value of all investments, but the one we noticed, of course, was the price of equities. So there–in that tripling of the gravitational pull of interest rates- -lies the major explanation of why tremendous growth in the economy was accompanied by a stock market going nowhere.
In his magisterial (and deeply witty) 2013 Year In Review, Cornell chemistry professor and economic agent provocateur David Collum reminds us that
The 32-year-old bond bull is long in the tooth, fully priced for an inflation-free world. We have central bankers on a bond buying spree that has the surreal effect of keeping interest rates low by printing money. Of course, these shenanigans will end, and price discovery in bonds will be accompanied by investors’ self-discovery. Optimists bray that rising rates are bullish, a sign that the world economy is recovering. In 1999, however, Buffett wrote a compelling article in Fortune attributing secular equity moves to one and only one parameter—the direction of long-term interest rates. Secular equity bull markets occur when long-term rates are dropping—not low but dropping—and secular bears occur when rates are rising. He didn’t equivocate..
“So are rates really that low? In a word, yes.. The salad days of the bond market are in our rear- view mirror. The rate bottom and subsequent rise will be global. Rising rates will spread into the markets and economy at large, causing concurrent stagnation, dropping price earnings ratios (from nosebleed Case–Shiller estimates of 24), collapse of credit-fuelled/capex-lite corporate profit margins, and crush under-funded pensions and municipalities rendering them less funded. If rates have nowhere to go but up, what direction are they headed?
So how you feel about asset allocation this year should largely be a function of how you feel about interest rates. And if you fear that interest rates are more likely to rise – triggered, perhaps, by a combination of Fed tapering and general weariness / revulsion at the manipulation of so many financial assets – then you should perhaps question your commitment to western equity markets as well as to bonds, given Buffett’s and Collum’s assertions above. The observation bears repeating. “Secular equity bull markets occur when long-term rates are dropping.. and secular bears occur when rates are rising.” This is hardly rocket science.
Of course, 2014 could be yet another year in which equity markets rise further, driven by hopes and expectations of still more QE, but that’s not a bet we’re entirely comfortable making. Since we’re primarily attracted by valuations and not by momentum, we’re now fishing for equities in a clearly demarcated pool (Asia and Japan – because that’s where values are most compelling). We are not interested in most western markets because the value isn’t visible to us and the underlying growth (fundamentals, anybody?) looks pathetic.
And our monetary authorities have showered financial markets with kerosene by ensuring that the conventional ‘risk-free’ alternative to equities (i.e. government debt) is anything but. So we find ourselves trimming fixed interest exposure and duration risk, and largely replacing it with floating rate exposure instead. (It has been several years since we held Gilts, and we’ve never held US Treasuries.)
Our two allocations to ‘alternative’ assets proved variously problematic in 2013. With a few exceptions, trend-following funds struggled to find sufficient strong trends to harvest meaningful returns. But we retain the exposure in large part because we think that a) human nature is unlikely to change profoundly this year, so any return to the primacy of fear over greed could easily generate profits to be reaped from the downside of markets and b) the position-sizing and in particular the risk management generally practised by trend-following managers offers some significant insurance in the event of any pronounced market ‘accidents’. Our other exposure to ‘alternative’ assets was, of course, in the monetary metals and related holdings. As David Collum accurately concedes,
It was a very expensive year to be in the Church of Austrian Economics and Hard Assets.
2013 was the year that the mainstream financial media went aggressively anti-gold, and Collum cites three pertinent quotations from the New York Times:
There is simply nothing in the economic picture today to cause a rush into gold. The technical damage caused by the decline is enormous and it cannot be erased quickly. Avoid gold and gold stocks.
Two years ago gold bugs ran wild as the price of gold rose nearly six times. But since cresting two years ago it has steadily declined, almost by half, putting the gold bugs in flight. The most recent advisory from a leading Wall Street firm suggests that the price will continue to drift downward, and may ultimately settle 40% below current levels.
The fear that dominated two years ago has largely vanished, replaced by a recovery that has turned the gold speculators’ dreams into a nightmare.
But as he also points out, these quotes are from 1976, when the spot price of gold fell from $200 to $100 an ounce. Thereafter, gold rose from $100 to $850. Why do we continue to keep the faith with gold (and silver) ? We can encapsulate the argument in one statistic. Last year, the US Federal Reserve enjoyed its 100th anniversary, having been founded in a blaze of secrecy in 1913. By 2007, the Fed’s balance sheet had grown to $800 billion. Under its current QE programme (which may or may not get tapered according to the Fed’s current intentions), the Fed is printing $1 trillion a year. To put it another way, the Fed is printing roughly 100 years’ worth of money every 12 months. (Now that’s inflation.) Conjuring up a similar amount of gold from thin air is not so easy.
This article was previously published at The price of everything.
“One good thing about Christmas shopping – it toughens you up for the January sales.” – Grace Kriley.
We first published the following doggerel in December 2007. In the finest tradition of reheating old Christmas chestnuts, we publish it again today. With some annotations to mark the passing of six extraordinary years and, in some cases, no substantive change or progress at all.
‘Twas the fright before Christmas; the merchants did grouse ,
Not a damn thing was selling, not even a house ;
Restocking was futile with goods still on shelves,
And the streets were now teeming with unemployed elves .
