“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.”
- Ernest Hemingway.
“Recovery in sight, says departing Bank of England governor Mervyn King..”
- The Daily Telegraph.
In one of the most powerful and memorable metaphors in finance, Charles Ellis, the founder of Greenwich Associates, cited the work of Simon Ramo in a study of the strategy of one particular sport: ‘Extraordinary tennis for the ordinary tennis player’. Ellis’ essay is titled ‘The loser’s game’, which in his view is what the ‘sport’ of investing had become by the time he wrote it in 1975. Whereas tennis is ‘won’ by professionals, the practice of investing is ‘lost’ by professionals and amateurs alike. Whereas professional sportspeople win their matches, investors tend to lose the equivalent of theirs through unforced errors. Success in investing, in other words, comes not from over-reaching, in straining to make the shot, but simply through the avoidance of easy errors.
Ellis was also making the point that as far back as the 1970s, investment managers were not beating the market; rather, the market was beating them. This is a mathematical inevitability given the crowded nature of the institutional fund management marketplace and the impact of management fees on end investor returns. Ben W. Heineman, Jr. and Stephen Davis for the Yale School of Management asked in their report of October 2011, ‘Are institutional investors part of the problem or part of the solution?’ By their analysis, in 1987, some 12 years after Ellis’ earlier piece, institutional investors accounted for the ownership of 46.6% of the top 1000 listed companies in the US. By 2009 that figure had risen to 73%. That percentage is itself likely understated because it takes no account of the role of hedge funds. Also by 2009 the US institutional landscape contained more than 700,000 pension funds; 8,600 mutual funds (almost all of whom were not mutual funds in the strict sense of the term, but rather for-profit entities); 7,900 insurance companies; 6,800 hedge funds; and more than 2,000 funds of funds (the horror! the horror!)
Following immediately on from this latter figure, it is worth observing that something has gone seriously awry in the order of the universe when the number of listed equity funds in a given market comes to outnumber the number of listed equities in that same market – a fantastic example of a fund management industry happily consuming itself.
In what ways do institutional asset managers create a rod for their own backs? The most widespread, and probably the most damaging to the interests of end investors, is in benchmarking. Being assessed relative to the performance of an equity or bond benchmark effectively guarantees (post the impact of fees) the institutional manager’s inability to outperform that benchmark – but does ensure that in bear markets, index-benchmarked funds are more or less guaranteed to lose money for their investors. In equity fund management the malign impact of benchmarking is bad enough; in bond fund management the malign impact of ‘market capitalisation’ benchmarking is disastrous from the get-go. Since a capitalisation benchmark assigns the heaviest weightings in a bond index to the largest bond markets by asset size, and since the largest bond markets by asset size represent the most heavily indebted issuers – whether sovereign or corporate – a bond- indexed manager is compelled to have the highest exposure to the most heavily indebted issuers. All things equal, therefore, it is likely that the bond index-tracking manager is by definition heavily exposed to objectively poor quality (because most heavily indebted) credits. Given that we are living through a once-in-a-generation crisis in the bond markets, chances are that this game will not end well for benchmarked managers.
Quite how this institutional insistence on benchmarking arose – whether versus indices or versus peer groups – is not precisely clear. But it would seem to give the majority of asset managers regulatory cover for sheltering amongst the consensus. And as SocGen’s Albert Edwards puts it, “The late Margaret Thatcher had a strong view about consensus. She called it: ‘The process of abandoning all beliefs, principles, values and policies in search of something in which no-one believes, but to which no-one objects.’” And the prevailing institutional imperative is to give customers what they think they want, or what can easily be sold, which most of the time is probably the same thing. Which accounts for the thousands of me-too fund offerings clogging the ‘Managed Funds’ section of the FT, most of which would be completely superfluous in a properly efficient market.
James Montier, in his bible on behavioural finance, ‘Behavioural investing’, points out two recent discoveries by neuroscientists that have relevance to all investors: we are hard-wired for the short term, and we seem to be hard-wired to herd. The first characteristic makes for an uncomfortable psychological journey whenever a portfolio incurs losses (in whole or in part); the second characteristic makes for an uncomfortable psychological journey whenever a portfolio pursues a remotely contrarian tack. Once again, the power of conformity is acute.
A particularly intriguing experiment used by Montier relates to our tendency towards anchoring. Feel free to follow it yourself. It goes as follows:
1. Please write down the last four digits of your telephone number.
2. Is the number of physicians in London higher or lower than this number?
3. What is your best guess as to the number of physicians in London?
In Montier’s words, anchoring is “our tendency to grab hold of irrelevant and often subliminal inputs in the face of uncertainty.”
The idea of the experiment, then, is to see whether respondents were influenced by their (random and irrelevant) phone number as a gauge in trying to estimate the number of doctors in London. The results of the experiment can be seen below:
As the chart indicates, those respondents with telephone numbers above 7,000 suggested, on average, that there were just over 8,000 doctors in London. Those with telephone numbers below 3,000 suggested 4,000 doctors. “This represents a very clear difference of opinion driven by the fact that investors are using their telephone numbers, albeit subconsciously, as inputs into their forecast.”
So our thesis goes as follows. In the absence of reliable knowledge about the future, investors have a tendency to anchor onto something – anything – to help them assess or predict future market returns. What better anchor to use for future market returns than prior ones? This is where the story gets more intriguing still.
The chart above attempts to answer a rhetorical question: why do so many financial advisers advocate equity-centric portfolios? We think the reason is: because so many of them worked during the most recent financial period. On a discrete 20 year basis, the period 1980-1999 is the only period of the last 300 years in which annual, real returns from the UK market offered investors between 8% and 10% on average. Note that for much of that three-century period, annualised real returns ended up either side of zero.
We think the story gets more intriguing still. We would advocate the thesis that a good part of those returns was somewhat illusory in nature. More specifically, given that they occurred during a once-in-a-century period of extraordinary credit creation, those market returns were in large part borrowed from the future, in the same way that governments have been funded, and their colossal bond markets serviced, by essentially loading the ultimate cost and the final reckoning onto the next generation.
If this thesis is even half correct, investors piling into stocks now, at current highs, on the premise of recapturing some of those 8% – 10% real annual returns, are being at least somewhat delusional. The credit bubble has burst. Messily. The stock market has not necessarily woken up to the fact. This does not detract from the sensible analysis of equity market opportunities. But for any investment, its most important characteristic is its starting valuation. Buy attractive equities at sufficiently undemanding multiples and you should rightly expect to do well. Buy – let us call it the index – expensively, and after a grotesque bubble of credit and associated distortions throughout the capital market structure, egged on by central banks who have long abandoned what limited policy mandates they previously pursued, and expect things to end in a train wreck. Winning the loser’s game is fine. Losing the loser’s game is not something to which we aspire.
Ludwig von Mises once wrote that all of economics can be neatly summed up in one of two studies: either you are studying how prices come into being, or you are studying how markets allocate goods. All economic problems can be distilled into one of these two categories.
