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Economics

QE will come to the eurozone – and, like elsewhere, it will be a failure

The data was not really surprising and neither was the response from the commentariat. After a run of weak reports from Germany over recent months, last week’s release of GDP data for the eurozone confirmed that the economy had been flatlining in the second quarter. Predictably, this led to new calls for ECB action. “Europe now needs full-blown QE” diagnosed the leader writer of the Financial Times, and in its main report on page one the paper quoted Richard Barwell, European economist at Royal Bank of Scotland with “It’s time the ECB took control and we got the real deal, instead of the weaker measure unveiled in June.”

I wonder if calls for more ‘stimulus’ are now simply knee-jerk reactions, mere Pavlovian reflexes imbued by five years of near relentless policy easing. Do these economists and leader writers still really think about their suggestions? If so, what do they think Europe’s ills are that easy money and cheap credit are going to cure them? Is pumping ever more freshly printed money into the banking system really the answer to every economic problem? And has QE been a success where it has been pursued?

The fact is that money has hardly been tight in years – at least not at the central bank level, at the core of the system. Granted, banks have not been falling over one another to extend new loans but that is surely not surprising given that they still lick their wounds from 2008. The ongoing “asset quality review” and tighter regulation are doing their bit, too, and if these are needed to make finance safer, as their proponents claim, then abandoning them for the sake of a quick – and ultimately short-lived – GDP rebound doesn’t seem advisable. The simple fact is that lenders are reluctant to lend and borrowers reluctant to borrow, and both may have good reasons for their reluctance.

Do we really think that Italian, French, and German companies have drawers full of exciting investment projects that would instantly be put to work if only rates were lower? I think it is a fairly safe bet that whatever investment project Siemens, BMW, Total and Fiat can be cajoled into via the lure of easy money will by now have been realized. The easy-money drug has a rapidly diminishing marginal return.

Global perspective

In most major economies, rates have been close to zero for more than five years and various additional stimulus measures have been taken, including some by the ECB, even if they fell short of outright QE. Yet, the global economy is hardly buzzing. The advocates of central bank activism will point to the US and the UK. Growth there has recently been stronger and many expect a rise in interest rates in the not too distant future. Yet, even if we take the US’ latest quarterly GDP data of an annualized 4 percent at face value (it was a powerful snap-back from a contraction in Q1), the present recovery, having started in 2009, still is the slowest in the post-World-War-II period, and by some margin. The Fed is not done with its bond-buying program yet, fading it out ever so slowly and carefully, fearful that the economy, or at any rate overstretched financial markets, could buckle under a more ‘normal’ policy environment, if anybody still knows what that may look like. We will see how much spring is left in the economy’s step once stimulus has been removed fully and interest rates begin to rise — if that will ever happen.

Then there is Japan, under Abe and Kuroda firmly committed to QE-square and thus the new poster-boy of the growth-through-money-printing movement. Here the economy contracted in Q2 by a staggering 6.8% annualized, mimicking its performance from when it was hit by a tsunami in 2011. This time economic contraction appears to have been mainly driven by an increase in the country’s sale tax (I guess the government has to rein in its deficit at some stage, even in Japan), which had initially caused a strong Q1, as consumers front-loaded purchases in anticipation of the tax hike. Now it was pay-back time. Still, looking through the two quarters, the Wall Street Journal speaks of “Japan’s slow recovery despite heavy stimulus”.

Elsewhere the debate has moved on

In the Anglo-Saxon countries the debate about the negative side-effects of ultra-easy money seems to be intensifying. Last week Martin Feldstein and Robert Rubin, in an editorial for the Wall Street Journal, warned of risks to financial stability from the Fed’s long-standing policy stimulus, pointing towards high asset values and tight risk premiums, stressing that monetary policy was asked to do too much. Paul Singer, founder of the Elliott Management hedge fund and the nemesis of Argentina’s Cristina Fernandez de Kirchner, was reported as saying that ultra-easy monetary policy had failed and that structural reforms and a more business-friendly regulatory environment were needed instead. All of this even before you consider my case (the Austrian School case) that every form of monetary stimulus is ultimately disruptive because it can at best buy some growth near term at the price of distorting capital markets and sowing the seeds of a correction in the future. No monetary stimulus can ever lead to lasting growth.

None of this seems to faze the enthusiasts for more monetary intervention in Europe. When data is soft, the inevitable response is to ask the ECB to print more money.

The ECB’s critics are correct when they claim that the ECB has recently been less accommodative than some of its cousins, namely the Fed and the Bank of Japan. So the eurozone economy stands in front of us naked and without much monetary make-up. If we do not like what we see then the blame should go to Europe’s ineffectual political elite, to France’s socialist president Hollande, whose eat-the-rich tax policies and out-of-control state bureaucracy cripple the country; to Ms Merkel, who not only has failed to enact a single pro-growth reform program since becoming Germany’s chancellor (how long can the country rest on the Schroeder reforms of 2002?) but now embraces a national minimum wage and a lower retirement age of 63, positions she previously objected to; to Italy’s sunny-boy Renzi who talks the talk but has so far failed to walk the walk. But then it has been argued that under democracy the people get the rulers they deserve. Europe’s structural impediments to growth often appear to enjoy great public support.

Calls for yet easier monetary conditions and more cheap credit are a sign of intellectual bankruptcy and political incompetence. They will probably be heeded.

Economics

Carl Menger’s Revolution

[Editor's note: this article, by Mateusz Machaj, first appeared at mises.org]

One often wonders whether differences in economic schools of thought are big enough to justify strict theoretical segregations. One such case is “marginal economics.” Most textbooks point to the triumvirate of Walras, Jevons, and Menger, who independently discovered the notion of marginal utility and its relevance to the pricing process. Quite often these brilliant thinkers are homogenized as more or less indistinguishable figures who paved the way for modern microeconomic theory.

The usual simplification of the history of economic thought will tell us that the big three introduced concepts of marginalism and marginal utility into economic science (the exact name “marginal utility” came from Friedrich von Wieser). In general, marginalism was introduced to combat the belief of classical economists that prices have not much to do with individual utility and consumer satisfaction (since many useful things have low prices, as the so-called paradox of value demonstrated). The biggest contribution of the marginal revolutionaries was to invite the concept of utility back into newly-rebuilt consumer theory. Consequently, economics became a much more universal science than it had been.

It cannot be denied that Walras, Jevons, and Menger all played major roles in the advancement of modern consumer theory. Marginal units and marginal utility well-explained how prices are shaped in accordance with subjective preferences and consumer choice. Yet it would be a mistake to say there were no major differences between them. Well-established economist William Jaffé published a famous article about “dehomogenization” of those thinkers. His main point was that Menger differed significantly from Walras and Jevons in presenting marginal theory with Menger’s usage of a non-mathematical apparatus. Various other authors describing the development of marginal theory also referred to this difference. Unfortunately, many of them focused on this aspect as if it somehow illustrated a deficiency of Menger’s thought in that he did not mathematized his theory. Famous Chicago economist George Stigler criticized Menger and argued that it was his main “weakness,” because he could not arrive at the concept of “maximizing want satisfaction.” In other words, Stigler claims Menger’s theory is inferior because he did not write equations and present his conclusions in the form of a mathematical apparatus.

Mathematical marginalism can indeed appear to be more rigorous. But just because it looks more complicated does not mean it is a better description of the valuation process. Menger’s so-called weakness is actually his strength, because it adds a more fruitful dimension to marginal theory, which was completely absent in the mathematical approaches of Jevons and Walras. Even though all three economists are seen as referring to “marginal units,” in Menger, this concept means something other than what it does in Jevons and Walras. In the case of Jevons and Walras, marginal units are infinitely small, continuous, and in consequence almost irrelevant. It becomes a part of a broader utility function which can be “maximized” as Stigler wishes with the use of various derivatives.

In the case of Menger, “marginal” units are something else. They are finite and discrete, not continuous, and therefore it is not part of some broader already-existing utility function which can be maximized with the use of derivatives (since only continuous functions can have derivatives).

It may all sound as a minor technical detail; nevertheless, the next steps in the reasoning process are significant and lead us to the vital role of social institutions for economizing scarce resources. If a marginal unit is irrelevant and seen as a part of an already-existing utility function, one can solve on paper the utility equations and offer an optimal solution for allocations. If, on the other hand, a marginal unit is something discrete, not subjected to an already-existing function, the “optimal” resolution cannot be derived a priori on paper. The concrete and discrete unit is possessed by someone and that someone has to make a choice to allocate it. Hence the main difference between marginal units in Menger and marginal units in Walras is Walras’s theory leads to an economics of assumed functions, whereas Menger’s theory leads to an economics of real choices. The term “marginal unit” in the Austrian and neoclassical theory may be the same. The content is radically different.

Through finite marginal units, Menger firmly opens the door for the explanation of how various units of goods are being monetarily appraised by acting individuals. If marginal units are scatters of Walrasian equations they do not have to be appraised by entrepreneurs — the mathematical function is in a way doing it for them. It is no surprise that Menger’s heir, Mises, was the one to build a theory of entrepreneurship and demonstrate entrepreneurial roles in solving problems of proper allocations for consumer satisfaction. It also comes as no surprise that Walras’s successors did not see the strength of Mises’s theory of entrepreneurship, because for them the process of optimal allocation can be simply solved by maximization of functions. Mengerian marginal units need to be acted upon and selectively valued. The driving force for their valuation is human choice. Their value is not pre-determined. Walrasian marginal units, on the contrary, are part of valuation equations, therefore they are already appraised once we mathematically describe their economic place. There is no room left for choice. Why bother then with examining the personal valuations of entrepreneurs if marginal units have already assigned roles?

Here in fact lies the main difference between the Austrian microeconomic theory and the neoclassical economic theory. Surely it cannot be denied there are similarities, but differences are not only of a pedagogical nature. Discrete marginalism, despite being non-mathematical, is superior to neoclassical marginalism. Usage of derivatives is not a sign of a more scientific method.

Economics

Stocks and the Stockdale Paradox

 “Anything can happen in stock markets and you ought to conduct your affairs so that if the most extraordinary events happen, you’re still around to play the next day.”