The FSA  warned of a housing collapse,
An environment hitherto known just to Japs .
And Shanghai and Shenzhen encountered sharp falls 
An ominous sign when east Asia appalls.
(Only Tesco  was thriving – and that was before
‘Fresh and Easy’ was launched – how Wal-Mart did guffaw.)
The bankers were choking on alphabet soup
Of CDOs, SIVs; all sorts of gloop .
Bond salesmen were sweating, awake in their beds,
With visions of dole queues  (and widening spreads).
In Floridian fund pools there was such a clatter
As portfolios blew up with foul fecal matter.
Their managers, much like their bonds, were distressed,
With the agents who’d rated them under arrest ,
And the banks that had sold everyone down the river
Saw their equity ratios down to a sliver;
Man turned against man, and the brokers the same
Lashed out at their rivals (it was all just so lame):
Punk, Ziegel slashed Goldman Sachs, Morgan and Merrill,
And Bear Stearns  and Lehman  they did also imperil,
The markets a-brim with black swans and fat tails –
What happens when mania with credit prevails.
The quant funds were savaged as bell curves deflated
And CFOs had to be strongly sedated.
Will central banks save us ? The stock markets rally,
But interbank lending now feels like Death Valley.
The bulls now see good news in looming recession 
But try to get upbeat about repossession.
The bank stocks are cheap now but could yet get cheaper
As retailers cower at the sight of the Reaper.
Diversification in assets should work
If lending conditions  continue berserk.
Some market neutrality also appeals
For when event-driven runs out of new deals,
And if the unthinkable does now unfold
There’ll be merit in silver and still more in gold .
Amid confidence crisis and capital flight
Happy Christmas to all, and to all a good night.
 Six years ago there were evidently signs of retail recession. Happily, the central banks have solved all the world’s problems now.
 And there were also visible issues in property markets. Happily, the central banks have solved all the world’s problems now.
 And there were evidently concerns about unemployment. Happily, the central banks have solved all the world’s problems now. Apart from the (youth) unemployment rates in Greece, Italy, Portugal, Spain..
 Now FCA. Which sounds like a rude acronym even if it isn’t.
 With apologies to any Japanese readers.
 Plus ça change..
 Happier days..
 Can’t believe this was six years ago.
 The City has shed 100,000 jobs since 2007. That noise you hear is the sound of the world’s smallest violin, playing just for them.
 Credit ratings agency staff were never actually imprisoned. Or fired – from giant howitzers into the sea.
[11,12] Takes you back, doesn’t it?
 Clearly, they already have, and will continue to do so in perpetuity.
 For the West to re-enter recession in 2014 would be to imply it ever enjoyed a recovery.
 It’s no longer bank lending we should be worried about, but central bank lending.
 Gold stood at $802 when this was first written, versus $1200+ today. The death / irrelevance of gold has been somewhat overstated during the ‘Panic of ‘13’.
This article was previously published at The price of everything
“We have the best government that money can buy.” – Mark Twain.
It says a lot about the financial establishment that the most revelatory coverage of the worst financial crisis in living memory has appeared, not in the pages of ‘The Financial Times’ or ‘The Wall Street Journal’, but in those of ‘Vanity Fair’ and ‘Rolling Stone’. In the first example, former bond salesman Michael Lewis displayed the finest characteristics of investigative journalism whilst exploring the more ridiculous examples of modern greed and credit-based insanity in forensic detail. In the second, Matt Taibbi broke new ground in gonzo journalism as he tilted against the previously impregnable windmills of Wall Street, giving us in the process the immortal description of the taxpayer-rescued brokerage firm Goldman Sachs as “a giant vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”. In the latest iteration of serious economic and cultural analysis arising from a non-mainstream source, we now have ‘Life After The State’ – a critique of government written by a stand-up comedian.
In Dominic Frisby’s defence, he wears multiple hats. As his Twitter profile puts it, he is an “Accidental financial bod, MoneyWeek writer, comedian, actor of unrecognized genius, voice of many things, & presenter.” And now an author. Published by the crowd-funding website Unbound, ‘Life After The State’ follows hot on the heels of Douglas Carswell’s ‘The End Of Politics’ and Guy Fraser-Sampson’s ‘The Mess We’re In’, and each attempts to address a nagging feeling from a slightly different perspective. That feeling was well expressed recently by the outspoken investor Paul Singer of Elliott Management when he remarked, almost in passing, that
America is deeply insolvent, and for that matter, so are most of continental Europe, the UK and Japan.
Or to put it another way, what the hell just happened, and why ?
The answer, and the beast that has to be slaughtered for any hope of progress and recovery, is Big Government. Many readers will doubtless respond that any retrenchment by an over-mighty State is simply wishful thinking. Some of us might respond in turn that it is actually a mathematical certainty. But Dominic, early on, spikes the guns of scepticism by citing the anonymous internet poster known as ‘Injin’:
Find the right answer, realise you’ll never see it in your lifetime, and then advocate it anyway, because it’s the right answer.