Prices and markets are innocuous concepts – they exist in various forms, and to paraphrase Adam Ferguson, “they are the work of human hands, but not of human design.” Both prices and markets are natural phenomena that have come into being as the result of our actions, and they serve no other purpose than facilitating our ends.
Yet from time to time, and the current time being a good case in point, prices and markets are viewed with much more sinister spectacles. Prices come to be seen as “right”, or more usually, “wrong”. They are too high or too low. Much sovereign debt is trading at a high price, too high if you believe some analysts. This is a function of its interest rate being low, too low as the case may be. The healthcare debacle in the United States is the consequence of a widespread belief that medical prices are too high, or more aptly that health insurance is too expensive.
Markets are those various places where prices come alive. Unsurprisingly, when prices seem “wrong” to people it must be that the markets that allow them to arise are themselves not functioning correctly. Main Street is in the midst of a recession, though Wall Street seems to be relishing record high stock prices. Might something be amiss in the financial markets? Millions of people are out of work, and yet the labour market seems woefully inept at getting jobs to them.
The apparent mispricings and market failures lead to many calls for changes to rectify these perceived errors. What is missing is some real thought into why it is that these prices and markets do not coincide with what we perceive to be the “right” price, or “well functioning” markets.
It is in response to these misgivings that I proudly announce The Journal of Prices & Markets, a scholarly peer-reviewed journal published bi-annually in collaboration with the Ludwig von Mises Institute of Canada.
The Journal’s goals are straightforward.
First, it is an outlet for those interested not in the glossy superficial nature of events, but the real underlying phenomena shaping them. The journal is not concerned with overly elaborate constructivist plans to recreate the wheel. We don’t need to invent new prices or markets when the old ones no longer seem sufficient at serving their original purposes. What we need is critical analysis into why current events seem so dysfunctional.
Second, and perhaps more importantly, The Journal of Prices & Markets stresses the lost art of relevance. Economics is a beautiful science that should serve the purpose of enlightening us. Instead it has gotten to the state where it creates confusion. As the jokes go, economists predicted ten of the last five recessions, and if you want a second opinion on something, just call back the economist you originally asked. Economists cannot even seem to reach agreement amongst themselves on simple questions, and in a bid to convince each other of their correctness they seek ever more levels of complexity in their theories. Complexity is not necessarily a bad thing, but we should never lose sight of the original question.
Economics aimed at relevant issues is what the doctor ordered, not economics aimed at irrelevant problems created by economists through their ever-increasingly complex answers to simple questions.
With its world-class editorial board behind it, the Journal seeks to further these aims by serving up a healthy dose of theory and practice.
Each issue will contain five editorials by specialists in their fields. These editorials will bring relevant and current problems to light, and enlighten the reader with analysis that is both elegant and simple. They will solve the age-old problem of economic analysis – how to give an obviously correct answer to a non-trivial question.
For the learned reader looking to delve more deeply into the problems at hand, each issue of The Journal of Prices & Markets offers longer scholarly and peer-reviewed articles. Written by academics, these articles explore the finer details of price formation and market allocations. For the bookworms, the Journal even has reviews of the books you should be reading to understand the world, as well as what you should be looking for as you read them.
Interested? Why not visit the website and put your name on the email list to receive updates when articles are published. If you are an academic, or know someone who is, and are interested in contributing to the Journal, please visit the submissions page for more details.
Most people — from young to old and from all ends of the political spectrum — are united by a common bond. The idea that banks are deserving of taxpayer support is viewed as morally repugnant to them. Business owners see bank bailouts as an unfair advantage that is not extended to all businesses. Those typically on the political left see it as support for the establishment, and a slap in the faces of the little people. Those more at home on the political right see it as just another form of welfare: a wealth redistribution from the hard working segment of the population to the reckless gambling class of banksters.
Despite this common disdain for bankers, there is considerable disagreement on how to deal with them. One group sees less regulation as the solution — letting market forces work will allow the virtues of prudence and industry to prevail. This formulation sees these same market forces as limiting firm size naturally to evade the “too big to fail” issue, through many of the same incentives that foment competitive economic advancement.
Another group sees the solution as more regulation. The natural tendency in business, according to this group, is for large monopolies to form. As companies grow in size, they gain political influence as well as an aura of indispensability. The consequence is that not only will a company come to be seen as too big to fail, but it will also be politically influential enough to seek such recourse if troubles surface.
Like most answers, the truth lies somewhere in the middle.
The first group correctly notes that there are two specific drawbacks of increasing regulation. On the one hand, “one size fits all” regulatory policies (such as is commonly the case on the Federal level) are rarely capable of handling the intricacies and dynamics of business. They also have the effect of relaxing the attention individuals and businesses afford to their own behavior. Under the pretense that the state has enacted wise regulations, individuals see little need to actively monitor companies to make sure they behave in a responsible manner. Businesses too succumb to this mentality. By abiding by the existing regulatory regime, they take solace in knowing that any attack on their integrity can be brushed aside as an attack placed more appropriately on the failures of the regulating body.
On the other hand, increased regulation breeds the problem of what economists call “moral hazard.” An activity is morally hazardous when a party can reap the benefits of an action without incurring the costs. The financial industry is very obviously afflicted with moral hazard today.
Banks and other financial companies have largely abided by the law. I would venture a guess that there is no industry more heavily regulated than the financial services industry, and no industry that spends more time and resources making sure that it complies with this complex regulatory maze. Capital levels must be maintained, reporting must be prompt and transparent, and certain types of assets must be bought or not bought. Banks following these regulations get a sense that they will survive, if not flourish, provided they work within the confines of the law.
However, it is increasingly evident that the financial regulations put in place over the past decades are woefully inept at maintaining a healthy financial industry. In spite of (or perhaps because of) all these regulations, a great many companies are, shall we say, less than solvent. So, who is to blame? It would be easy to blame the companies themselves, except that they did everything that the regulators told them to do.
Why not at least consider relaxing regulations? Doing so would have a two-fold advantage.
On the one hand, businesses would be more obviously responsible for the instability they have now created. On the other hand, without regulations, more reckless or clumsily managed companies would have gone out of business already, lacking the benefit of a regulatory “parent” scolding them for their mistakes. The result would be fewer unstable businesses, and more attention to the dangers of one’s own actions.
I previously mentioned that both sides are correct to some degree, implying that those calling for more regulation had some merit to their arguments. And this is indeed true. However, to paraphrase Inigo Montoya, when they use the word “regulation,” I do not think it means what they think it means.
It is true that not all companies play on a level field. In the financial services industry, and particularly in the banking sector, this is especially apparent. Banks are granted a legal privilege of “fractional reserves.” The result is that banks behave in a way which is fundamentally different from any other type of business, and which is easy to misdiagnose as “inadequate regulation.”