  • Warren Buffett.

Vice Admiral James Stockdale has a good claim to have been one of the most extraordinary Americans ever to have lived. On September 9th, 1965 he was shot down over North Vietnam and seized by a mob. Having broken a bone in his back ejecting from his plane he had his leg broken and his arm badly injured. He would spend the next seven years in Hoa Lo Prison, the infamous “Hanoi Hilton”. The physical brutality was unspeakable, and the mental torture never stopped. He would be kept in solitary confinement, in total darkness, for four years. He would be kept in heavy leg-irons for two years, on a starvation diet, deprived even of letters from home. Throughout it all, Stockdale was stoic. When told he would be paraded in front of foreign journalists, he slashed his own scalp with a razor and beat himself in the face with a wooden stool so that he would be unrecognisable and useless to the enemy’s press. When he discovered that his fellow prisoners were being tortured to death, he slashed his wrists to show his torturers that he would not submit to them. When his guards finally realised that he would die before cooperating, they relented. The torture of American prisoners ended, and the treatment of all American prisoners of war improved. After being released in 1973, Stockdale was awarded the Medal of Honour. He was one of the most decorated officers in US naval history, with 26 personal combat decorations, including four Silver Stars. Jim Collins, author of the influential study of US businesses, ‘Good to Great’, interviewed Stockdale during his research for the book. How had he found the courage to survive those long, dark years ?

“I never lost faith in the end of the story,” replied Stockdale.

“I never doubted not only that I would get out, but also that I would prevail in the end and turn the experience into the defining moment of my life, which in retrospect, I would not trade.”

Collins was silent for a few minutes. The two men walked along, Stockdale with a heavy limp, swinging a stiff leg that had never properly recovered from repeated torture. Finally, Collins went on to ask another question. Who didn’t make it out ?

“Oh, that’s easy,” replied Stockdale. “The optimists.”

Collins was confused.

“The optimists. Oh, they were the ones who said, ‘We’re going to be out by Christmas.’ And Christmas would come, and Christmas would go. Then they’d say, ‘We’re going to be out by Easter.’ And Easter would come, and Easter would go. And then Thanksgiving. And then it would be Christmas again. And they died of a broken heart.”

As the two men walked slowly onward, Stockdale turned to Collins.

“This is a very important lesson. You must never confuse faith that you will prevail in the end – which you can never afford to lose – with the discipline to confront the most brutal facts of your current reality, whatever they might be.”

As Collins’ book came to be published, this observation came to be known as the Stockdale Paradox. For Collins, it was exactly the same sort of behaviour displayed by those company founders who had led their businesses through thick and thin. The alternative was the average managers at also-ran companies that enjoyed average returns at best, or that failed completely.

At the risk of stating the blindingly obvious, this is hardly a ‘good news’ market. Ebola. Ukraine. Iraq. Gaza. In a more narrowly financial sphere, the euro zone economy looks to be slowing, with Italy flirting with a triple dip recession, Portugal suffering a renewed banking crisis, and the ECB on the brink of rolling out QE. If government bond yields are a reflection of investor confidence, the fact that two-year German rates have gone below zero is hardly inspiring.

And we have had interest rates held at emergency levels for five years now – gently igniting who knows what form of as yet unseen problems to come. In Europe interest rates seem set to stay low or go even lower. But in the UK and the US, the markets nervously await the first rate hike of a new cycle while central bankers bluster and dither.

What are the implications for global asset allocation and stock selection ?

Both in absolute terms and relative to equities, most bond markets (notably the Anglo-Saxon) are ridiculously overvalued. Since the risk-free rate has now become the return-free risk, cash now looks like the superior asset class diversifier.

As regards stock markets, price is what you pay, and value (or lack thereof) is what you get. On any fair analysis, the US market in particular is a fly in search of a windscreen. Using Professor Robert Shiller’s cyclically adjusted price / earnings ratio for the broad US stock market, shown below, US stocks have only been more expensive than they are today on two occasions in the past 130 years: in 1929, and in 2000. The peak-to-trough fall for the Dow Jones Industrial Average from 1929 equated to 89%. The peak-to-trough fall for the Dow from 2000 equated to “just” 38%. Time will tell just how disappointing (both by scale and by duration) the coming years will be for US equity market bulls.

But we’re not interested in markets per se – we’re interested in value opportunities incorporating a margin of safety. If the geographic allocations within Greg Fisher’s Asian Prosperity Fund are any guide, those value opportunities are currently most numerous in Japan and Vietnam. In the fund’s latest report he writes:

“Interestingly, and despite China’s continued underperformance, the Asian markets in aggregate have done better at this stage in 2014 than last year, while other global markets have fared less well. In our view the reason is simple – a combination of more attractive valuations than western markets, especially the US, but also, compared with 12-18 months ago, recognisably poor investor sentiment and consequently under-positioning in Asia, leading to the chance of positive surprises.”

Cylically adjusted price / earnings ratio for the S&P 500 Index

Cyclically Adjusted PE Ratios

Source: www.econ.yale.edu/~shiller/data/ie_data.xls

The Asian Prosperity Fund is practically a poster child for the opportunity inherent in global, unconstrained, Ben Graham-style value investing. Its average price / earnings ratio stands at 9x (versus 18x for the FTSE 100 and 17x for the S&P 500); its price / book ratio stands at just one; historic return on equity is an attractive 15%; average dividend yield stands at 4.2%. And this from a region where long-term economic growth seems entirely plausible rather than a delusional fantasy.

Vice Admiral Stockdale was unequivocal: while we need to confront the “brutal facts” of the marketplace, we also need to keep faith that we will prevail. To us, that boils down to avoiding conspicuous overvaluation (in most bond markets, for example, and a significant portion of the developed equity markets) and embracing equally conspicuous value – where poor sentiment is likely to intensify subsequent returns. In this uniquely oppressive financial environment, with the skies darkening with the prospect of a turn in the interest rate cycle, we think optimism could be fatal. Or as Warren Buffett once observed,

“You pay a very high price in the stock market for a cheery consensus.”

Economics

John Butler’s interview with Jim Rickards

When it comes to the world of international finance, Jim Rickards has quite nearly seen it all. As a young man, he worked for Citibank in Pakistan, of all places. In the 1990s, he served as General Counsel for Long-Term Capital Management, Jim Merriwether’s large, notorious hedge fund that collapsed spectacularly in 1998. In recent years, he has been a regular participant in Pentagon ‘wargames’, in particular those incorporating financial or currency warfare in some way, and he has served as an advisor to the US intelligence community.

Yet while his experiences are vast in breadth, they have all occurred within the historically narrow confines of a peculiar international monetary regime, one lacking a gold- or silver-backed international reserve currency. Yes, reserve currencies have come and gone through history, but it is the US dollar, and only the US dollar, that has ever served as an unbacked global monetary reserve.

Nevertheless, in CURRENCY WARS and THE DEATH OF MONEY, Jim does an excellent job of exploring pertinent historical parallels to the situation as it exists today, in which the international monetary regime has been critically undermined by a series of crises and flawed policy responses thereto. He also applies not only economic but also complexity theory to provide a framework and deepen understanding.

As for what happens next, he does have a few compelling ideas, as we explore in the following pages. To begin, however, we explore what it was that got him interested in international monetary relations in the first place.

 

BACK TO THE 1970S: THE DECADE OF DISCO AND DOLLAR CRISES

JB: Jim, you might recall the rolling crises of the 1970s, beginning with the ‘Nixon Shock’ in 1971, when the US ‘closed the gold window’, to the related oil shocks and then the de facto global ‘run on the dollar’ at the end of the decade. At the time, as a student, did you have a sense as to what was happening, or any inclination to see this as the dollar’s first real test as an unbacked global monetary reserve? Did these events have any influence on your decision to study international economics and to work in finance?

 

JR: I was a graduate student in international economics in 1972-74, and a law student from 1974-77, so my student years coincided exactly with the most tumultous years of the combined oil, inflation and dollar crises of the 1970s. Most observers know that Nixon closed the gold window in 1971, but that was not considered the end of the gold standard at the time. Nixon said he was ‘temporarily’ suspending convertibility, but the dollar was still officially valued at 1/35th of an ounce of gold. It was not until 1975 that the IMF officially demonitised gold although, at French insistence, gold could still be counted as part of a country’s reserve position. I was in the last class of students who were actually taught about gold as a monetary asset. Since 1975, any student who learns anything about gold as money is self-taught because it is no longer part of any economics curriculum. During the dark days of the dollar crisis in 1977, I spoke to one of my international law professors about whether the Deutschemark would replace the dollar as the global reserve currency. He smiled and said, “No, there aren’t enough of them.” That was an important lesson in the built-in resilience of the dollar and the fact that no currency could replace the dollar unless it had a sufficiently large, liquid bond market – something the euro does not yet have to this day. From law school I joined Citibank as their international tax counsel. There is no question that my academic experiences in a period of borderline hyperinflation and currency turmoil played a powerful role in my decision to pursue a career in international finance.

 

JB: As you argued in CURRENCY WARS and now again in THE DEATH OF MONEY, the US debt situation, public and private, is now critical. It would be exceedingly difficult for another Paul Volcker to arrive at the Federal Reserve and shore up confidence in the system with high real interest rates. But why has it come to this? Why is it that the ‘power of the printing press’ has been so abused, so corrupted? Is this due to poor federal governance, as David Stockman argues in THE GREAT DEFORMATION? Is it due to the incompetence or ignorance of the series of Federal Reserve officials who failed to appreciate the threat of global economic imbalances? Or is it due perhaps to a fundamental flaw in the US economic and monetary policy regime itself?

 

JR: It is still possible to strengthen the dollar and cement its position as the keystone of the international financial system, but not without costs. Reducing money printing and raising interest rates would strengthen the dollar, but they would pop the asset bubbles in stocks and housing that have been re-created since 2009. This would also put the policy problem in the laps of Congress and the White House where it belongs. The problems in the economy today are structural, not liquidity-related. The Fed is trying to solve structural problems with liquidity solutions. That will never work, but it might destroy confidence in the dollar in the process. Federal Reserve officials have misperceived the problem and misapprehend the statistical properties of risk. They are using equilbirium models in a complex system. (Ed note: Complexity Theory explores the fundamental properties of dynamic rather than equilibrium systems and how they react and adapt to exogenous or endogenous stimuli.) That is also bound to fail. Fiat money can work but only if money issuance is rule-based and designed to maintain confidence. Today’s Fed has no rule and is destroying confidence. Based on present policy, a complete loss of confidence in the dollar and a global currency crisis is just a matter of time.