Frédéric Bastiat’s broken window fallacy also gets an early airing, which is entirely justifiable – it’s one of the most powerful ideas in the history of economics. We can ‘see’ what in the economy gets spent (by Big Government, having raided our wallets first, or worse, the wallets of those as yet unborn), but we cannot ‘see’ how that money might have been spent in the absence of Big Government. And there are only four ways of spending money. We can spend our money on ourselves. Which is nice. Or we can spend it on other people. Which is quite nice. We can spend other people’s money on ourselves (generally illegal). Or we can spend other people’s money on other people, which is what government actually does, and which tends to lead to malinvestment, waste, zombie banking, and so on. Happily, although there’s no shortage of economics in ‘Life After The State’, it’s all painlessly incorporated into the general argument, which makes for a highly readable and engaging book.
Another powerful idea arises in Chapter 8, and it’s a killer – quite literally. If governments had been separated from their monopoly control to print money, World War I would have been over by Christmas 1914.
Neither the British nor the German governments had the money, or gold, to pay for it. Both came off the gold standard and printed the money they needed. Had either government not had the power to print money or create debt – i.e. if they did not have control of money – the war would have had to stop.. Think about the implications.. German reparations.. Weimar hyperinflation.. the rise of Hitler..
And the same holds for almost all wars.
No war has ever been fought on a cash basis. Costs are concealed by deficit spending. If taxes had to rise concomitantly in the same year that wars were being fought, people would not pay. Instead, the cost is added to the national debt. People don’t have to pay £10 billion this year; instead they pay an extra £500 million every single year for eternity in interest on the national debt. Take away this power to create money and run deficits, and you suddenly limit the scope of the war to the amount of money the government has. In other words you limit government power – and you limit the damage that they can do. That alone is reason enough to separate money and state.
‘Life After The State’ is particularly good as a primer on gold, sound money and inflation. The anecdotal always helps, for context.
But the price of oil in US dollars has gone from $3.50 a barrel in 1972 to around $100 now. That’s something like a.. 96% loss in purchasing power. The same goes for all modern government currencies, which buy you less and less each year: less house, less chocolate bar, less anything. In 1971 I could have taken my son to the FA Cup Final for £2 (now over £100). The Mars bar I bought him at half-time would have been 2p (now 60p). The beer I bought myself would have been 11p (now £5 a pint at Wembley). The gallon of petrol I needed to get me there and back would have been 33p (now £7). And the house we went home to would have been something like 40 times cheaper.
The State is so entrenched in our lives it is sometimes difficult to imagine life without it. It “looks after the birth of the baby, educates the child, employs the man, cares for the aged, and buries the dead.” But in doing so it also spends £700 insuring each birth against negligence claims; while it educates the child, there can be no guarantee that it does so well – no matter, the examination pass rates, like the currency, can easily be inflated; the man may be employed, but not gainfully so..
On Thursday last week, the newspaper of the neo-Keynesian financial establishment, ‘The Financial Times’ had room for three stories on its front page. One of them covered the resignation of Barclays’ head of compliance, Sir Hector Sants, on the grounds of stress and exhaustion (cue mass playing by an orchestra of the world’s smallest violins). Sir Hector was previously chief executive of the Financial Services Authority, an arm of Big Government – in other words, not a particularly successful one, if current financial scandals and the health of the banking system are any guide. Another detailed how a Prime Minister evidently deeply committed to free markets was pressing mobile phone companies to cut their bills to customers. If David Cameron were really serious about inflation, though, he would be advised to pay closer attention to what Mark Carney has been up to at the Bank of England. The FT’s main story, ‘Rate rise signalled for 2014 as UK recovery takes hold’, was accompanied by a photograph of Mr. Carney looking for all the world like an evil little elf (for all we know, perhaps he is one).
Apparently the Bank of England is now considering a UK rate hike as soon as next year, and 18 months sooner than previously expected by the market. One wonders what all those first-time buyers lured into buying property by the government, the Bank of England and their easy money policies, might make of that.
This article was previously published at The price of everything.
“No warning can save people determined to grow suddenly rich.” – Lord Overstone.
We have seen a confluence of events that suggests we may be reaching the terminal point of the financial markets merry-go-round – that point just before the ride stops suddenly and unexpectedly and the passengers are thrown from their seats. Having waited with increasing concern to see what might transpire from the gridlocked US political system, the market was rewarded with a few more months’ grace before the next agonising debate about raising the US debt ceiling. There was widespread relief, if not outright jubilation. Stock markets rose, in some cases to all-time highs. But let there be no misunderstanding on this point: the US administration is hopelessly bankrupt. (As are those of the UK, most of western Europe, and Japan.)
The market preferred to sit tight on the ride, for the time being. Three professors were awarded what was widely misreported as ‘the Nobel prize in economics’ for mutually contradictory research. What they actually received was the ‘Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel’, which is not quite the same thing. But then economics is not a science, and Eugene Fama’s ‘efficient market hypothesis’ is not just empirically wrong, but dangerously so. History, it would seem, is clearing the decks. Perhaps the most intriguing development of the week was the news that Neil Woodford would soon be retiring from his role managing £33 billion of other people’s money at Invesco Perpetual to start up his own business. It was widely reported that Mr. Woodford nursed growing frustration at the short-termism of the financial services industry. We will return to this theme.
One of the sadder stories in the history of investment management is that of Mr. Tony Dye. The following extract is taken from his obituary in The Independent:
Tony Dye was one of Britain’s best known fund managers, becoming a household name in the late 1990s due to his controversial opinions about the outlook for global stock markets. At a time when markets were soaring, Dye insisted they were overvalued and on the verge of a crash – a view which put him at odds with most other investors at the time and earned him the nickname “Dr Doom”.