A depositor places money in his bank. The result is a deposit, and the depositor has a claim to this sum of money at any moment. One would think that the bank would be obliged to keep the money on hand, much in the same way that other deposited goods — like grain in an elevator — must be kept on hand. The law begs to differ. Banks are obliged to keep only a portion, or fraction, of that deposit in their vaults and are free to use the remaining sum as they please. Canada and the United Kingdom are examples of countries where there is no legal requirement for a bank to hold any percentage of that original deposit in its vault. In the United States, if a bank has net transactions accounts (deposits and accounts receivable) of less than $12.4 million, the reserve ratio is also set at zero. This differs greatly from grain elevators, where the law strictly states that the elevator owner must keep 100 percent of the deposited grain in the silo.
There are two results of the practice of fractional reserve banking, neither of them positive for the average person.
First, banks grow larger because they have access to a funding source that would otherwise not be available if they conducted themselves by the same laws as other businesses. When commentators say “banks are different,” there is truth in the statement. They have a legal privilege that enables them to grow in scope beyond that which they could naturally. This also explains why many banks, and financial services companies, come to be viewed as too big to fail.
Second, banks become riskier. Every time a deposit is not backed 100 percent, the depositor is exposed to the possibility of not getting his deposit back in full. If a bank uses his deposit to fund a mortgage, and the borrower defaults and cannot repay the bank, there is a risk that the original depositor will lose some of his money. A more common case is a bank run, in which many depositors try to withdraw money at the same time. The result will be insufficient funds to simultaneously honor all redemption demands. This occurred with various banks in Iceland, Ireland, Britain, and Cyprus over the last four years.
Few people worry about this latter problem, however, because of the former one. Since banks have become too big to fail, we are assured that if one goes bankrupt, we as depositors do not stand to lose personally. The government has pledged implicitly, or even explicitly through deposit insurance, that it will step in and bail out the irresponsible actors.
The result is the confusing state of affairs that we have today with two sides both arguing for the same thing — banking stability — via two diametrically opposed means. The “more regulation” camp is pitted against the “less regulation” camp.
These two camps are not mutually exclusive. We can solve the problems of moral hazard and “too big to fail” in one fell swoop by ending fractional reserve banking.
By ending this legal privilege, we eliminate the ability for banks to grow to such inordinate sizes. By abiding by the same legal principles (or “regulations,” if you will) as any other deposit-taking firm, banks are not unduly advantaged. If banks shrink in size, the “too big to fail” doctrine is eliminated, or at least greatly reduced. This means that depositors and bankers will realize that if a loss occurs to their bank, they personally stand to lose.
The risk of loss is a great force in removing moral hazard. Remember that it only arises when one person’s ability to gain is not constrained by the threat of a loss. Cognizant of ensuing losses, depositors will demand that their banks adhere to more prudent operating principles, and bankers will be forced to meet these demands.
The critics worried about “too big to fail” are right. We do need more “regulations,” in a sense. We need banks to be regulated by the same legal principles regarding fraud as every other business. The critics worried about moral hazard are also right. We need fewer of every other kind of regulation.
Repairing a broken financial system does not have to be hampered by irreconcilable political differences. Recognizing the true issues at stake — legal privilege and unconstrained risk taking — allows one to bring together advocates of widely differing solutions into one coherent group. Getting bankers to agree to all this is another story.
This article was previously published at Mises.org.
There has been a growing shift in favour of assets relative to bank deposits. This was initially encouraged by zero interest rates, but more recently there is little doubt that Cyprus’s bail-in has accelerated the trend. This explains the bull markets in bonds and equities, which conveniently underwrites the entire banking system. It is however too early to offer evidence of falling deposit balances held by non-banks and the general public because depositors as a whole have been remarkably complacent, but there is ample evidence that liquidity from monetary expansion is inflating financial assets faster than bank deposits.
This helps explain why, for example, Italian 10-year bonds are on a 4% yield. The reason, doubtless reaffirmed by the Cyprus bail-in, is that investors with cash balances think over-priced sovereign debt is less risky than adding to their euro deposits. However, the central banks are relaxed because weakness in deposits at any single bank is easily covered through the banking system, insulating individual banks from depositor-withdrawal systems. Presumably, banking counterparties are also complacent because they can be reasonably sure to be exempt from any bail-ins. They have the comfort of knowing the banking system is underwritten by all those complacent enough to leave money on deposit beyond the insured level.
However, some of depositors’ cash balances post-Cyprus will have gone into physical gold and silver, which explains why the bullion banks operating in the futures markets and the central banks behind them are so keen to dissuade us that gold and silver is a safe haven. I recently interviewed Ronnie Stoerferle, the Vienna-based analyst, who put his finger on it: since Cyprus, there has been a sharp rise in European demand for physical gold, with the pressure being felt by the bullion banks unable to deliver bullion.
At least one bank was recently reported to be only prepared to settle bullion liabilities in cash. Therefore the price knock-down in April was a logical response by the bullion banks, which had to defuse customer demand for physical delivery. But given that the driving factor was not speculation but a reluctance to add to deposits in the banking system, the jump in demand for bullion at lower prices was inevitable.
Where does this leave things? The crisis in bullion markets is worse than it was before. A good example of how little physical stock there is can be gained by tracking bullion deliveries on the Shanghai Gold Exchange. In the last few weeks they have dwindled to virtually nothing, having been a truncated 190 tonnes in April and 297 tonnes in March. Yet we know from reports that retail demand in China has taken off; so it is only a matter of time before prices are bid up on the Shanghai Gold Exchange enough to replace lost inventory.
It will be interesting to see how many more bullion banks are forced to admit the fiction behind their customer accounts in the coming weeks. For the moment the temporary solution amounts to rationing bullion supplies to the public.
This article was previously published at GoldMoney.com.
The Honorable Ron Paul says:
Why is gold good money? Because it possesses all the monetary properties that the market demands: it is divisible, portable, recognizable and, most importantly, scarce – making it a stable store of value.
True. Yet those properties are not the most relevant today. The most important characteristic that makes gold a good reference point for money today is its enormous stock to flow ratio as the recent gold report by Erste Bank points out.
By neglecting the stock to flow ratio argument and using other, less important ones, it is much easier for anti-gold economists to confuse the public. For instance, Paul Krugman and others mercilessly criticize gold by conflating deflation with contraction and inflation with expansion.
Gold is money not because it is scarce but because it is abundant (relative to its production and consumption). This factor makes for a huge buffer that stabilizes its value against other things.
The same can be said about water. Water is abundant on Earth. Water evaporates from the land and oceans, falls down as rain and snow, rivers bring it back to oceans – at widely volatile rates.
Approximately 505,000 km3 of water falls as precipitation each year. But the world’s water supply is estimated at 1,386,000,000 km3 (97 per cent of which is stored in oceans). A huge stock to flow ratio that makes for a useful reference point.
The Erste Bank’s Gold Report concludes:
We believe that gold is not precious because it is scarce, but because the opposite is true: gold is precious because the annual production is so low relative to the stock. The aggregate volume of all the gold ever produced comes to about 170,000 tonnes. This is the stock. Annual production was close to 2,600 tonnes in 2011. That is the flow. Dividing the former by the latter, we receive the stock-to-flow ratio of 65 years (which is far more than for any other good offered in the world economy).