 

JB: Thinking more internationally, the dollar is in quite good company. ‘Abenomics’ in Japan appears to have failed to confer any meaningful, lasting benefits and has further undermined what little confidence was left in the yen; China’s bursting credit and investment bubble threatens the yuan; the other BRICS have similar if less dramatic credit excess to work off; and while the European Central Bank and most EU fiscal authorities have been highly restrained for domestic political reasons in the past few years, there are signs that this may be about to change. Clearly this is not a situation in which countries can easily trust one another in monetary matters. But as monetary trust supports trust in trade and commerce generally, isn’t it just a matter of time before the currency wars of today morph into the trade wars of tomorrow? And wouldn’t a modern-day Smoot-Hawley be an unparalleled disaster for today’s globalised, highly-integrated economy?

 

JR: Currency wars can turn into trade wars as happened in the 1920s and 1930s. Such an outcome is certainly possible today. The root cause is lack of growth on a global basis. When growth is robust, large countries don’t care if smaller trading partners grab some temporary advantage by devaluing their currencies. But when global growth in anemic, as it is now, a positive sum game becomes a zero-sum game and trading partners fight for every scrap of growth. Cheapening your currency, which simultaneously promotes exports and imports inflation via the cross rate mechanism, is a tempting strategy when there’s not enough growth to go around. We are already seeing a twenty-first century version of Smoot-Hawley in the form of economic sanctions imposed on major countries like Iran and Russia by the United States. This has more to do with geopolitics than economics, but the result is the same – reduced global growth that makes the existing depression even worse.

 

JB: You may recall that, in my book, THE GOLDEN REVOLUTION, I borrow your scenario of how Russia could, conceivably, undermine the remaining international trust in the dollar with a pre-emptive ‘monetary strike’ by backing the rouble with gold. Do you regard the escalating situation in Ukraine, as well as US policies in much of the Black Sea/Caucasus/Caspian region generally, as a potential trigger for such a move?

 

JR: There is almost no possibility that either the Russian rouble or the Chinese yuan can be a global reserve currency in the next ten years. This is because both Russia and China lack a good rule or law and a well-developed liquid bond market. Both things are required for reserve curreny status. The reason Russia and China are acquiring gold and will continue to do so is not to launch a new gold-backed currency, but rather to hedge their dollar positions and reduce their dependence on dollar reserves. If there is a replacement for the dollar as the leading reserve currency, it will either be the euro, the special drawing right (SDRs), or perhaps a new currency devised by the BRICS.

 

JB: Leaving geo-politics aside for the moment, you mention right at the start of THE DEATH OF MONEY, citing the classic financial thriller ROLLOVER, that even non-state actors could, perhaps for a variety of reasons, spontaneously begin to act in ways that, given the fragility of the current global monetary order, cascade into a run on the dollar and rush to accumulate gold. If you were to do a remake of ROLLOVER today, how would you structure the plot? Who could be the first to begin selling dollars and accumulating gold? Who might join them? What would be the trigger that turned a trickle of dollar selling into a flood? How might the US government respond?

 

JR: If Rollover were re-made today, it would not be a simple Arab v. US monetary plot. The action would be multilateral including Russia, China, Iran, the Arabs and others. Massive dumping of dollars might be the consequence but it would not be the cause of the panic. A more likely scenario is something entirely unexpected such as a failure to deliver physical gold by a major gold exchange or dealer. That would start panic buying of gold and dumping of dollars. Another scenario might begin with a real estate collapse and credit crash in China. That could cause a demand shock for gold among ordinary Chinese investors, which would cause a hyperbolic price spike in gold. A rising gold price is just the flip side of a collapsing dollar.

 

JB: This entire discussion all follows from the fragility of the current international monetary system. Were the system more robust, we could leave the dollar crisis topic to Hollywood for entertainment rather than to treat it with utmost concern for personal, national or even international security. But what is it that makes systems fragile? Authors ranging from George Gilder (KNOWLEDGE AND POWER), to Joseph Tainter (THE COLLAPSE OF COMPLEX SOCIETIES) and even Edward Gibbon (THE RISE AND FALL OF THE ROMAN EMPIRE) have applied such thinking to ancient and modern economies and societies. They all conclude that, beyond a certain point, centralisation of power is destabilising. Does this mean that a robust monetary system would ‘de-centralise’ monetary power? Isn’t this incompatible with any attempt by the G20 and IMF to transform the Special Drawing Right (SDR) from a unit of account into a centrally-managed, global reserve currency?

 

JR: Yes. Complex systems collapse because increases in complexity require exponential increases in energy to maintain the system. Energy can take many forms including money, which can be thought of as a form of stored energy. We are already past the point where there is enough real money to support the complexity of the financial system. Elites are now resorting to psuedo-money such as deriviatives and other forms of leverage to keep the system going but even that will collapse in time. The proper solution is to reduce the complexity of the system and restore the energy/money inputs to a sustainable level. This means reducing leverage, banning most derivatives and breaking up big banks. None of this is very likely because it cuts against the financial interests of the power elites who run the system. Therefore a continued path toward near-term collapse is the most likely outcome.

 

JB: In CURRENCY WARS you make plain that, although you are highly critical of the current economic policy mainstream for a variety of reasons, you are an agnostic when it comes to economic theory. Yet clearly you draw heavily on economists of the Austrian School (eg Hayek) and in THE DEATH OF MONEY you even mention the pre-classicist and proto-Austrian Richard Cantillon. While I doubt you are a closet convert to the Austrian School, could you perhaps describe what it is about it that you do find compelling, vis-à-vis the increasingly obvious flaws of current, mainstream economic thinking?

 

JR: There is much to admire in Austrian economics. Austrians are correct that central planning is bound to fail and free markets produce optimal solutions to the problem of scarce resources. Complexity Theory as applied to capital markets is just an extension of that thinking with a more rigorous scientific foundation. Computers have allowed complexity theorists to conduct experiments that were beyond the capabilities of early Austrians. The results verify the intuition of the Austrians, but frame the issue in formal mathematical models that are useful in risk management and portfolio allocation. If Ludwig von Mises were alive today he would be a complexity theorist.

 

JB: You may have heard the old Irish adage of the young man, lost in the countryside, who happens across an older man and asks him for directions to Dublin, to which the old man replies, unhelpfully, “Well I wouldn’t start from here.” If you were tasked with trying, as best you could, to restore monetary stability to the United States and by extension the global economy, how would you go about it? You have suggested devaluing the dollar (or other currencies) versus gold to a point that would make the existing debt burdens, public and private, credibly serviceable. But does this solve the fundamental systemic problem? What is to stop the US and global economy from printing excessive money and leveraging up all over again, and in a decade or two facing the same issues, only on a grander scale? Is there a better system? Could a proper remonetisation of gold a la the classical gold standard do the trick? Might there be a role for new monetary technology such as cryptocurrency?

 

JR: The classic definition of money involves three functions: store of value, medium of exchange and unit of account. Of these, store of value is the most important. If users have confidence in value then they will accept the money as a medium of exchange. The unit of account function is trivial. The store of value is maintained by trust and confidence. Gold is an excellent store of value because it is scarce and no trust in third parties is required since gold is an asset that is not simultaneously the liability of another party. Fiat money can also be a store of value if confidence is maintained in the party issuing the money. The best way to do that is to use a monetary rule. Such rules can take many forms including gold backing or a mathematical formula linked to inflation. The problem today is that there is no monetary rule of any kind. Also, trust is being abused in the effort to create inflation, which is form of theft. As knowledge of this abuse of trust becomes more widespread, confidence will be lost and the currency will collapse. Cryptocurrencies offer some technological advantages but they also rely on confidence to mainatin value and, in that sense, they are not an improvement on traditional fiat currencies. Confidence in cryptocurrencies is also fragile and can easily be lost. It is true that stable systems have failed repeatedly and may do so again. The solution for individual investors is to go on a personal gold standard by acquiring physical gold. That way, they will preserve wealth regardless of the monetary rule or lack thereof pursued by monetary authorities.

 

JB: Thanks Jim for your time. I’m sure it is greatly appreciated by all readers of the Amphora Report many of whom have probably already acquired a copy of THE DEATH OF MONEY.

 

POST-SCRIPT

In a world of rapidly escalating crises in several regions, all of which have a clear economic or financial dimension, Jim’s answers to the various questions above are immensely helpful. The world is changing rapidly, arguably more rapidly that at any time since the implosion of the Soviet Union in the early 1990s. Yet back then, the changes had the near-term effect of strengthening rather than weakening the dominant US position in global geopolitical, economic and monetary affairs. Today, the trend is clearly the opposite.

Jim’s use of Complexity Theory specifically is particularly helpful, as the balance of power now shifts away from the US, destabilising the entire system. Were the US economy more robust and resilient, perhaps a general global rebalancing could be a gradual and entirely peaceful affair. But with the single most powerful actor weakening not only in relative but arguably in absolute terms, for structural reasons Jim explains above, the risks of a disorderly rebalancing are commensurately greater.

The more disorderly the transition, however, the less trust will exist between countries, at least for a time, and as Jim points out it is just not realistic for either the Russian rouble or Chinese yuan to replace the dollar any time soon. As I argue in THE GOLDEN REVOLUTION, this makes it highly likely that as the dollar’s share of global trade declines, not only will other currencies be competing with the dollar; all currencies, including the dollar, will increasingly be competing with gold. There is simply nothing to prevent one or more countries lacking trust in the system to demand gold or gold-backed securities of some kind in exchange for exports, such as oil, gas or other vital commodities.