As early as 1995, as the FTSE 100 was approaching 4,000 points, Dye began to make the case that markets were too expensive. At the time, he was the chief investment officer for Phillips & Drew, one of Britain’s biggest asset management firms, and by 1996 he had begun to move large sums of clients’ money out of equities and into cash.
In the years that followed, however, stock markets continued to soar, driven by the technology boom. But Dye stuck to his guns, avoiding the high-growth, high-risk internet stocks, maintaining large positions in cash, and consequently ensuring that Phillips & Drew’s funds significantly underperformed their rivals. By 1999, the firm was ranked 66th out of 67 for performance amongst Britain’s institutional fund managers, and was haemorrhaging clients – and in February the following year, just weeks after the FTSE had broken through 7,000 points for the first time, Dye was sacked.
Days later, his prophesy finally came true. Markets collapsed, and settled into a three year slump, which saw more than 50 per cent wiped off the value of global stock markets.
Neil Woodford’s apparent concerns are well placed. There is a grotesque mismatch between the set-up of institutional asset managers and what is in the best interests of their end clients, the individual members of the public who pay their fees. The investment fund marketplace is grotesquely oversupplied. There is far too much, to use the dismal phrase, product. The problem is exacerbated by perhaps inevitable weaknesses in psychology – both on the part of the manager, and on the part of the investor. Stress points abound throughout the chain. The investment fund world is hopelessly balkanised, and brimming over with a degree of product specialisation utterly unwarranted by investors’ real needs. The fund management industry is a perpetual production line of novelty, or rather an endless rehash of the same old ideas. The point of absurdity was reached and surpassed when there were more mutual funds listed on the New York Stock Exchange than there were common stocks with which to populate them. The industry is a monstrous hydra, busily consuming its own, and its investors’, capital. New funds are launched daily. Failing older funds are quietly tidied away, merged, or destroyed. They are ‘uninvented’.
Alison Smith and Stephen Foley covered the news of Neil Woodford’s resignation for the Financial Times. They cited the FT’s own John Kay, who carried out a review of UK equity markets last year, and who said,
The short-term horizon is basically introduced by the intermediary sector.. Pension trustees [for example] are told they should keep reviewing managers, while retail investors get constant invitations to trade from independent financial advisers [for example] and the platforms set up to enable them to do so.
As they suggest, Neil Woodford’s past success means that raising money for his new business is unlikely to be much of a struggle. “But imagine the hurdles in the way of a manager who would like to purse long-term strategies but is just starting out.” In the words of Professor Kay,
How easy would Warren Buffett find it to set up now?
We have not been immune to the demands of clients frustrated at the performance of diversified portfolios lagging the broader equity markets (although this explicit benchmarking against stocks was never a mandate to which we subscribed). We struggle, in some cases, to make sufficiently clear our concerns about broader market valuation, or just as importantly the gravity of the global financial situation (including a potential QE-driven currency crisis), which makes a wholehearted commitment to the stock market in late 2013 seem to us a risky strategy. So where, if anywhere, does the fault lie? Sometimes it is not just asset managers who should be accused of being short-termist, or of missing the big picture.
Our thesis has been consistent for five years now. We believe we are at the tail end of a 40-years’ and counting experiment in money and the constant expansion of credit. This experiment is not ending well. Because government money, unbacked and unchecked as it now is by anything of tangible value, can be created at will, it has been. What is extraordinary is that despite trillions of dollars / pounds / yen of stimulus, there are few visible signs of what we would call inflation, in anything other than the prices of financial assets themselves.
We are living through a historic period of global currency debasement. The neo-Keynesian money-printers who dominate the world’s central banks have ‘won’ the debate, but are now scratching their heads, looking in vain for the economic recovery that they were expecting all those trillions to have bought. They will continue to look in vain, because money creation and true wealth creation are polar opposites. As portfolio manager Tony Deden has asked,
If cheaper currency is the source of wealth, where has Bangladesh gone wrong? If cheaper money means economic prosperity, why not just print as much as we can and give it out to everyone? We have become fools. The customers know nothing and the advisers know even less. And then we have the idiot economists – the neo-classical Keynesian variety with solutions to problems they did not even anticipate; solutions that have, in fact, been long discredited. And so we lurch from crisis to crisis, eating our meagre capital in the hopes of becoming rich in money. It is a pity.
Those words were written four years ago. The printing presses have been run to exhaustion ever since. So far they have bought us an inflationary rally in the prices of financial assets, and not much else. It has been a lousy time for anyone focused on the disciplined and genuinely diversified pursuit of capital preservation in real terms (more recently, for anyone seeking to escape the inflationary insanity via the honest money that is gold). We have not, to any significant extent, participated in the ‘phony rally’. But then we are playing a longer game than most of our peers. Round and round and round she goes; where she stops, nobody knows. Fund manager Sebastian Lyon recently quoted another celebrated fund manager, Jean-Marie Eveillard:
I would rather lose half of my shareholders than half of my shareholders’ money.
This article was previously published at The price of everything.
“The goods and services traded on the semi-secretive website Silk Road since February 2011 with the virtual currency Bitcoins were so varied that the Federal Bureau of Investigation described it as “the most sophisticated and extensive criminal marketplace on the internet today”.