Gold has acquired this feature over centuries, and cannot lose it anymore.
Most commodities are consumed, whereas gold stocks are augmented, gradually.
Let’s suppose then that production of gold increases twofold or is cut in half. No big deal. There is a huge reserve to make up for difference. This does not really apply to any other commodity.
It should be also noted that CPI is a sum of two different and separate things.
CPI has a monetary component and a component related to business cycle.
When too much money is created the prices rise – prices of gold first, then other commodities and liquid assets. The prices of goods that are included in CPI rise thereafter.
But there may be other reasons for a rise in CPI. Let us assume that monetary policy in a given country is OK, but the economy is growing really fast, as was Ireland and Estonia before the crisis. CPI had been rising there due to the (relatively) huge inflow of capital – there was more demand than supply for everything, especially immovable property. Symmetrically, one can get a drop of CPI in a recession.
This is how adjusting interest rates works. Interest rates are not a monetary instrument, but an instrument to effect business cycle. By raising interest rates central banks depress economic activity and force marginal firms out of business. This reduces CPI. Symmetrically, central banks try to revive growth by reducing interest rates in an attempt to bring about an increase in CPI.
Why was there no surge in CPI after such a huge injection of money after September 2008?
There appear two things working in opposite directions here: too much money pushing prices up and severe recession bringing them down. Taken together they made, and are making, for modest CPI increases. In 1970 monetary expansion was much stronger (23X rise in gold prices against 3 fold now) and real economic growth as weak as it was, was stronger than it has been.
This article was previously published at The Gold Standard Now.
In his New York Times article of May 7, columnist Bruce Bartlett laments that given the current state of economic affairs we need more Keynesian medicine to fix the US economy. According to Bartlett the core insight of Keynesian economics is that there are very special economic circumstances in which the general rules of economics don’t apply and are in fact counterproductive. This happens when interest rates and inflation rate are so low that monetary policy becomes impotent; an increase in the money supply has no boosting effect because it does not lead to additional spending by consumers or businesses. Keynes called this situation a “liquidity trap”. Keynes wrote,
There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest 
Bartlett holds that under such circumstances government spending can be highly stimulative because it causes money that is sitting idle in bank reserves or savings accounts to circulate and become mobilized through consumption or investment. Thus monetary policy becomes effective once again. Bartlett regards this as an extremely important insight that policy makers have yet to grasp. According to our columnist, despite massive monetary pumping by the Fed since 2008, it has produced very little boosting effect on the economy. The Fed’s balance sheet jumped from $0.897 trillion in January 2008 to $3.3trillion in early May 2013. The Federal Funds
Rate target stood at 0.25% in early May against 3% in January 2008.
According to Bartlett, in normal times one would expect such an increase in money pumping to be highly inflationary and sharply raise market interest rates. That this has not happened says Bartlett, is a proof that we have been in a liquidity trap for several years. Bartlett concludes that we needed a lot more government spending than we got to get the economy out of its doldrums. Note also that Nobel Laureate in economics Paul Krugman holds similar views. For them what is needed is a re-activation of the monetary flow that for some unknown reasons got stockpiled in the banking system. Observe that in the Keynesian framework the ever-expanding monetary flow is the key to economic prosperity. What drives economic growth is monetary expenditure.
Why is money not the driver of economic growth?
Contrary to popular thinking monetary flow has nothing to do with an economic growth as such. Money is simply a medium of exchange and nothing more than that. Also, note that people don’t pay with money but rather with the goods and services that they have produced.
For instance, a baker pays for shoes by means of the bread he produced, while the shoemaker pays for the bread by means of the shoes he made. When the baker exchanges his money for shoes, he has already paid for the shoes, so to speak, with the bread that he produced prior to this exchange. Again, money is just employed to exchange goods and services. Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer.
What drives the economic growth is savings that are used to fund the increase and the enhancement of tools and machinery i.e. capital goods or the infra-structure that permits the increase in final goods and services i.e. real wealth to support people’s lives and well beings.
Contrary to popular thinking, an increase in the monetary flow is in fact detrimental to economic growth since it sets in motion an exchange of something for nothing – it leads to the diversion of real wealth from wealth generators to wealth consumers. This in the process reduces the amount of wealth at the disposal of wealth generators thereby diminishing their ability to enhance and maintain the infrastructure. This in turn undermines the ability to grow the economy.
What is behind the so called liquidity trap?
The fact that so far the Fed’s massive pumping has not resulted in a massive monetary flood should be regarded as good news. Imagine that if all that pumping were to enter the economy it would have entirely decimated the machinery of wealth generation and produced massive economic impoverishment. It seems that market forces have so far managed to withstand the onslaught by the US central bank. What allowed this resistance is not some kind of ideology against aggressive pumping by the Fed (in fact most experts and commentators are of the view that the Fed should push a lot of money in difficult times) but the fact that the process of real wealth generation has been severely damaged by the previous loose monetary policies of Greenspan’s and Bernanke’s Fed.
The badly damaged process of wealth generation has severely impaired true economic growth, and obviously this has severely reduced the number of good quality borrowers and so has reduced banks’ willingness to lend. Remember that in essence banks lend real wealth by means of money. They are just intermediaries. Obviously, then, if wealth formation is getting impaired, less lending can be done. We suggest that it is this fact alone that explains why all the pumping by the Fed has ended up stacked in the banking system. So far in early May banks have been sitting on over $1.7 trillion in surplus cash. In January 2008 surplus cash stood at $2.4 billion.
Given the high likelihood that the process of real wealth generation has been severely damaged this means that the pace of wealth generation must follow suit. Now, contrary to popular thinking an increase in government spending cannot revive the process of wealth generation, but on the contrary it can only make things much worse. Remember: government is not a wealth generating entity so in this sense increases in government spending generate the same damaging effect as monetary printing does (it leads to the diversion of wealth from wealth generators to wealth consumers). Observe that in 2012 US Government outlays stood at $3.538 trillion, an increase of 98% from 2000.
As long as the rate of growth of the pool of real wealth stays positive, this can continue to sustain productive and nonproductive activities.
Trouble erupts, however, when, on account of loose monetary and fiscal policies, a structure of production emerges that ties up much more wealth than the amount it releases.
This excessive consumption relative to the production of wealth leads to a decline in the pool of wealth.
This in turn weakens the support for economic activities, resulting in the economy plunging into a slump. (The shrinking pool of real wealth exposes the commonly accepted fallacy that loose monetary and fiscal policies can grow the economy.)
Needless to say, once the economy falls into a recession because of a falling pool of real wealth, any government or central-bank attempts to revive the economy must fail.
This means that a policy such as lifting government outlays to counter the liquidity trap will make things much worse.
Not only will these attempts not revive the economy; they will deplete the pool of real wealth further, thereby prolonging the economic slump.
Likewise any policy that forces banks to expand lending “out of thin air” will further damage the pool and will further reduce banks’ ability to lend.
Again the foundation of lending is real wealth and not money as such. It is real wealth that imposes restrictions on banks’ ability to lend. (Money is just the medium of exchange, which facilitates the flow of real wealth.)