Jim puts the IMF’s SDR forward as a possible alternative, but here, too, he is sceptical there is sufficient global cooperation at present to turn the SDR into a functioning global reserve currency. The world may indeed be on the path to monetary collapse, as Jim fears, but history demonstrates that collapse leads to reset and renewal, and in this case it seems more likely that not that gold will provide part of the necessary global monetary foundation, at least during the collapse, reset and renewal period. Once trust in the new system is sufficient, perhaps the world will once again drift away from gold, and perhaps toward unbacked cryptocurrencies such as bitcoin, but it seems unlikely that a great leap forward into the monetary unknown would occur prior to a falling-back onto what is known to have provided for the relative monetary and economic stability that prevailed prior to the catastrophic First World War, which as readers may note began 100 years ago this month.

 

Economics

Signs Of The Fed’s Era Of Secrecy Coming To An End

The Federal Reserve increasingly is attracting scrutiny across the board.  Now add to that a roller coaster of a thriller, using a miracle of a rare device, shining a light into the operations of the Fed — that contemporary riddle wrapped in a mystery inside an enigma: Matthew Quirk’s latest novel, The Directive.

“If I’ve made myself too clear, you must have misunderstood me,” Fed Chairman Alan Greenspan once famously said.  The era of a mystagogue Fed may be ending.  Recently, the House Government Oversight Committee passed, and referred to the full House, theFederal Reserve Transparency Act of 2014.  This legislation is part of the legacy of the great former Representative Ron Paul.  It popularly is known as “Audit the Fed.” How ironic that a mystery novel proves a device to dispel some of the Fed’s obscurantist mystery.

Novelist/reporter Matthew Quirk’s The Directive does for he Fed what Alan Drury did for Senate intrigue with his Pulitzer Prize winning Advise and Consent, what Aaron Sorkin did for the White House in The West Wing and, now, what Beau Willimon, is doing for the Congress with House of Cards.  Quirk takes the genre of political thriller into virgin territory: the Fed. Make to mistake.  Engaging the popular imagination has political potency.  As Victor Hugo, nicely paraphrased, observed: Nothing is as powerful as an idea whose time has come.

Quirk, according to his website,“studied history and literature at Harvard College. After graduation, he spent five years at The Atlantic reporting on crimes, private military contractors, the opium trade, terrorism prosecutions, and international gangs.”  His background shows. Quirk’s writings drips with the kind of eye for the telling detail that only a canny reporter, detective, or spy possesses.  (Readers will learn, just in passing, the plausible identity of the mysterious “secure undisclosed location” where the vice president was secreted following 9/11.)

If you like Ludlum you are certain to like Quirk.  And who isn’t intrigued by such a mysteriously powerful entity as the Fed?  Booklist calls The Directive a “nonstop heart-pounding ride in which moral blacks and whites turn gray in the ‘efficient alignment of power and interests’ that is big time politics.”  Amen.

The Directive describes an effort to rob the biggest bank in the world.  The object of the heist is not the tons of gold secured in the basement of 33 Liberty Street. (As Ian Fleming pointed out, in Goldfinger it logistically is impossible to move the mass of so much gold quickly enough to effect a robbery.)  Rather, Quirk uses as his literary device, with a touch of dramatic license, the interception of the Federal Open Market Committee’s directive to the trading desk of the Federal Reserve Bank of New York to raise (or lower) interest rates in order to use that insider information to make a fast killing.

Lest anyone doubt the power of such insider information consider William Safire’s report, from his White House classic memoir Before the Fall, of the weekend at Camp David before Nixon “closed the gold window.”

After the Quadriad meeting, the President remained alone while the rest of the group dined at the Laurel Cabin.   The no-phone-calls edict was still in force, raising some eyebrows of men who had shown themselves to be trustworthy repositories of events. but the 6’8″, dour Treasury Under Secretary Volcker explained a different dimension to the need for no leaks:  “Fortunes could be made with this information.”  Haldeman, mock-serious, leaned forward and whispered loudly, “Exactly how?”  The tension broken, Volcker asked Schulz, “How much is your budget deficit?”  George estimated, “Oh, twenty three billion or so — why?”  Volcker looked dreamily at the ceiling.  “Give me a billion dollars and a free hand on Monday, and I could make up that deficit in the money markets.”

Safire provides context making Volcker’s integrity indisputable lest anyone be tempted to misinterpret this as a trial balloon.

This columnist has been inside the headquarters of the Fed, including, many years ago, the boardroom.  Quirk:

Every eight weeks or so, a committee gathers near the National Mall in a marble citadel known as the Board of Governors of the Federal Reserve.  Twenty-five men and women sit at a long wooden table with an inset of black stone shined to a high gloss.  By noon they decide the fate of the American economy.

This columnist never has stepped foot inside the Federal Reserve Bank of New York, much less its trading floor(s).  Few have entered that sanctum sanctorum.  By taking his readers inside Quirk provides his readers a narrative grasp to how the Fed does what it does.

Quirk:

[T]he Fed is by design very friendly to large New York banks.  When the committee in DC decides what interest rates should be, they can’t simply dictate them to the banks.  They decide on a target interest, and then send the directive to the trading desk at the New York Fed to instruct them about how to achieve it.  The traders upstairs go into the markets and wheel and deal with the big banks, buying and selling Treasury bills and other government debts, essentially IOUs from Uncle Sam.  When the Fed buys up a lot of those IOUs, they flood the economy with money; when they sell them, they take money out of circulation.

They are effectively creating and destroying cash.  By shrinking or expanding the supply of money in the global economy, making it more or less scarce, they also make it more or less expensive to borrow; the interest rate.  In this way, trading back and forth with the largest banks in the world, they can drive interest rates toward their target.

The amount of actual physical currency in circulation is only a quarter of the total monetary supply.  The rest is just numbers on a computer somewhere.  When people say the government can print as much money as it wants, they’re really talking about the desk doing its daily work of resizing the monetary supply—tacking zeros onto a bunch of electronic accounts—that big banks are allowed to lend out to you and me.

***

Every morning, on the ninth floor of the New York Fed, the desk gets ready to go out and manipulate the markets according to the instructions laid out in the directive.  Its traders are linked by computer with twenty-one of the largest banks in the world.  When they’re ready to buy and sell, in what are called open market operation, one trader presses a button on his terminal and three chimes — the notes F-E-D — sound on the terminals of his counterparties.  Then they’re off to the races.

There are usually eight to ten people on that desk, mostly guys in their late twenties and early thirties, and they manage a portfolio of government securities worth nearly $4 trillion that backs our currency.  Without it, the bills in your wallet would be as worthless as Monopoly cash.  The traders on that floor carry out nearly $5.5 billion in trades per day, set the value of every penny you earn or spend, and steer the global economy.

As Quirk recently told Matthew Yglesias, at Vox.com:

I was casting about for the biggest hoards of money in the world, and you get to the Federal Reserve Bank in New York fairly quickly. But that’s been done. Then I learned more and more about the trading desk, and my mind was blown.

You get to have this great line where you say, “There’s $300 billion worth of gold in the basement, but the real money is on the ninth floor.” …

I was a reporter in Washington for a while, and I thought, “Oh, the Fed sets interest rates,” because that’s always what people say. But as you dig into it, you realize that the Fed just has to induce interest rates to where they want to be. They have to trade back and forth with these 19 or 20 banks, and they have 8‑10 guys at this trading desk, trading about $5.5 billion a day. That’s actually how the government prints money and expands and contracts the monetary supply.

It’s this high wire act. You explain it to people and they say, “Oh, it’s a conspiracy thriller.” You say, “No, no. That’s the real part. I haven’t gotten to the conspiracy yet.” But it’s a miracle that it works.

Quirk’s own dual mandate? Combine fast-paced drama with a peek behind the scenes of the world’s biggest bank, providing vivid entertainment while teaching more about the way that one of the most powerful and mysterious institutions in the world works. In The Directive Matthew Quirk shakes, rather than stirs, his readers brilliantly.

Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/08/04/signs-of-the-feds-era-of-secrecy-coming-to-an-end/

Economics

Keep calm and carry on

At the end of July global equity bull markets had a moment of doubt, falling three or four per cent. In the seven trading days up to 1st August the S&P500 fell 3.8%, and we are not out of the woods yet. At the same time the Russell 2000, an index of small-cap US companies fell an exceptional 9%, and more worryingly it looks like it has lost bullish momentum as shown in the chart below. This indicates a possible double-top formation in the making.

Russell 2000 08082014

 

Meanwhile yield-spreads on junk bonds widened significantly, sending a signal that markets were reconsidering appropriate yields on risky bonds.

This is conventional analysis and the common backbone of most brokers’ reports. Put simply, investment is now all about the trend and little else. You never have to value anything properly any more: just measure confidence. This approach to investing resonates with post-Keynesian economics and government planning. The expectations of the crowd, or its animal spirits, are now there to be managed. No longer is there the seemingly irrational behaviour of unfettered markets dominated by independent thinkers. Forward guidance is just the latest manifestation of this policy. It represents the triumph of economic management over the markets.

Central banks have for a long time subscribed to management of expectations. Initially it was setting interest rates to accelerate the growth of money and credit. Investors and market traders soon learned that interest rate policy is the most important factor in pricing everything. Out of credit cycles technical analysis evolved, which sought to identify trends and turning points for investment purposes.

Today this control goes much further because of two precedents: in 2001-02 the Fed under Alan Greenspan’s chairmanship cut interest rates specifically to rescue the stock market out of its slump, and secondly the Fed’s rescue of the banking system in the wake of the Lehman crisis extended direct intervention into all financial markets.

Both of these actions succeeded in their objectives. Ubiquitous intervention continues to this day, and is copied elsewhere. It is no accident that Spanish bond yields for example are priced as if Spain’s sovereign debt is amongst the safest on the planet; and as if France’s bond yields reflect a credible plan to repay its debt.

We have known for years that through intervention central banks have managed to control the prices of currencies, precious metals and government bonds; but there is increasing evidence of direct buying of other financial assets, including equities. The means for continual price management are there: there are central banks, exchange stabilisation funds, sovereign wealth funds and government-controlled pension funds, which between them have limitless buying-power.

Doubtless there is a growing band of central bankers who believe that with this control they have finally discovered Keynes’s Holy Grail: the euthanasia of the rentier and his replacement by the state as the primary source of business capital. This being the case, last month’s dip in the markets will turn out to be just that, because intervention will simply continue and if necessary be ramped up.