￼Its philosophical underpinnings, however, were not solely a desire to get rich quick but, according to the FBI complaint published on Wednesday after the site was shut down, “Austrian economic theory” and the works of Ludwig von Mises and Murray Rothbard, economists closely associated with the Mises Institute, in the US state of Alabama.”
- More obnoxious anti-Austrian School slurs from the Financial Times, on this occasion by John Aglionby and Tracy Alloway.
The Daily Mail no longer has a monopoly on libelling the dead: the Financial Times is also doing a pretty good job. John Aglionby’s story this week (‘Libertarian economics underpinned Silk Road Bitcoin drug website’) was, even by the standards of a paper coloured pink that should really be coloured yellow, an extraordinary piece of character assassination. You do not have to be a believer in Austrian business cycle theory to find the linkage between an apparently criminal website and two widely respected economic theorists to be utterly objectionable. Those FT readers who were moved to respond on the paper’s website tended to think similarly:
“the lowest of lows..”
“FT trying to discredit Ludwig von Mises, the Austrian business cycle theory and Bitcoins all in one go.. for god’s sake, you do not have any decency left..”
“childish, glib and misleading.. a new low for the FT.. Disgusting, to say the least”
“Another shining example of the death of journalism”
“The goods and services traded on the semi-secretive website Silk Road since February 2011 with the virtual currency Bitcoins were so varied that the Federal Bureau of Investigation described it as “the most sophisticated and extensive criminal marketplace on the internet today”.
￼￼“Sorry to say, but you all seem to fail to understand that the FT is making a heroic attempt to switch from factual financial reporting to a top position in entertainment of the masses. Don’t you think they are doing well? I most certainly do.”
That the Austrian business cycle theory should be held in such low esteem by such a prominent financial journal might be taken as an admission of guilt for not having noticed the credit bubble while it was inflating, and for then having continually defended the (neo-Keynesian) establishment line rather than debate the practical value of any alternative policy course.
In Austrian business cycle theory, the central bank is the culprit responsible for every boom and bust, firstly in fuelling excessive bank credit growth and maintaining interest rates at overly stimulative lows; then in prolonging the inevitable recession by propping up asset prices, bailing out insolvent banks, and attempting to stimulate the economy via the mechanism of deficit spending. It is difficult to see why the theory is so problematic given that the US Federal Reserve, for example, is not an agency of the US government per se but rather a private banking cartel. When push comes to shove, whose interests will the Fed ultimately protect – those of the banks, or those of the rest of the productive population?
But in any discussion of the ‘long emergency’ enduring throughout the insolvent West, the role of politicians should not be ignored. If politicians had moderated their tendencies to make unaffordable promises to their electorates, western fiscal disasters and the attendant debt mountains would now be less dramatic. And if politicians were not slaves to the electoral calendar, it is fair to assume that difficult choices might even have been taken in the long term interests of their respective economies.
The current gridlock in the US political system (first over the shutdown and latterly over the debt ceiling) is a perfect example of grandstanding politicians abdicating all responsibility for the electorate they claim to serve. And as a glaring example of cognitive dissonance, Treasury bond investors’ responses to fears over a looming default really do take some beating. That beating should, of course, be reserved for investors stupid enough to believe that debt issued by the world’s largest debtor country should be somehow treated as risk-free, especially when the possibility of formal default is only a matter of days away.
Treasury bond defenders will no doubt point out that in a fiat currency world where the central bank has the freedom to print ex nihilo money to its heart’s content, the very idea of default is absurd. But that is to confuse nominal returns with real ones. Yes, the Fed can expand its balance sheet indefinitely beyond the $3 trillion they have already conjured out of nowhere. The world need not fear a shortage of dollars. But in real terms, that’s precisely the point. The Fed can control the supply of dollars, but it cannot control their value on the foreign exchanges. The only reason that US QE hasn’t led to a dramatic erosion in the value of the dollar is that every other major economic bloc is up to the same tricks. This makes the rational analysis of international investments virtually impossible. It is also why we own gold – because it is a currency that cannot be printed by the Fed or anybody else.
On the topic of gold, the indefatigable Ronni Stoeferle of Incrementum in Liechtenstein has published his latest magisterial gold chartbook. (FT: if you’re reading, Ronni is an Austrian, so you’ll probably want to start the character assassinating now.) Set against the correction in the gold price 1974-1976, the current sell-off (September 2011 – ?) is nothing new. The question is really whether our financial (and in particular debt) circumstances today are better than they were in the 1970s. We would merely suggest that they are objectively worse.
Trying to establish a fair price for gold is obviously difficult, but treating it as a commodity like any other suggests that the current sell-off is not markedly different from any previous correction during its bull run:
To cut to the chase, it makes sense to own gold because currencies are being printed to destruction; the long term downtrend in paper money (as expressed in terms of gold) remains absolutely intact:
And we cannot discuss the merits of gold as money insurance over the medium term without acknowledging the scale of the problem in (US) government debt:
Whatever happens in the absurd and increasingly dangerous debate over raising the US debt ceiling, the fundamental problem remains throughout the western economic system. Governments have lived beyond their means for decades and must tighten their belts. Taxes are certain to rise, and welfare systems certain to contract. Even if western governments manage to rein in their morbidly obese consumption patterns without a disorderly market crisis, their legacy will be felt by generations yet to come. The debt mountain cannot and will not resolve itself. (Why, again, we own gold; because we think there is a non-trivial chance of a gigantic financial system reset.) The piper must, at some point, be paid. Western economic policy can be distilled down into just four words: the unborn cannot vote.