Note that without an expanding pool of real wealth any expansion of bank lending is going to lift banks’ nonperforming assets.
Summary and conclusion
Contrary to various experts we suggest that in the current economic climate an increase in government outlays is not going to make Fed’s loose monetary policies more effective as far as boosting economic activity is concerned.
On the contrary, it will weaken the process of wealth generation and will retard economic growth.
What is needed to get the economy going is to close all loopholes for money creation and drastically curtail government outlays.
This will leave a greater amount of wealth in the hands of wealth generators and will boost their ability to grow the economy.
 John Maynard Keynes, The General Theory of Employment, Interest, and Money, MacMillan & Co. Ltd. (1964), p. 207.
“When the cover of a major financial magazine features a cartoon of a bull leaping through the air on a pogo stick, it’s probably about time to cash in the chips.”
- John Hussman of Hussman Funds in his April letter.
￼Amsterdam, March 1637 (Ruyters): The latest Dutch tulip harvest is in, and experts confidently predict another bumper year for tulip growers and tulip investors alike. Billionaire hedge farmer Jon Paulsen is rumoured to have added hyacinths to his multi-strategy offering and has just launched a fund denominated in daffodils. Tulip stocks climbed by a few millimetres, as they are prone to every day if they grow at their normal organic rate; Couleren bulbs rallied another 2 guilders in heavy Antwerp trading; Rosen and Violetten bulbs ended the trading session more or less unchanged, albeit a bit squashed, and at record highs. The market has been further buoyed in recent weeks by a tide of manure issued by the leading tulip advocate Pol Kruygman from his op-ed column in the New Amsterdam Times, ‘Witterings of a Tulip Fanatic’. Kruygman promised to keep the manure coming, whether anybody wanted it or not.
The popularity and rising value of this colourful perennial plant evidently know no bounds and this is surely a golden age that is never likely to end. Future generations will evidently marvel at the effortless wealth on offer to investors committing their capital unreservedly to tulips today. Dutch housewives bedecked in tulip hats, tulip scarves, tulip dresses and tulip shoes danced gaily in the streets of Tuliptown (formerly Amsterdam) whilst smoking tulip cigarettes, slurping tulip soup, and drinking tulip beer from tulip beer glasses with tulip straws. Given that the anthocyanin Tulipanin is toxic to horses, cats and dogs, the inhabitants of Amsterdam have long since stopped rearing horses, cats and dogs; they have chosen to rear tulips as pets instead.
Many Dutch households have also abandoned the traditional export trades in herring, gin and cheese in order to concentrate their energies where the action is: tulips. Tulip promoter Dirck Pieter Tulip commented:
Tulip tulip tulip! At my tulip worship museum and emporium, ‘All Things Tulip’, you can see the very latest in tulip technology, tulip breeding and tulip trading strategies.
Dirck Pieter Tulip is offering courses in tulip cash / futures arbitrage. Price: One Tulip. Mr Tulip was formerly a stockbroker. In addition to curating his tulip museum he also edits the specialist tulip fanciers’ magazine, ‘Bulb!’
“I have just sold my house, its contents and all my family in order to speculate indefinitely in tulips, heavily on margin, and advised all my friends to do the same,” he added. “What can possibly go wrong?”
Tulip Reserve Bank Governor Ben Berninckje agreed, and greeted the news of the tulip harvest warmly.
“There has never hitherto been a nationwide fall in tulip prices,” he pointed out, “So evidently that can never ever happen.”
And Governor Berninckje pledged to support tulip prices down to the very last taxpayer, now that the tulip-related economy accounted for about 99.6% of Dutch GDP. Lending against tulips accounted for the other 0.4%.
Analysts at the business network ZeeNBZee were quick to voice their compliance with the almost universal approbation for the pretty, multi-hued offspring of Tulipa gesneriana.
“Tulips are definitely the way forward,” said one.
“Although I have only been in the market since about 7.30 this morning, this is the most incredible and exciting thing I have ever seen. So I recommend long tulip positions to anyone witless enough to listen to me.”
New derivative markets in tulips are sprouting up daily to enable people to speculate in tulip price appreciation without having to worry about the tiresome fuss of actually taking delivery of the attractively patterned flowers. And prices are continually reaching new highs, even in new digital- only varieties of the plant, or bit-tulips. Talk of tulip millionaires is all the rage. Popular balladeer Jostin Beebor is said to have been an early investor, but he is rumoured to have sold all his tulip positions now.
Sceptics of the tulip cult are obviously fusty-minded dullards who lack imagination, vision or a healthy sense of disbelief. One sceptic, speaking on condition of anonymity although his name is Cornelis Tromp and he resides at 33 Medomsley Road, Utrecht, remarked,
Something about this environment feels dreadfully wrong to me – a contradiction in terms of logic, common sense and fundamental economics. Every day new tulips come onto the market and the supply of them has never been higher, and yet every day the prices also reach new records. But the market is drowning in tulips and there is almost nobody left who doesn’t already own them. There’s not a whole lot you can do with them. And they only bloom for a week. Unless the laws of supply and demand have been magically rescinded, this fantastical bubble in
dotcom stocks US property bank stocks subprime credit government bonds equities tulips is likely to end very badly, particularly for neophyte investors who have been urged by irresponsible reserve banks and an unregulated financial media into the tulip market to the exclusion of just about everything else.
Commentators aside from Mr Tromp, however, were unanimous in their confidence that for as long as the tulip reserve banks stood ready and willing to throw liquidity at the tulip market, and for as long as that market was going up, there were no clouds on the horizon, although the weather correspondent for the New Amsterdam Times pointed out that there was actually a gigantic, dense, threatening mass of clouds on the horizon.
This article was previously published at The price of everything.
Back in mid-March I made the latest of my somewhat rare specific, near-term market predictions, in this case that a US stock market correction or even a crash was imminent. Now some six weeks and a further 5% rally later, I revisit this view. Why, amid surprisingly weak economic data, corporate profit warnings and continued softness in global commodity prices, has the stock market risen to fresh highs? A key explanation is not one that the bulls are going to like: Central banks are increasingly monetising equities, implying further currency debasement. Investors should thus now begin to deploy idle cash; not in allocations to stocks, however, but to a broad basket of relatively depressed commodities, in particular metals and certain agricultural products.
THE (ONGOING) ROAD TO RECORD HIGHS
All investors make mistakes but not all investors learn from them. Those that do make better investors. I like to consider myself in this latter category.
Therefore, the time has come for me to evaluate my most recent prediction, from mid-March, that the US stock market was likely to suffer a serious correction or even a crash over the coming weeks. While there was indeed a slight stumble and loss of momentum in April, this has not prevented a net 5% rally in the S&P500 index to 1,630 this week.
For those not familiar with my prediction, here follow some brief excerpts from the relevant Amphora Report, ASSUME THE BRACE POSITION:
Year to date, both broad money and private sector credit growth are outright negative even through the monetary base is growing at nearly a 70% annualised rate. The Fed is, therefore, pushing harder than ever before, but still pushing on a string.