But in the process, all market risk is being transferred from bonds, equities and all other financial assets into currencies themselves; and it is the outcome of their purchasing power that will prove to be the final judgement in the debate of markets versus economic planning.

Economics

The crisis of interventionism, the end of globalisation, and the looming tech trade war

[Editor's note: this edition of the Amphora Report is from several weeks ago, but is still apt at the moment]

“I say to all those who bet against Greece and against Europe: You lost and Greece won. You lost and Europe won.” –Jean-Claude Juncker, former prime minister of Luxembourg and president of the Eurogroup of EU Finance Ministers, 2014

We have indeed at the moment little cause for pride: As a profession we have made a mess of things.” –Friedrich Hayek, Nobel Laureate in Economic Science, 1974

Jean-Claude Juncker is a prominent exception to the recent trend of economic and monetary officials openly expressing doubt that their interventionist policies are producing the desired results. In recent months, central bankers, the International Monetary Fund, the Bank for International Settlements, and a number of prestigious academic economists have expressed serious concern that their policies are not working and that, if anything, the risks of another 2008-esque global financial crisis are building. Thus we have arrived at a ‘Crisis of Interventionism’ as the consequences of unprecedented monetary and fiscal stimulus become evident, fuelling a surge in economic nationalism around the world, threatening the end of globalisation and the outbreak of trade wars. Indeed, a tech trade war may already have started. This is is perhaps the least appreciated risk to financial markets at present. How should investors prepare?

 

THE FATAL CONCEIT

Friedrich Hayek was the first Austrian School economist to win the Nobel Memorial Prize in Economic Science. Yet Hayek took issue with the characterisation of modern economics as a ‘science’ in the conventional sense. This is because the scientific method requires theories to be falsifiable and repeatable under stable conditions. Hayek knew this to be impossible in the real world in which dynamic, spontaneous human action takes place in response to an incalculable number of exogenous and endogenous variables.

Moreover, Hayek believed that, due to the complexity of a modern economy, the very idea that someone can possibly understand how it works to the point of justifying trying to influence or distort prices is nonsensical in theory and dangerous in practise. Thus he termed such hubris in economic theory ‘The Pretence of Knowledge’ and, in economic policy, ‘The Fatal Conceit’.1

History provides much evidence that Hayek was correct. Interventionism has consistently failed either to produce the desired results or has caused new, unanticipated problems, such as in the 1920s and 1930s, for example, an age of particularly active economic policy activism in most of the world.

Indeed, as Hayek wrote in his most famous work, The Road to Serfdom, economic officials tend to respond to the unintended consequences of their failed interventions with ever more interventionism, eventually leading to severe restrictions of economic liberty, such as those observed under socialist or communist regimes.2

Hayek thus took advantage of his Nobel award to warn the economics profession that, by embracing a flawed, ‘pseudo-scientific method’ to justify interventionism, it was doing itself and society at large a great disservice:

The conflict between what in its present mood the public expects science to achieve in satisfaction of popular hopes and what is really in its power is a serious matter because, even if the true scientists should all recognize the limitations of what they can do in the field of human affairs, so long as the public expects more there will always be some who will pretend, and perhaps honestly believe, that they can do more to meet popular demands than is really in their power. It is often difficult enough for the expert, and certainly in many instances impossible for the layman, to distinguish between legitimate and illegitimate claims advanced in the name of science…

If we are to safeguard the reputation of economic science, and to prevent the arrogation of knowledge based on a superficial similarity of procedure with that of the physical sciences, much effort will have to be directed toward debunking such arrogations, some of which have by now become the vested interests of established university departments.

 

Hayek made these comments in 1974. If only the economics profession had listened. Instead, it continued with the pseudo-science, full-steam ahead. That said, by 1974 a backlash against traditional Keynesian-style intervention had already begun, led by, among others, Milton Friedman. But Friedman too, brilliant as he no doubt was, was seduced also by the culture of pseudo-science and, in his monetary theories, for which he won his Nobel prize in 1976, he replaced a Keynesian set of unscientific, non-falsifiable, intervention-justifying equations with a Monetarist set instead.3

Economic interventionism did, however, fall out of intellectual favour following the disastrous late-1970s stagflation and subsequent deep recession of the early 1980s—in the US, the worst since WWII. It never really fell out of policy, however. The US Federal Reserve, for example, facilitated one bubble after another in US stock and/or property prices in the period 1987-2007 by employing an increasingly activist monetary policy. As we know, this culminated in the spectacular events of 2008, which unleased a global wave of intervention unparalleled in modern economic history.

 

THE KEYNESIANS’ NEW CLOTHES

Long out of fashion, Keynesian theory and practice returned to the fore as the 2008 crisis unfolded. Some boldly claimed at the time that “we are all Keynesians now.” Activist economic interventionism became the norm across most developed and developing economies. In some countries, this has taken a more fiscal policy form; in others the emphasis has been more on monetary policy. Now six years on, with most countries still running historically large fiscal deficits and with interest rates almost universally at or near record lows, it is entirely understandable that the economics profession is beginning to ask itself whether the interventions it recommended are working as expected or desired.

While there have always been disputes around the margins of post-2008 interventionist policies, beginning in 2012 these became considerably more significant and frequent. In a previous report, THE KEYNESIANS’ NEW CLOTHES, I focused on precisely this development:

In its most recent World Economic Outlook, the International Monetary Fund (IMF) surveys the evidence of austerity in practice and does not like what it finds. In particular, the IMF notes that the multiplier associated with fiscal tightening seems to be rather larger than they had previously assumed. That is, for each unit of fiscal tightening, there is a greater economic contraction than anticipated. This results in a larger shrinkage of the economy and has the unfortunate result of pushing up the government debt/GDP ratio, the exact opposite of what was expected and desired.

While the IMF might not prefer to use the term, what I have just described above is a ‘debt trap’. Beyond a certain point an economy has simply accumulated more debt than it can pay back without resort to currency devaluation. (In the event that a country has borrowed in a foreign currency, even devaluation won’t work and some form of restructuring or default will be required to liquidate the debt.)

The IMF is thus tacitly admitting that those economies in the euro-area struggling, and so far failing, to implement austerity are in debt traps. Austerity, as previously recommended by the IMF, is just not going to work. The question that naturally follows is, what will work?

Well, the IMF isn’t exactly sure. The paper does not draw such conclusions. But no matter. If austerity doesn’t work because the negative fiscal multiplier is larger than previously assumed, well then for now, just ease off austerity while policymakers consider other options. In other words, buy time. Kick the can. And hope that the bond markets don’t notice.4

 

Now, nearly two years later, the IMF has been joined in its doubts by a chorus of economic officials and academics from all over the world increasingly concerned that their interventions are failing and, in some cases, putting forth proposals of what should be done.

Let’s start with the Bank of England. Arguably the most activist central bank post-2008, as measured by the expansion of its balance sheet, several members of the Banks’ Monetary Policy Committee have expressed concern about the risks to financial stability posed by soaring UK property prices, a lack of household savings and a financial sector thatremains highly leveraged. In a recent speech, BoE Chief Economist Charlie Bean stated that:

[T]he experience of the past few years does appear to suggest that monetary policy ought to take greater account of financial stability concerns. Ahead of the crisis, Bill White and colleagues at the Bank for International Settlements consistently argued that when leverage was becoming excessive and/or asset prices misaligned, central bankers ought to ‘lean against the wind’ by keeping interest rates higher than necessary to meet the price stability objective in the short run. Just as central banks are willing to accept temporary deviations from their inflation targets to limit output volatility, so they should also be willing to accept temporary deviations to attenuate the credit cycle. Essentially it is worth accepting a little more volatility in output and inflation in the short run if one can thereby reduce the size or frequency of asset-price busts and credit crunches.

 

In other words, perhaps central bank policy should change focus from inflation targeting, which demonstrably failed to prevent 2008, and instead to focus on money and credit growth. This is clearly an anti-Kenyesian view in principle, although one wonders how it might actually work in practice. In closing, he offered these thoughts:

I opened my remarks tonight by observing that my time at the Bank has neatly fallen into two halves. Seven years of unparalleled macroeconomic stability have been followed by seven years characterised by financial instability and a deep recession. It was a salutary lesson for those, like me, who thought we had successfully cracked the problem of steering the economy, and highlighted the need to put in place an effective prudential framework to complement monetary policy. Policy making today consequently looks a much more complex problem than it did fourteen years ago.5

 

Indeed. Policy making does look increasingly complex. And not only to the staff of the IMF and to Mr Bean, but also to the staff at the Bank for International Settlements, to which Mr Bean referred in his comments. In a recent speech, General Manager of the BIS, Jaime Caruana, taking a global view, expressed fresh concern that:

There is considerable evidence that, for the world as a whole, policy interest rates have been persistently below traditional benchmarks, fostering unbalanced expansions. Policy rates are comparatively low regardless of the benchmarks – be these trend growth rates or more refined ones that capture the influence of output and inflation… Moreover, there is clear evidence that US monetary policy helps explain these deviations, especially for small open and emerging market economies. This, together with the large accumulation of foreign exchange reserves, is consistent with the view that these countries find it hard, economically or politically, to operate with rates that are considerably higher than those in core advanced economies. And, alongside such low rates, several of these economies, including some large ones, have been exhibiting signs of a build-up of financial imbalances worryingly reminiscent of that observed in the economies that were later hit by the crisis. Importantly, some of the financial imbalances have been building up in current account surplus countries, such as China, which can ill afford to use traditional policies to boost domestic demand further. This is by no means new: historically, some of the most disruptive financial booms have occurred in current account surplus countries. The United States in the 1920s and Japan in the 1980s immediately spring to mind.6

 

The above might not sound terribly controversial from a common-sense perspective but to those familiar with the core precepts of the neo-Keynesian mainstream, this borders on economic heresy. Mr Caruana is implying that the Great Depression was not caused primarily by the policy failures of the early 1930s but by the boom preceeding it and that the stagnation of Japan in recent decades also has its roots in an unsustainable investment boom. In both cases, these booms were the product of economic interventions in the form of inappropriately easy monetary policy. And whence does current inappropriate policy originate? Why, from the US Federal Reserve! Mr Caruana is placing the blame for the renewed, dangerous buildup of substantial global imbalances and associated asset bubbles specifically on the Fed!