This article was previously published at The price of everything.
“This took guts.”
- Comment by Steven Ricchiuto of Mizuho Securities in response to the Federal Reserve’s surprise decision to refrain from “tapering” its $85 billion monthly bond purchase programme, as reported by the Financial Times, 19 September.
Human beings are suckers for a story. The story peddled by mainstream economic commentators goes that the US Federal Reserve and its international cousins have acted boldly to prevent a second Great Depression by stepping in to support the banks (and not coincidentally the government bond markets) by printing trillions of dollars of ex nihilo money which, through the mechanism of quantitative easing, will mysteriously reflate the economy. It’s a story alright, but more akin to a fairy story. We favour an alternative narrative, namely that with politicians abdicating all real responsibility in addressing the financial and economic crisis (see this article), the heavy lifting has been left to central bankers, who have run out of conventional policy options and are now stoking the fire for the next financial crisis by attempting to rig prices throughout the financial system, notably in property markets, but having a grave impact on volatility across credit markets, government bond markets, equities, commodities.. As politicians might have told either them, or Steven Ricchiuto of Mizuho Securities, it’s quite easy to be brave when you’re spending other people’s money.
Before we get back to the Fed, it’s worth a minute recapping why it was created, namely as a private banking cartel with a monopoly over the country’s financial resources and the facility to shift losses when they occur to the taxpayers. Satire goes a long way here (not least because the reality is so depressing) – here is Punch’s take on the banks from April 1957*:
Q: What are banks for?
A: To make money.
Q: For the customers?
A: For the banks.
Q: Why doesn’t bank advertising mention this ?
A: It wouldn’t be in good taste. But it is mentioned by implication in references to reserves of $249,000,000 or thereabouts. That is the money they have made.
Q: Out of the customers?
A: I suppose so.
Q: They also mention Assets of $500,000,000 or thereabouts. Have they made that too ? A: Not exactly. That is the money they use to make money.
Q: I see. And they keep it in a safe somewhere?
A: Not at all. They lend it to customers.
Q: Then they haven’t got it?
Q: Then how is it Assets?
A: They maintain that it would be if they got it back.
Q: But they must have some money in a safe somewhere?
A: Yes, usually $500,000,000 or thereabouts. This is called Liabilities.
Q: But if they’ve got it, how can they be liable for it?
A: Because it isn’t theirs.
Q: Then why do they have it?
A: It has been lent to them by customers.
Q: You mean customers lend banks money?
A: In effect. They put money into their accounts, so it is really lent to the banks.
Q: And what do the banks do with it?
A: Lend it to other customers.
Q: But you said that money they lent to other people was Assets?
Q: Then Assets and Liabilities must be the same thing.
A: You can’t really say that.
Q: But you’ve just said it. If I put $100 into my account the bank is liable to have to pay it back, so it’s Liabilities. But they go and lend it to someone else, and he is liable to pay it back, so it’s Assets. It’s the same $100, isn’t it?
A: Yes, but..
Q: Then it cancels out. It means, doesn’t it, that banks don’t really have any money at all?
Q: Never mind theoretically. And if they haven’t any money, where do they get their Reserves of $249,000,000 or thereabouts?
A: I told you. That is the money they’ve made.
A: Well, when they lend your $100 to someone they charge him interest.
Q: How much?
A: It depends on the Bank rate. Say five and a half percent. That’s their profit.
Q: Why isn’t it my profit ? Isn’t it my money ?
A: It’s the theory of banking practice that..
Q: When I lend them my $100 why don’t I charge them interest?
A: You do.
Q: You don’t say. How much?
A: It depends on the Bank rate. Say half a percent.
Q: Grasping of me, rather?
A: But that’s only if you’re not going to draw the money out again.
Q: But of course I’m going to draw it out again. If I hadn’t wanted to draw it out again I could have buried it in the garden, couldn’t I ?
A: They wouldn’t like you to draw it out again.
Q: Why not? If I keep it there you say it’s a Liability. Wouldn’t they be glad if I reduced their Liabilities by removing it?
A: No. Because if you remove it they can’t lend it to anyone else.
Q: But if I wanted to remove it they’d have to let me?
Q: But suppose they’ve already lent it to another customer?
A: Then they’ll let you have someone else’s money.
Q: But suppose he wants his too.. and they’ve let me have it?
A: You’re being purposely obtuse.
Q: I think I’m being acute. What if everyone wanted their money at once?
A: It’s the theory of banking practice that they never would.
Q: So what banks bank on is not having to meet their commitments?
A: I wouldn’t say that.
Q: Naturally. Well, if there’s nothing else you think you can tell me..
A: Quite so. Now you can go off and open a banking account.
Q: Just one last question.
A: Of course.
Q: Wouldn’t I do better to go off and open up a bank?
*Cited in G. Edward Griffin’s history of the Fed, ‘The Creature From Jekyll Island’.