Corporate insiders… are cashing out at the fastest rate in years. Many companies are raising new capital through either initial or secondary offerings. Such activity is a sign of a market top…
[F]orward earnings growth estimates are in the double-digits, even though profit margins are already at record highs. If history is a guide, profit margins are highly unlikely to remain this wide for long.
[T]he current rally has been characterised by steadily declining volumes. In other words, a relatively small number of transactions have been responsible for pushing up prices. This is in sharp contrast to much research suggesting that a ‘wall of cash’ has been pushing the market higher.
As it happens, each of these cited conditions continues. Alongside a further weakening of broad money and credit growth, leading economic indicators have, on balance, been surprisingly soft. (Remember: jobs data lag, not lead.) By some measures the balance of negative economic data is the worst it has been for over two years.
Second, realised corporate profits and guidance have continued to miss expectations across most sectors. While this had a negative impact on the specific names affected, the rest of the market shrugged it off quickly and, more recently, even the firms that disappointed, including bellwethers such as Caterpillar and FedEx, have rallied to new highs for the year. Corporate insiders, meanwhile, continue to sell holdings and raise new capital.
Finally, turning to trading volumes, these have continued to decline. Daily market turnover in recent weeks has been only a fraction of the average through the entire rally which began in early 2009.
In my opinion, in this last observation lies to key to understanding why the market has continued to post gains when so many negative factors have suggested at a minimum a pause in the rally and possibly the correction or crash that I predicted.
Normally, a steady decline in volume is understood as an indicator that a given trend, bullish or bearish, may be tiring and due a reversal. But we do not live in normal times. We live in an age of unprecedented policymaker activism. Thin volumes, other factors equal, make it even easier for official agents—primarily central banks—to manipulate markets as a policy tool.
There is nothing conspiratorial about this. After all, central banks set short-term interest rates. They also increasingly set long-term interest rates, both via QE purchases and more subtle mechanisms, such as the ‘duration paradox’ phenomenon associated with a zero-rate policy. (For more on this somewhat esoteric topic please see my report linked here.) From time to time they intervene in the foreign exchange markets. Central banks are also active buyers of gold, or sellers for that matter. But did you know that, in recent months, central banks have also been unusually large buyers of… wait for it… equities!
As reported by Bloomberg News and elsewhere, central banks around the world, including the Bank of Japan, the Bank of Korea and the Swiss National Bank have been unusually large buyers of equities:
Among central banks that are buying shares, the SNB has allocated about 12 per cent of assets to passive funds tracking equity indexes. The Bank of Israel has spent about 3 per cent of its $77 billion reserves on U.S. stocks.
In Asia, the BOJ announced plans to put more of its $1.2 trillion of reserves into exchange-traded funds this month as it doubled its stimulus program to help reflate the economy. The Bank of Korea began buying Chinese shares last year, increasing its equity investments to about $18.6 billion, or 5.7 per cent of the total, up from 5.4 per cent in 2011. China’s foreign-exchange regulator said in January it has sought “innovative use” of its $3.4 trillion in assets, the world’s biggest reserves, without specifying a strategy for investing in shares.
MARKET MANIPULATION IS THE NEW NORMAL
These reports may surprise some, but when you line up what amounts to creeping equity monetisation against all the other market-manipulating activities of central banks, including rhetoric expressly supporting rising asset prices as a useful policy tool, then it is just par for the pathological course: central bankers will stop at nothing to reflate their respective economies in order to avoid any meaningful debt deleveraging and restructuring in their respective financial systems. Yes, some in Germany and a handful of other creditor countries may be putting up some resistance around the margins but the general thrust of policy is clear. And while printing money to purchase government bonds is monetisation—unless it is subsequently reversed—printing money to purchase equities is monetisation on steroids: it comes closer to an outright ‘helicopter drop’ of money in that it largely bypasses the financial system by directly supporting equity market valuations, providing corporations with a form of ‘currency’ that can be spent on actual, real expansion, acquisitions and job creation.
(For those sceptical that central bank equity purchases are highly relevant, consider the unusually strong relationship at present between central bank balance sheet expansion and the stock market: the correlation has reached 90%. Correlation is not causation but this is strong circumstantial evidence of an indirect link between central bank asset purchases and equity prices. If central banks are now switching to direct equity purchases then naturally the indirect link becomes direct and presumably more powerful.)
Still, as with money creation generally, there is no guarantee that the beneficiaries will choose to respond as the central banks desire. Indeed, corporations in most of the developed world are highly leveraged on average, face unusually high tax and regulatory regime uncertainty, and thus remain highly reluctant to invest. (As mentioned previously, some are even choosing to raise capital.)
So while there is zero guarantee that the corporate horses being led to water by outright central bank equity purchases and the elevated valuations they support will act as desired and increase investment, central banks are doing their part to repair what they see as a damaged monetary transmission mechanism by leapfrogging the impaired financial intermediaries.
But is the transmission mechanism in fact damaged at all, or does it largely just reflect a shift in the demand function for money? Keynesians and Monetarists argue the former; Austrian economists the latter. Regular readers of this report will know that I side with the Austrians in this matter and in all matters monetary. Indeed, I would go so far as to argue that the Austrian economic school is the only one that has a consistent or even coherent theory of money, notwithstanding the tangled web of abstruse equations proffered by the mainstream PhDs ensconced in the high ivory towers of academia and essentially non-accountable economic policy making.
In my opinion, the shifting demand function for money reflects the private sector’s efforts to rebuild savings following a series of bubbles, busts and the associated realised and as yet unrealised resource misallocations. Central banks wish at a minimum to halt or ideally outright reverse this reckoning process indefinitely. As I have written before, preventing the realisation of resource misallocations by introducing further resource misallocations merely accelerates the deterioration of the economy’s capital stock, leading to outright capital consumption and a permanently reduced standard of living. This is the road we are on.
In any case, as a direct result of unprecedented policymaker activism, the disconnect between lofty stock market valuations and the economic reality on the ground in the US, Europe, Japan and elsewhere grows and grows. Some still dare call this ‘capitalism’ but really, some who do are among those pulling the strings; you’d think they would know better. Perhaps they do and it simply remains their cover story to blame the supposedly ‘free’ market for the escalating failures of interventionism, thereby obfuscating their responsibility for the mess while excusing the next round of Hail-Mary interventionism.
For those who step outside the system and look back at it with unbiased eyes, the dysfunctionality is increasingly apparent. It also goes beyond ordinary politics. As I have written before, the addiction to fiscal deficits and monetary inflationism cross all major party lines in all major economies.
Around the margins, those who do understand the problems are beginning to get themselves organised. The US ‘Tea-Party’ revolt of 2010 was an inchoate example. The ‘Five Star’ movement in Italy has met with considerably greater success. In Germany, the ‘Alternative for Germany’ party has just got off the ground but with much potential. And in the UK, against all expectations, the alternative UKIP party’s support soared in the most recent local elections.