Yet Mr Caruana doesn’t stop there. He concludes by noting that:

[T]he implication is that there has been too much emphasis since the crisis on stimulating demand and not enough on balance sheet repair and structural reforms to boost productivity. Looking forward, policy frameworks need to ensure that policies are more symmetrical over the financial cycle, so as to avoid the risks of entrenching instability and eventually running out of policy ammunition.

 

So now we have had the IMF observing that traditional policies aren’t working as expected; BoE Chief Economist Bean noting how policy-making has become ‘complex’; and BIS GM Caruana implyingthis is primarily due to the boom/bust policies of the US Federal Reserve. So what of the Fed itself? What have Fed officials had to say of late?

Arguably the most outspoken recent dissent of the policy mainstream from within the Fed is that from Jeffrey Lacker, President of the regional Richmond branch. In a recent speech, he voiced his clear opposition to growing central bank interventionism:

There are some who praise the Fed’s credit market interventions and advocate an expansive role for the Fed in promoting financial stability and mitigating financial system disruptions. They construe the founders of the Federal Reserve System as motivated by a broad desire to minimize and prevent financial panics, even beyond simply satisfying increased demand for currency. My own view, which I must note may not be shared by all my colleagues in the Federal Reserve System, favors a narrower and more restrained role, focused on the critical core function of managing the monetary liabilities of the central bank. Ambitious use of a central bank’s balance sheet to channel credit to particular economic sectors or entities threatens to entangle the central bank in distributional politics and place the bank’s independence at risk. Moreover, the use of central bank credit to rescue creditors boosts moral hazard and encourages vulnerability to financial shocks.7

 

By explicitly referencing moral hazard, Mr Lacker is taking on the current leadership of the Federal Reserve, now headed by Janet Yellen, which denies that easy money policies have had anything to do with fostering financial instability. But as discussed earlier in this report, the historical evidence is clear that Fed activism is behind the escalating boom-bust cycles of recent decades. And as Mr Caruana further suggests, this has been a global phenomenon, with the Fed at the de facto helm of the international monetary system due to the dollar’s global reserve currency role.8

 

EURO ‘MISSION ACCOMPLISHED’? UH, NO

As quoted at the start of this report, Jean-Claude Juncker, prominent Eurocrat and politician, recently claimed victory in the euro-crisis. “Greece and Europe won.” And who lost? Why, those who bet against them in the financial markets by selling their debt and other associated assets.

But is it really ‘mission accomplished’ in Europe? No, and not by a long shot. Yes, so-called ‘austerity’ was absolutely necessary. Finances in many EU countries were clearly on an unsustainable course. But other than to have bought time through lower borrowing costs, have EU or ECB officials actually achieved anything of note with respect to restoring economic competitiveness?

There is some evidence to this effect, for example in Ireland, Portugal and Spain, comprising some 15% of the euro-area economy. However, there is also evidence to the contrary, most clearly seen in France, comprising some 20% of the euro-area. So while those countries under the most pressure from the crisis have made perhaps some progress, the second-largest euro member country is slipping at an accelerating rate into the uncompetitive abyss. Italy, for many years a relative economic underperformer, is not necessarily doing worse than before, but it is hard to argue it is doing better. (Indeed, Italy’s recent decision to distort its GDP data by including estimates for non-taxable black-market activities smacks of a desperate campaign to trick investors into believing its public debt burden is more manageable than it really is.)

There is also a surge in economic nationalism throughout the EU, as demonstrated by the remarkable surge in support for anti-EU politicians and parties. It is thus far too early for Mr Juncker to claim victory, although politicians are naturally given to such rhetoric. The crisis of interventionism in the euro-area may is not dissipating; rather, it is crossing borders, where it will re-escalate before long.

 

THE SHORT HONEYMOON OF ‘ABENOMICS’

Turning to developments in Japan, so-called ‘Abenomics’, the unabashedly interventionist economic policy set implemented by Prime Minister Abe following his election in late 2012, has already resulted in tremendous disappointment. Yes, the yen plummeted in late 2012 and early 2013, something that supposedly would restore economic competitiveness. But something happened on the way, namely a surge in import prices, including energy. Now Japan is facing not just economic stagnation but rising inflation, a nasty cocktail of ‘stagflation’. Not that this should be any surprise: Devaluing your way to prosperity has never worked, regardless of when or where tried, yet doing so in the face of structural economic headwinds is guaranteed to produce rising price inflation, just as it did in the US and UK during the 1970s.With reality now having arrived, it will be interesting to see what Mr Abe does next. Will he go ‘all-in’ with even more aggressive yen devaluation? Or will he consider focusing on structural reform instead? Although I am hardly a Japan expert, I have travelled to the country regularly since the late 1990s and my sense is that the country is likely to slip right back into the ‘muddle through’ that characterised the economy during most of the past decade. Of course, in the event that another major global financial crisis unfolds, as I regard as inevitable in some form, Japan will be unable to avoid it, highly integrated as it is.

 

THE BUCK STOPS HERE: A ‘BRIC’ WALL

In my book, THE GOLDEN REVOLUTION, I document how the BRIC economies (Brazil, Russia, India, China, now joined by South Africa to make the BRICS) have been working together for years to try and reorient themselves away from mercantilist, dollar-centric, export-led economic development, in favour of a more balanced approach. Certainly they have good reasons to do so, as I described in a 2012 report, THE BUCK STOPS HERE: A BRIC WALL:

[T]he BRICS are laying the appropriate groundwork for their own monetary system: Bilateral currency arrangements and their own IMF/World Bank. The latter could, in principle, form the basis for a common currency and monetary policy. At a minimum it will allow them to buy much global influence, by extending some portion of their massive cumulative savings to other aspiring developing economies or, intriguingly, to ‘advanced’ economies in need of a helping hand and willing to return the favour in some way.

In my new book, I posit the possibility that the BRICS, amid growing global monetary instability, might choose to back their currencies with gold. While that might seem far-fetched to some, consider that, were the BRICS to reduce their dependence on the dollar without sufficient domestic currency credibility, they would merely replace one source of instability with another. Gold provides a tried, tested, off-the-shelf solution for any country or group of countries seeking greater monetary credibility and the implied stability it provides.

Now consider the foreign policy angle: The Delhi Declaration makes clear that the BRICS are not at all pleased with the new wave of interventionism in Syria and Iran. While the BRICS may be unable to pose an effective military opposition to combined US and NATO military power in either of those two countries, they could nevertheless make it much more difficult for the US and NATO to finance themselves going forward. To challenge the dollar is to challenge the Fed to raise interest rates in response. If the Fed refuses to raise rates, the dollar will plummet. If the Fed does raise interest rates, it will choke off growth and tax revenue. In either case, the US will find it suddenly much more expensive, perhaps prohibitively so, to carry out further military adventures in the Middle East or elsewhere.9

 

While the ongoing US confrontations with Iran and Syria have been of concern to the BRICS for some time, of acute concern to member Russia of late has been the escalating crisis in Ukraine. The recent ‘Maidan’ coup, clearly supported by the US and possibly some EU countries, is regarded with grave concern by Russia, which has already taken action to protect its naval base and other military assets in the Crimea. Now several other Russian-majority Ukrainian regions are seeking either autonomy or independence. The street fighting has been intense at times. The election this past weekend confirming what Russia regards as an illegitimate, NATO-puppet government changes and solves nothing; it merely renders the dipute more intractable and a further escalation appears likely. (Russia is pressing Kiev as I write to allow it to begin providing humanitarian assistance to the rebellious regions, something likely to be denied.)

US economic sanctions on Russia have no doubt helped to catalyse the most recent BRICS initiative, in this case one specific to Russia and China, who have agreed a landmark 30-year gas deal while, at the same time, preparing the groundwork for the Russian banking system to handle non-dollar (eg yuan) payments for Russian gas exports. This is a specific but nevertheless essential step towards a more general de-dollarisation of intra-BRICS trade, which continues to grow rapidly.

The dollar’s international role had been in slow but steady decline for years, with 2008 serving to accelerate the process. The BRICS are now increasingly pro-active in reducing their dollar dependence. Russia has been dumping US dollar reserves all year and China is no longer accumulating them. India has recently eased restrictions on gold imports, something that is likely to reduce Indian demand for US Treasuries. (Strangely enough, and fodder for conspiracy theorists, tiny Belgium has stepped in to fill the gap, purchasing huge amounts of US Treasuries in recent months, equivalent to some $20,000 per household! Clearly that is not actually Belgian buying at all, but custodial buying on behalf of someone else. But on behalf of whom? And why?)

As I wrote in my book, amid global economic weakness, the so-called ‘currency wars’ naturally escalate. Competitive devaluations thus have continued periodically, such as the Abenomics yen devaluation of 2012-13 and the more recent devaluation of the Chinese yuan. As I have warned in previous reports, however, history strongly suggests that protracted currency wars lead to trade wars, which can be potentially disastrous in their effects, including on corporate profits and valuations.10

 

THE END OF GLOBALISATION?

Trade wars are rarely labelled as such, at least not at first. Some other reason is normally given for erecting trade barriers. A popular such reason in recent decades has been either environmental or health concerns. For example, the EU and China, among other countries, have banned the import of certain genetically modified foods and seeds.

Rather than erect formal barriers, governments can also seek ways to subsidise domestic producers or exporters. While the World Trade Organisation (WTO) aims to prevent and police such barriers and subsidies, in practice it can take it years to effectively enforce such actions.

Well, there is now a new excuse for trade barriers, one specific to the huge global tech and telecommunications industry: Espionage. As it emerges that US-built and patented devices in widespread use around the world contain various types of ‘backdoors’ allowing the US National Security Agency to eavesdrop, countries are evaluating whether they should ban their use. Cisco’s CEO recently complained of losing market share to rivals due to such concerns. Somewhat ominously, China announced over the past week that it would prohibit public entities from using Microsoft Windows version 8 and would require banks to migrate away from IBM computer servers.11

There has also been talk amongst the BRICS that they should build a parallel internet infrastructure to avoid routing information via the US, where it is now assumed to be automatically and systematically compromised. Given these concerns, it is possible that a general tech trade war is now breaking out under an espionage pretext. What a convenient excuse for protecting jobs: Protecting secrets! What do you think the WTO will have to say about that?