If only. In defending an insolvent banking system, central banks have now created a more absurd situation than Punch could ever have dreamed of. This commentator, for example, has a meaningful cash deposit with a UK commercial bank that is currently earning 0.0% interest (let’s say minus 3% in real terms). To put it another way, we have 100% counterparty and credit risk with a minus 3% annual return. Is it any wonder the UK savings rate is not higher ? Is it any wonder that savers are stampeding into risk assets ? But the likes of the Fed have muddied the pond further by attempting a policy of “forward guidance” that is little more than a sick joke, given the recent sell-off in government bond markets and the resultant rise in government bond yields, on fears of “tapering”. The Fed has lost control of the bond market. As Swiss investor Marc Faber puts it,
The question is when will it lose control of the stock market.
For several years we have been warning of the dangers of central banks becoming increasingly interventionist in the capital markets. We are old school free market libertarians: if bankers make bad decisions, let their banks fail. This is essentially the same perspective taken by Michael Lewis, recently interviewed in Bloomberg Businessweek. On the fifth anniversary of its bankruptcy, Lewis was asked whether he thought Lehman Brothers had been unfairly singled out when it was allowed to fail (given that every other investment bank was quickly rescued, courtesy of the US taxpayer). His response:
Lehman Brothers was the only one that experienced justice. They should’ve all been left to the mercy of the marketplace. I don’t feel, oh, how sad that Lehman went down. I feel, how sad that Goldman Sachs and Morgan Stanley didn’t follow. I would’ve liked to have seen the crisis play itself out more. The problem is, we would’ve all paid the price. It’s a close call, but I think the long-term effects would’ve been better.
But that is not what happened. We didn’t get runs on investment banks. We got bank bailouts, taxpayer rescues, QE1, QE2, QE3 and now QE-Infinity. The impact on the real economy has been questionable, to say the least:
But the impact on financial markets has been demonstrably beneficial to investment banks and their largest clients.
As Stanley Druckenmiller points out, the Fed didn’t act bravely, they bottled it. They had the opportunity to start, ever so gently, to reverse a policy of monstrous intervention in the capital markets, and they blew it. That makes it all the harder for them to “taper” next time round. When do capital markets free themselves from the baleful manipulation of the state? Marc Faber was similarly unimpressed:
The endgame is a total collapse, but from a higher diving board. The Fed will continue to print and if the stock market goes down 10% they will print even more. And they don’t know anything else to do. And quite frankly, they have boxed themselves into a corner where they are now kind of desperate.
The Fed may be desperate, but we’re not. We have our client assets carefully corralled into four separate asset classes. High quality debt (not US Treasuries or UK Gilts) offers income and a degree of capital protection given that the central banks have demolished deposit rates. Defensive equities give us some skin in the game given central bank bubble-blowing in the stock market – but this game ends in tears. Uncorrelated, systematic trend-followers give us a “market neutral” way of prospectively benefiting from any disorderly market panic. And real assets give us some major skin in the game in the event of an inflationary disaster. Since pretty much all of these assets can be marked to market on a daily basis, they are not free of volatility, but we are more concerned with avoiding the risk of permanent loss of capital, Cypriot bank-style. We have, in other words, Fed-proofed our portfolios to the best of our ability. And on the topic of gold alone, Marc Faber again:
I always buy gold and I own gold. I don’t even value it. I regard it as an insurance policy. I think responsible citizens should own gold, period.
Now that the Fed has blinked in the face of market resistance, it seems inevitable to us, as it does to people like Marc Faber, that at some point, possibly in the near future, traditional assets are at risk of loudly going bang. How close are you going to be to the explosion?
This article was previously published at The price of everything.
“Sir, Martin Sandbu writes: “We should not worry about inflation – if we strip out volatile or policy-driven elements, it stands at 1.5%, according to Citigroup”, (“Carney has not yet bent the markets to his will”, August 14.)
“Please arrange for Mr Sandbu to cancel the policies concerned and to prevent the volatile situations encountered. When was the last time inflation was 1.5% ? This comment is as meaningless as my saying: “If savings rates were 5%, then I could afford two more holidays a year.” They aren’t, and I can’t.”
- Letter to the editor of the Financial Times, from Mr Charles Kiddle, Gateshead, UK.
King Cnut The Great, more commonly known as Canute, was a king of Denmark, England, Norway and parts of Sweden (thanks Wikipedia !). He is likely to be known to any English schoolchildren still being educated for two specific things: extracting Danegeld – a form of protection racket – from the citizenry, and for the possibly apocryphal story that once, from the shoreline, he ordered back the sea. Over to Wikipedia:
Henry of Huntingdon, the 12th-century chronicler, tells how Cnut set his throne by the sea shore and commanded the tide to halt and not wet his feet and robes. Yet “continuing to rise as usual [the tide] dashed over his feet and legs without respect to his royal person. Then the king leapt backwards, saying: ‘Let all men know how empty and worthless is the power of kings, for there is none worthy of the name, but He whom heaven, earth, and sea obey by eternal laws.’ He then hung his gold crown on a crucifix and never wore it again “to the honour of God the almighty King”. This incident is usually misrepresented by popular commentators and politicians as an example of Cnut’s arrogance.