These are observations, not endorsements. None of the parties mentioned above could remotely be called a ‘sound money’ party. But they do demonstrate that the disgust with the inflationist status quo is growing rapidly. The terms of debate are shifting. This is a healthy if at times messy process and is likely to be regarded by future economic historians as an essential part of ending the current economic experiment with unsound, unbacked, manipulated fiat money. As I wrote way back in 2010, “Long may the activism continue.”
 To see just how dramatic these money and credit developments are please see the relevant charts from the St Louis Fed’s weekly US financial data publication here.
 For a discussion of this development please see this article from Zerohedge here.
Laissez Faire Books have just released a splendid new edition of Doug French’s book, Early Speculative Bubbles, previously published by Mises.org. So how do I know this book is splendid? Because I wrote the new Foreword, which just by itself is magnificent. For those who want more of a breakdown, you can see a review I did of the first edition, here. Below, is the new Foreword to this book’s LFB edition, a book which mainly concentrates on the hard-money inflation of Tulipmania:
IN A SINGLE LIFETIME, there are only so many books you can read. Obviously, at the top of that time-limited list is Human Action, followed by Man, Economy, and State. Following that, you might add the Bible, and The Complete Works of Shakespeare. Though as I’ve yet to meet any man or woman who has actually read the whole of The Complete Works of Shakespeare, from cover to cover, then perhaps we need to add another book to fill that coveted fourth spot.
Should it be this book, the one that you currently hold in your hands?
Okay, so perhaps Lord of the Rings, the complete set of Patrick O’Brian novels and Socialism by Ludwig von Mises spring to mind ahead of this one.
Maybe even Sword of Marathon — by my very good friend, Jack England — earns that coveted fourth spot.
Yes, well, except for these magnificent testaments to the creativity and brilliance of mankind — especially when unleashed from the ten-thousand-year-old tyranny of the state — what should we read next?
Well, my friends, I think it has to be this book. Why? Because it is extraordinary, that’s why.
Why is it extraordinary? Because it is filled with the spirit of one of the greatest men who ever lived, Murray N. Rothbard, as propagated through the fingers of one of his lucky students, Douglas E. French. For where most Austrian economic texts deal with paper money, and its problems, this book deals with something most others have been afraid of exploring, which is hard, precious-metal money, and its problems.
There is a reason why centuries passed before any Austrians attempted to explain the problem of hard-money inflation, as opposed to the much easier subject of paper-money inflation, and that is because nobody possessed the requisite testosterone and the essential nerve to do it. And as a former American football player, Doug French possesses that requisite testosterone and that essential nerve by the syringeful.
How could hard metal fail? How could a 100 percent reserve of pure, physical silver fail? How could the Bank of Amsterdam fail — the hardest hard-money bank in the world, which made the goblin Gringotts Wizarding Bank look like a Federal Reserve outlet populated by Paul Krugman clones?
Tulipmania, based upon a banking system with a 100 percent silver metal reserve has to be explained. Otherwise, we are left with the madness of crowds as an explanation to everything, which our friends in government would love to be seen as the solution to everything, so that they can bring a hobgoblin promise of order to this supposed madness of crowds. But if you’re an Austrian, you believe that all events, no matter how illogical on the surface, possess a valid praxeological explanation.
And that is what Douglas French provides when describing Tulipmania.
I shall leave him to explain how hard-money metal failed, in this magnificent new edition of his book. However, let us assume for now that it had something to do with the power-crazed protection-racket gang known as the state. French uncovers how the chaos of government managed to mess up such a simple and otherwise perfectly functioning system of a totally voluntary money supply. He achieves this with the dexterity of a quarterback winning a Super Bowl in the last second, with one inch to spare on the final touchdown.
And just when you think he’s done, French also explains the South Sea Bubble and the Mississippi Bubble too, as a postgame treat. However, as these were both based upon paper monies and paper share certificates, it’s like men playing against boys. The real meat of this book is delivered in his section on Tulipmania, as supervised by Murray Rothbard, and as brought to us now by the hall-of-fame team of Laissez Faire Books.
Read something and learn.
This article was previously published at The Euro Vigilante.
While the stance of monetary policy around the world has, on any conceivable measure, been extreme, by which I mean unprecedentedly accommodative, the question of whether such a policy is indeed sensible and rational has not been asked much of late. By rational I simply mean the following: is this policy likely to deliver what it is supposed to deliver? And if it does fall short of its official aim, then can we at least state with some certainty that whatever it delivers in benefits is not outweighed by its costs? I think that these are straightforward questions and that any policy that is advertised as being in ‘the interest of the general public’ should pass this test. As I will argue, the present stance of monetary policy only has a negligible chance, at best, of ever fulfilling its stated aim. Furthermore, its benefits are almost certainly outweighed by its costs if we list all negative effects of this policy and do not confine ourselves, as the present mainstream does, to just one obvious cost: official consumer price inflation, which thus far remains contained. Thus, in my view, there is no escaping the fact that this policy is not rational. It should be abandoned as soon as possible.
The policy and its aims
The key planks of this policy are super low interest rates and targeted purchases (or collateralized funding) of financial assets by central banks. While various regional differences exist in respect of the extent of these programmes and the assets chosen, all major central banks – the US Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan – have been engaged and continue to be committed to versions of this policy. Its purpose is to facilitate exceptionally cheap funding for banks and to affect the pricing of a wide range of financial assets, in particular and most directly government bonds but also mortgage bonds in the US and real-estate investment trusts and corporate securities in Japan. There is an ongoing debate in the UK and in the Euro Zone, too, about directly boosting prices of other, ‘private’ securities, that is, to have their prices manipulated upwards by direct purchases from the central banks.
To the wider public this policy is described as ‘stimulating’ growth, ‘unlocking’ the flow of credit and ‘jump-starting’ the economy. If that is indeed the aim, this policy has already failed.
We have now had almost five years of near-zero interest rates around the world. If such low interest rates were indeed the required kick-starter for the economy, we should have seen the results by now. ‘Stimulus’ is something that incites or arouses to action, a kind of ‘ignition’ that sets off processes, in this case, one assumes, a self-sustained economic recovery. But if the world economy was really fundamentally healthy and only in need of a dose of caffeine to stir it back into action, then dropping rates from around 4 to 5 percent to zero, as happened 4 or 5 years ago, should have done the trick by now.
Defenders of the policy will argue that we would all be in much more of a bind without it, but this is not the point here. This is something we can discuss when comparing costs and benefits. There is no escaping the conclusion that this policy has failed if its aim is to provide a required ignition – the stimulus – to ‘jump start’ the economy.
In support of my conclusion that this policy has failed as a ‘kick-starter’ of self-sustained growth I can quote as witnesses the very officials and experts who advocated this policy in the first place and who are still implementing it. Not a single one of the major central banks is even close to announcing the successful conclusion of these policies or is even beginning to contemplate an exit. 5 years into ‘quantitative easing’ and zero interest rates, the Fed last week began to openly consider increasing its monthly debt monetization programme. Although the week ended on a bright note, at least for the professional optimists out there, as the unemployment rate came in a tad lower than expected, manufacturing data during the week was disappointing and the US economy is evidently entering another growth dip.