Imagine what a tech trade war would do to corporate profits. Name one major tech firm that does not have widely dispersed global supply chains, manufacturing operations and an international customer base. Amid rising trade barriers, tech firms will struggle to keep costs down. Beyond a certain point they will need to pass rising costs on to their customers. The general deflation of tech in recent decades will go into reverse. Imagine what that will do to consumer price inflation around the world.

Yes, a tech trade war would be devastating. Household, ‘blue-chip’ tech names might struggle to survive, much less remain highly profitable. And the surge in price inflation may limit the ability of central banks to continue with ultra-loose monetary policies, to the detriment also of non-tech corporate profits and financial health. This could lead into a vicious circle of reactionary protectionism in other industries, a historical echo of the ‘tit-for-tat’ trade wars of the 1930s that were part and parcel of what made the Great Depression such a disaster.

Given these facts, it is difficult to imagine that the outbreak of a global tech trade war would not result in a major equity market crash. Current valuations are high in a historical comparison and imply continued high profitability. Major stock markets, including the US, could easily lose half their value, even more if a general price inflation led central banks to tighten monetary conditions by more than financial markets currently expect. Of all the ‘black swans’ out there, a tech trade war is not only taking flight; it is also potentially one of the largest, short of a shooting war.

 

A SILVER LINING TO THE GLOOM AND DOOM

With equity valuations stretched and complacency rampant—the VIX volatility index dipped below 12 this week, a rare event indeed—now is the time to proceed with extreme caution. The possible outbreak of a tech trade war only adds to the danger. Buying the VIX (say, via an ETF) is perhaps the most straightforward way to insure an equity portfolio, but there are various ways to get defensive, as I discussed in my last report.12

Where there is risk, however, there is opportunity, and right now there is a silver lining: With a couple of exceptions, metals prices are extremely depressed relative to stock market valuations. Arguably the most depressed is silver. Having slipped below $20/oz, silver has given up all of its previous, relative outperformance vs other metals from 2010-11. It thus appears cheap vs both precious and industrial metals, with silver being something of a hybrid between the two. Marginal production capacity that was brought on line following the 2010-11 price surge is now uneconomic and is shutting down. But the long slide in prices has now attracted considerable speculative short interest. If for any reason silver finds a reason to recover, the move is likely to be highly asymmetric.

Investors seeing an opportunity in silver can, of course, buy silver mining shares, either individually or through an ETF. A more aggressive play would be to combine a defensive equity market stance—saybuying the VIX—with a long position in the miners or in the metal itself. My view is that such a position is likely to perform well in the coming months. (Please note that volatility of the silver price is normally roughly double that of the S&P500 index, so a market-neutral, non-directional spread trade would require shorting roughly twice as much of the S&P500 as the purchasing of silver. Also note, however, that correlations are unstable and thus must be dynamically risk-managed.)

As famed distressed-debt investor Howard Marks says, investing is about capturing asymmetry. Here at Amphora we aim to do precisely that. At present, there appears no better way to go about it than to buy silver, either outright or combined with a stock market short/underweight. From the current starting point, this could well be one of the biggest trades of 2014.

 

 

 

A QUICK WORD ON AMPHORA

Regular readers of this Report are aware that Amphora provides a commodity-focused advisory service to institutions and high net worth investors around the world. Having added new resources of late, we are looking to accelerate our growth and are open to the possibility of a strategic partnership to expand our client base. We encourage those who see value in a potential collaboration to consider reaching out to us at info@amphora-alpha.com

1 Hayek’s eloquent Nobel Memorial speech on this topic can be found at the link here.

2 Hayek explained his motivation to write the Road to Serfdom as a warning specifically to open, free societies that, even with entirely benign intentions, failed interventions on failed interventions could, over time, turn open, free societies into closed, authoritarian ones.

3 In later life Friedman came to question a number of his key assumptions, for example whether money-supply targeting could work consistently in practice and whether or not it was realistic to assume that central banks could remain independent of politics.

4 This report can be found at the link here.

5 The transcript of this speech can be found here.

6 This speech can be located at the link here.

7 The link to this speech can be found here.

8 For a thorough discussion of the dollar’s reserve role and the inflationary consequences thereof, please see THE CURSE OF THE RESERVE CURRENCY, Amphora Report vol. 3 (November 2012). The link to this report is here.

9 The link to this report is here.

10 For example please see A VICIOUS CYCLE, Amphora Report vol. 3 (October 2012). The link is here.

11 These events were reported by Bloomberg News here.

12 Please see 2014: A YEAR OF INVESTING DANGEROUSLY, Amphora Report vol. 5, (February 2014). The link is here.

Economics

Lessons in investment warfare

“Let us learn our lessons. Never, never, never believe any war will be smooth and easy, or that anyone who embarks on that strange voyage can measure the tides and hurricanes he will encounter. The statesman who yields to war fever must realise that once the signal is given, he is no longer the master of policy but the slave of unforeseeable and uncontrollable events.

“Antiquated War Offices, weak, incompetent or arrogant commanders, untrustworthy allies, hostile neutrals, malignant fortune, ugly surprises, awful miscalculations – all take their seats at the Council Board on the morrow of a declaration of war. Always remember, however sure you are that you can easily win, that there would not be a war if the other man did not think he also had a chance.”

  • Winston Churchill, ‘My Early Life’, quoted by Charles Lucas in a letter to the FT, 23rd July 2014.

And there is a war being conducted out there in the financial markets, too, a war between debtors and creditors, between governments and taxpayers, between banks and depositors, between the errors of the past and the hopes of the future. How can investors end up on the winning side ? History would seem to have the answers.

For history, read in particular James O’Shaughnessy’s magisterial study of market data, ‘What Works on Wall Street’ (hat-tip to Abbington Investment Group’s Peter Van Dessel). O’Shaughnessy offers rigorous analysis of innumerable equity market strategies, but we are instinctively and philosophically drawn most strongly towards the value factors highlighted hereafter.

The chart below shows the results accruing to various strategies across the All Stocks universe – all companies in the Standard & Poor’s Compustat database with market capitalisations above $150 million, a dataset which comprises between 4,000 and 5,000 individual companies. The analysis takes in over half a century’s worth of data.

Making the (fairly reasonable) assumption that the data in this study is sufficiently broad to mitigate the effects of shorter term market “noise”, the results are unequivocal. Buying stocks with high price-to-sales (PSR) ratios; buying stocks with high price / cashflow ratios; buying stocks with high price / book ratios; buying stocks with high price / earnings (PE) ratios; all of these are disastrous strategies relative to the performance of the broad index itself. Caution: these all happen to be ‘growth’ strategies.

Value of $10,000 invested in various strategies using the All Stocks universe, from January 1951 to December 2003

RatesOfReturn1

(Source: What Works on Wall Street by James P. O’Shaughnessy, Third Edition, McGraw-Hill 2005)

But the converse is also true – in spades. Buying stocks with low price-to-sales ratios; buying stocks with low price / book ratios; these are both outstandingly successful strategies over the longer term, converting that initial $10,000 into over $22 million in each case. Buying stocks on low price / cashflow ratios is also a winning strategy. The relatively simple ‘high yield’ and ‘low p/e’ strategies also comfortably outperform the broad market. Note that these are all ‘value’ strategies.

This leads O’Shaughnessy to question the legitimacy of the so-called Capital Asset Pricing Model, in which investors are compensated for taking more risk:

“..the higher risk of the high P/Es, price-to-book, price-to-cashflow, and PSRs went uncompensated. Indeed, each of the strategies significantly underperformed the All Stocks Universe.”

Perhaps the market is indeed less efficient than certain academics would have us believe. The world’s most successful investor, Warren Buffett, would seem to think so. As he was quoted in a 1995 issue of Fortune magazine,

“I’d be a bum on the street with a tin cup if the markets were always efficient.”

And note that careful addition of the word “always”. Buffett wasn’t even going so far as to suggest that the markets are never efficient, but rather that the patient investor can take advantage of Mr. Market’s occasional lapses into the realms of absurdity, whether in the form of bullishness or outright despair.

O’Shaughnessy frames the returns from these various ‘growth’ and ‘value’ strategies more explicitly in the chart below.

Compound average annual rates of return across various strategies for the 52 years ending in December 2003

RatesOfReturn

(Source: What Works on Wall Street by James P. O’Shaughnessy, Third Edition, McGraw-Hill 2005)

Special pleaders on the part of ‘growth at any cost’ might argue that the time series is insufficient. But if 52 recent years – easily an investor’s lifetime – taking in at least two grinding bear markets are not enough, how much would be ?

Again, the conclusions are clear. Buying stocks on low price-to-sales ratios is a winner, tying with stocks on a low price-to-book ratio with an annualised return over the longer term of 15.95%. Low price-to-cashflow is also a stellar performer. Buying stocks with a high yield also beats the broad market, as does buying stocks with low price / earnings ratios. Again, these are all explicit ‘value’ strategies.

Since we appear to be living through something of a speculative bubble (a bubble inflated quite deliberately by explicit central bank action), it is worth recalling one prior instance of ‘growth’ outperforming. As O’Shaughnessy points out,

“Between January 1, 1997 and March 31, 2000, the 50 stocks from the All Stocks universe with the highest P/E ratios compounded at 46.69 percent per year, turning $10,000 into $34,735 in three years and three months. Other speculative names did equally as well, with the 50 stocks from All Stocks with the highest price-to-book ratios growing a $10,000 investment into $33,248, a compound return of 44.72 percent. All the highest valuation stocks trounced All Stocks over that brief period, leaving those focusing on the shorter term to think that maybe it really was different this time. But anyone familiar with past market bubbles knows that ultimately, the laws of economics reassert their grip on market activity. Investors back in 2000 would have done well to remember Horace’s Ars Poetica, in which he states: “Many shall be restored that are now fallen, and many shall fall that are now in honour.”