This story may be apocryphal. While the contemporary Encomium Emmae has no mention of it, it would seem that so pious a dedication might have been recorded there, since the same source gives an “eye-witness account of his lavish gifts to the monasteries and poor of St Omer when on the way to Rome, and of the tears and breast-beating which accompanied them”. Goscelin, writing later in the 11th century, instead has Cnut place his crown on a crucifix at Winchester one Easter, with no mention of the sea, and “with the explanation that the king of kings was more worthy of it than he”. Nevertheless, there may be a “basis of fact, in a planned act of piety” behind this story, and Henry of Huntingdon cites it as an example of the king’s “nobleness and greatness of mind.” Later historians repeated the story, most of them adjusting it to have Cnut more clearly aware that the tides would not obey him, and staging the scene to rebuke the flattery of his courtiers; and there are earlier Celtic parallels in stories of men who commanded the tides..
The encounter with the waves is said to have taken place at Thorn-eye (Thorn Island), or Southampton in Hampshire. There were and are numerous islands so named, including at Westminster and Bosham in West Sussex, both places closely associated with Cnut. According to the House of Commons Information Office, Cnut set up a royal palace during his reign on Thorney Island (later to become known as Westminster) as the area was sufficiently far away from the busy settlement to the east known as London. It is believed that, on this site, Cnut tried to command the tide of the river to prove to his courtiers that they were fools to think that he could command the waves. Conflictingly, a sign on Southampton city centre’s Canute Road reads, “Near this spot AD 1028 Canute reproved his courtiers”.
Cnut did exist, even if his mythologised battle with Nature was a fabrication. And for anyone who thinks that politicians are capable of learning from disastrous policy failures, the following lesson from history is also instructive. Explicitly linking economic policy and monetary policy rates to unemployment rates is not an innovation of either Ben Bernanke’s Fed or Mark Carney’s Bank of England. As Ferdinand Lips points out in his ‘Gold Wars’ (hat-tip to The Real Asset Company’s Will Bancroft):
With the passage of [the US Employment Act of 1946], the US government officially declared war on unemployment and promised to maintain full employment regardless of cost. Thus, it hoped to eliminate the business cycle and to prevent the country from ever sinking to the economic depths of the 1930s.
In the 1950s and the 1960s a weekly column in Barron’s called “The Trader” was written by a certain Mr. Nelson. Week after week, he untiringly drew readers’ attention to the consequences the Employment Act had on the purchasing power of the currency..
One would have thought that economic central planning would have been somewhat discredited after the Soviet empire collapsed in 1989, in favour of free markets. That message has yet to get to the US Federal Reserve or the Bank of England. But the Soviet experience is doubly instructive, in that it shows just how long a fatally dysfunctional system can last in the face of its obvious, existential, contradictions and absurdities.
Our thesis is that we are perilously close to the disorderly end-stage of a 40 year experiment in money and unfettered credit. That experiment started when US President Nixon took the US dollar off gold in 1971, and in the process created a global unbacked fiat currency system for the first time in world history. The history of paper currencies is instructive, too. Not one has ever lasted. Fast forward 40 years.. Texan fund manager Kyle Bass points out that total credit market debt now stands at some 360% of global GDP. For an individual country to maintain a debt to GDP ratio of 250% is consistent with that country deficit-spending its way through a war – such as was the position for the UK in 1945. For the entire world (read: notably the western world) to be loaded with such an untenable debt burden today suggests that something has gone catastrophically wrong with our banking and credit system.
We don’t know what the future holds but, crucially, our investment process does not explicitly require us to, and we have engineered it such that our process carries a degree of insurance against our own overconfidence as asset management fiduciaries. The market can be directed, coerced, bribed, manipulated, distorted and pummelled, but we don’t believe it can ever be completely destroyed – despite the best efforts of central bankers. There is early evidence that bond market vigilantes have had enough with QE and other desperate policy manoeuvrings, and are voting with their feet. If bond yields continue to rise, think very carefully about your exposure to market risk in all its other forms. We have, and are positioned accordingly.
In the current context, if Cnut did ever order back the tide, whether he did so to instruct his courtiers or to display his arrogance over the forces of nature is somewhat moot. The great physicist Richard Feynman made a similar admonition to NASA after the 1986 space shuttle disaster ending up killing seven crew members. In his infamous warning to a bureaucracy seemingly overtaken by ‘spin’, he said in his conclusion to the Challenger report,
For a successful technology, reality must take precedence over public relations, for Nature cannot be fooled.
For Feynman, and for Cnut, it was Nature. For us, it is the markets. Modern critics of the central banks, like ourselves, would suggest that we now have a modern equivalent of Cnut’s Danegeld, in the form of punitively low interest rates, rates which are being kept artificially low to try and resurrect a borderline insolvent banking system which is still content to pay significant executive bonuses and, in some instances, even dividends (to shareholders foolish enough to own common stock issued by banks whose fundamental value cannot be remotely assessed on any sensible economic basis). The economy, in other words, is being held hostage to cater to narrow and largely unreconstructed banking interests. At the same time, the farce of “forward guidance” – the pledge to keep interest rates unchanged until there is tangible evidence of economic recovery, almost irrespective of the latent inflationary pressure being stoked up – is being revealed as farce by Gilt yields that have risen by over 100 basis points since May (and the same holds for US Treasuries). Despite the king’s orders, in other words, the tide continues to come in.
A version of this article was previously published at The price of everything.