Still, many argue that the roughly 2 percent growth that the US economy may achieve this year is nothing to be sniffed at. Yet, for a $15 trillion dollar economy that is just $300 billion in new goods and services. In the first quarter of 2013, the Fed expanded the monetary base by $300 billion alone, and the central bank is on course for $1 trillion in new money by Christmas, while the federal government will run a close to $1 trillion deficit despite the ‘sequester’. That is very little growth ‘bang’ for a lot of stimulus ‘buck’. Self-sustained looks different.
Last week in the Euro-Zone, the ECB cut its repo rate to 0.5%, a record low. If suppressing interest rates from 3.75% in 2007 to 0.75% by 2012, has not lead to a meaningful, let alone self-sustaining recovery, or at a minimum the type of underachieving recovery that would at least allow the ECB to sit tight and wait a bit, what will another drop to 0.5% achieve?
Shamelessly, some economists and financial commentators cite high youth unemployment in countries such as Spain as a good reason to cut rates further. The image that is projected here is evidently one of countless Spanish entrepreneurs standing at the ready with their investment projects, willing and eager to employ numerous Spanish young people if only rates were 0.25% lower. Then all their ambitious investment plans would become potentially profitable, and the long promised recovery could finally commence.
The number of young Spanish people who will find employment thanks to the ECB cutting rates close to zero cannot be known but I suggest a number equally close to zero is a reasonably good guess.
The ‘benefits’ – or are they costs?
This is not to say that this policy has no effects. It even had benefits, for some.
By suppressing market yields and boosting the prices of financial assets this policy has delivered substantial windfall profits for owners of stocks, bonds, and real estate. Those who did, for example, speculate heavily on rising property prices in the run-up to the recent crisis, then were put through the wringer by the financial meltdown, now find themselves happily resurrected and restored to their previous wealth, if not more wealth, courtesy of central bank charity.
The 0.25% rate cut from the ECB may not lift many young Spaniards into employment but it surely makes ‘owning’ financial assets on credit cheaper. For every €1 billion of assets the rate cut means a €2.5 million saving per year in cost of carry, as duly noted by the big banks, ‘investment’ banks and hedge funds. After the ECB rate cut, German Bunds reached new all-time highs as did, a few days later, Germany’s main stock index.
That we are witnessing strange and dangerous deformations of the capitalist system, if we can still even call it capitalist, and that new bubbles are being blown everywhere, is not only evident by the increasingly grotesque dichotomy between a woefully underperforming real economy perennially teetering on the brink of renewed recession and a financial system, in which almost every sector is trading at record levels, but also by the fact that the high correlation among asset classes on the way up to new records is beginning to strain the minds of the economists to come up with at least marginally plausible fundamental justifications for such uniform asset inflation. ‘Safe haven’ government bonds that would usually prosper at times of economic pain are equally ‘bid only’ as are risky equities and the grottiest of high yield bonds. The common denominator is, of course, cheap money. And if cheap money for the foreseeable future is not enough, then how about cheaper money – forever?
A conflicted conscience or outright embarrassment are now stirring some financial economists to suggest that the joys of bubble finance should be brought straight to the economic war zones in the European periphery, and that in order to have a bigger impact on the ‘real’ economy, the ECB should buy private loans and other local assets in these regions and thus more directly interfere in their pricing. The manipulations of the monetary central planners are too blunt, they need to be more fine-tuned. These suggestions are dangerously wrongheaded. Extending the addiction to the monetary crack cocaine of cheap credit beyond the financial dealing rooms of London, New York and Frankfurt and to the economy’s productive heartland is not going to solve anything, at least not in the long run, and that is a timescale that may still matter to some people, at least outside of the financial industry. There is nothing Spain needs less than a new artificially propped up real estate boom. The aforementioned Spanish youth would only swap today’s dependency on state hand-outs for dependency on never-ending cheap-credit policies from the ECB and ongoing asset-boosting price manipulations. This has nothing whatsoever to do with sustainable growth, lasting and productive employment and real wealth creation.
The fact that trained economists today seriously contemplate these policies and are willing to dress them up as ‘solutions’ only goes to show how far the new ’entitlement culture’ on Wall Street and in the City of London, where everybody now feels entitled to cheap credit and ongoing asset-boosting policy programs as the universal cure-all, has affected economic thinking. The speculating classes are beginning to feel generous: “Hey, this free cash is great. Let’s extend it to everybody.”
Would a deflationary correction be better?
Back to our cost-benefit analysis. The defenders of the present policy will argue that without it GDP in the major economies would have dropped more, that asset prices and lending would be more depressed, and that we might even be in the middle of some dreadful debt deflation. Maybe so. But to the extent that the present GDP readings are the result of central bank pump priming and not the result of renewed growth momentum, they are simply artificial and thus ultimately unsustainable. In fact, the mere suspicion that this might be so must undoubtedly depress optimism and thus the willingness to engage in the economy and put capital at risk. Nobody knows any longer what the real state of the economy is.
While the unemployed Spanish youth may not benefit – or only very marginally so – from record high German stock prices and their own government’s renewed ability to borrow yet more and yet more cheaply – they may in fact ultimately benefit from a deflationary clear-out that would cause prices on many everyday items to drop. Deflation is not such a bad thing if you have to live on your savings or a modest, nominally fixed payment stream. Additionally, reshuffling the economy’s deck of cards could also offer opportunities. Tearing down the old structures and allowing the market to price things honestly again, according to real risks and truly available savings, may at first cause some shock but ultimately bring new possibilities. The present monetary policy is inherently conservative. It bails out those who got it wrong in the recent crisis at the expense of those who didn’t even participate in the last boom. Some Schumpeterian creative destruction is urgently needed.
I am not advocating deflation or economic cleansing for the sake of deflation and contraction, or out of some sense of economic sadism, or even out of moral considerations of any kind. However, it strikes me that what ails the economy is not a lack of money or lack of a powerful ‘kick-starting’ stimulant, and it may not suffer from unduly high borrowing costs either. Wherever borrowing costs are still high in this environment of ‘all-in’ central bank accommodation they may be high for a reason, maybe even a good one. What ails the economy are the structural impediments that are well established and that had been long in the making, such as inflexible labor markets with their permanently enshrined high unit labor costs and excessive regulation that have always protected current job-holders at the expense of those out of work or entering the labor market. Overbearing welfare systems, high tax rates and outsized public sectors have long held back major economies. Easy money that, for some time, enabled high public sector borrowing and spending, and facilitated local property booms, helped cover up these structural rigidities. Now these issues simply come to the fore again. New rounds of easy money will not make these problems disappear but only create a new illusion of sustainability.
I haven’t even touched upon the growing risk that never-ending monetary accommodation will end in inflation and monetary chaos but it is apparent already that this policy has no convincing claim on rationality. Nevertheless, it is almost certain that it will be continued.
This will end badly.
This article was previously published at DetlevSchlichter.com.