“For fall they did, and they fell hard. A near-sighted investor entering the market at its peak in March of 2000 would face true devastation. A $10,000 investment in the 50 stocks with the highest price-to-sales ratios from the All Stocks universe would have been worth a mere $526 at the end of March 2003..

“You must always consider risk before investing in strategies that buy stocks significantly different from the market. Remember that high risk does not always mean high reward. All the higher-risk strategies are eventually dashed on the rocks..”

This might seem to imply that there is safety simply in the avoidance of explicitly high-risk strategies, but we would go further. We would argue today that central bank bubble-blowing has made the entire market high-risk, with a broad consensus that with interest rates at 300-year lows and bonds hysterically overpriced and facing the prospect of interest rate rises to boot, stocks are now “the only game in town”. We concede that by a process of logic and elimination, selective stocks look way more attractive than most other traditional assets, but the emphasis has to be on that word “selective”. We see almost no attraction in stock markets per se, and we are interested solely in what might be called ‘special situations’ (notably, in ‘value’ and ‘deep value’ strategies) wherever they can be identified throughout the world. We note, in passing, that markets such as those of the US appear to be virtually bereft of such ‘value’ opportunities, whereas those in Asia and Japan seem to offer them in relative abundance. In this financial war, we would prefer to be on the side of the victors. If history is any guide, the identity of the losers seems to be self-evident.

Economics

World War One and the End of the Bourgeois Century

[Editor's Note: this first appeared on mises.org]

Last week marked the 100 Anniversary of the beginning of World War I. That war, which produced over 37 million casualties, not counting the related famines and epidemics that came in the war’s wake, also destroyed the political systems of numerous countries, setting the stage for fascism and communism in Europe. In the United States, and of course also throughout Europe, the war led to paranoia and political repression rarely seen during the previous century, and in the United States, the Wilson administration’s “anti-sedition” efforts led to a large-scale destruction of basic American liberties unmatched even by the Alien and Sedition acts of the eighteenth century.

For Americans especially, the war and the more than 100,000 American war dead gained nothing more than a post-war depression. While some Europeans could at least claim to be fighting against physical invasion, the Americans fought for nothing except to defend some authoritarian regimes from some other authoritarian regimes. The idea that the war had something to do with “democracy” was obviously untrue even at the time, and in retrospect, the claim is all the more ridiculous given the rise of totalitarianism, which was fostered by the Treaty of Versailles.

The deadly effects of the war, the repressive measures enacted by supposedly enlightened regimes, and how the war paved the way for its even bloodier sequel twenty-five years later, have been covered by a number of excellent historians and economists, including Ralph RaicoRobert Higgs, Hunt Tooley, and Murray Rothbard. The war led to revolutions in ideology, public administration, government, and war itself. Few of these changes improved the lives of ordinary people, and most of these changes led to the commodification and cheapening of human life and human freedom.

The revolutionary nature of the war is little disputed today, but rather than focus on the war itself or its aftermath, it may also be helpful to consider what the war relegated to the dustbin of history.

The Economics of the Bourgeois Century

What some historians now call “the bourgeois century” was the ninety-nine years between the Napoleonic Wars and the beginning of the First World War. From 1815 to 1914, there was no major war in Europe and the standard of living increased far beyond anything ever witnessed before as industrialization, mechanization, and the resulting increases in worker productivity spread throughout the continent.

During the middle of the century, free trade became more widespread than ever, with labor and capital enjoying never-before-seen freedom to move across national borders. Throughout much of central and western Europe, no passport was necessary to move between nation states. Indeed, passports and border checkpoints became associated with despotic and backward countries like Russia.

It was during this period that we saw the rise of the Cobdenites (also known as the Manchester liberals) in Britain who, beginning with the Anti-Corn Law League, slowly rolled back the mercantilist rule of the landed nobility who opposed free trade. The rise of the middle classes both economically and politically were buttressed by mass movements of classical liberalism Europe-wide that demanded greater economic freedoms for themselves and fewer tax-funded privileges for the ruling classes.

As free trade spread, and lessened the advantages of controlling foreign colonies, imperialism receded as well, and an international peace movement arose with John Cobden, dubbed “the international man” as one of its celebrities.

At the same time, many luxuries became available to the middle classes, and this was a time when much of what we now take for granted was quite novel. It was during this time that something that might be recognized as “the weekend” became known. For most people it was still just a one-day affair (Sunday), but it was the first time in human history that average people had the ability to not only stop work for a few hours, but to actually spend some money on recreation such as a short trip to the seaside, or shopping, organized sports, or a trip to a museum, play, or other cultural event.

The new economic realities led to major changes in families as well. For the first time, a large number of parents could afford to formally educate their children in schools or with books. More leisure and income also meant that parents could give children individual attention, play games in the home, read books as a family and more. Fewer and fewer children needed to work to help the family maintain a subsistence living. With the economic liberation of children also came much better conditions for women who became far better educated, and became valued for their ability to manage complex tasks such as the education of children, household hygiene (no small matter in a nineteenth century city) twice-a-day food shopping and more. Moreover, men and women began to engage in the odd practice of marrying for reasons of “sentiment and physical attraction” as marrying for financial reasons became less a matter of life and death. Just as leisure on Sundays allowed for more public recreation, leisure time within the family allowed for more “private” recreation as well, which was complimented by marriage manuals, such as those found in France, that reminded men to tend to women’s sexual needs.

The Rise of Imperialism and the Road to World War I

Naturally, sex, family, and an afternoon at the beach struck many conservative politicians and “deep thinkers” as frivolous wastes of time. Family time and leisure was wasted on mere ordinary people when far more “honorable” pursuits such as nation-building, colonial adventurism, and the art of war were being neglected.

Certainly Otto von Bismarck, a great enemy of the liberals, was expressing contempt for such domestic pursuits when he declared his disdain for the Manchester liberals as “Manchester moneybags” who were concerned not with the glory of the nation-state, but with making money.

By the late nineteenth century, bourgeois liberalism was in decline. Assaulted on one side by the Marxists and other socialists, and on the other side by conservatives, nationalists, and imperialists, the great powers of Europe began to sink back into mercantilism, nationalism, and imperialism. The Scramble for Africa was representative of the new imperialism as the European great powers looked ever more aggressively for new colonies. Meanwhile, the British tightened their grip on India while inventing the concentration camp in its efforts to starve the Boers into submission.

In the late nineteenth century, Bismarck was hard at work inventing the welfare state and hammering together Germany into one unified nation-state. By the turn of the century, one of the few remaining liberals, Vilfredo Pareto in Italy, was able to declare that socialism had finally triumphed in Europe.

In the decade before the First World War, The generation of European liberals such as Gustav de Molinari, Cobden, John Bright, Herbert Spencer, Eugen Richter, and others were dead or near death. There were few young, new liberal scholars to replace them.

At the same time, trade barriers abound throughout Europe as the great powers turned to the economics of imperialism characterized by mercantilism, tariffs, border controls, regulation, and militarism.

Conclusion

Europe during the bourgeois century was certainly no utopia. The new cities were filled with disease, pollution, and crime. Medical science had yet to achieve what it would in the twentieth century, and of course, standards of living remained low when compared to today. But even if we consider these problems, which plague many societies even today, the enormous gains made for ordinary people, thanks to industrialization and the rise of free trade, were fostered all the more by the rise of classical liberalism which actively sought to avoid war, political repression, and economic intervention as the means to a more prosperous society.

Indeed, historian Daniel Yergin would come to refer to this period as the time of “the first era of globalization” and to note that “the world economy experienced an era of peace and growth that, in the aftermath of the carnage of World War I, came to be remembered as a golden age.”

Liberalism was already deeply in decline by 1914, but the First World War was perhaps the final nail in the coffin. Following the war, depression followed, and for Europe, this was followed by hyperinflation in many places, political instability, a declining standard of living — and finally — fascism, communism, and war. In the United States, which managed to avoid most of the destruction of the war, prosperity was achieved during the 1920s, only to be lost and followed by fifteen years of depression and war.

One hundred years after the beginning of the end for bourgeois Europe, we are fortunate to be looking on a new classical liberalism, now known as libertarianism, which is not in decline, but instead is making great strides globally in the face of a still-ascendant ideology of interventionism, mercantilism, and war. We can hope that a third world war will not bring it all crashing down.

Economics

The state of Austrian Economics and classical liberalism in Latin America

[Editor's Note: The following piece was written exclusively for The Cobden Centre by Axel Kaiser, the Executive Director of think tank Fundacion para el Progresso, based in Santiago. It gives a good outline of how Austrian/free market ideas are developing in South America. Many young people globally are now embracing the ideas of Mises and Hayek, but we are also currently seeing undesirable reactions among many people, who now tragically associate free market ideas with crony capitalism and bailouts for the wealthy in society.] 

The Austrian school of economics has gained increasing attention since the 2008 financial crisis and Latin America has not been an exception in this trend. It is mostly young people who have been captivated by the ideas of Hayek, Mises, Rothbard and Huerta de Soto. The most powerful proponents of these ideas in the Spanish-speaking world presently are the Juan de Mariana Institute and the Universidad Rey Juan Carlos in Spain. The first actively participates in the public debate while the second has introduced both a Masters degree and a PhD in Austrian Economics under the leadership of Austrian economist Jesús Huerta de Soto. Many Latin Americans have been trained in the Universidad Rey Juan Carlos and returned to their countries to teach and influence in the public debate.

But there are also several institutions supported by private sponsors that actively promote Austrian economics and classical liberalism in Latin America itself. A remarkable case is Caminos de la Libertad in Mexico. Financed by Ricardo Salinas Pliego, head of the Salinas Group, Caminos de la libertad focuses on educating students in the ideas of liberty. It also organizes the most competitive classical liberal essay contest for scholars in the Spanish-speaking world. Fundación Libertad in Rosario, Argentina is another think tank that advances the Austrian school with great success among young people. Perhaps the most notable case of an institutional effort made to spread classical liberalism and the Austrian school is the Universidad Francisco Marroquín in Guatemala, which was founded entirely on a classical liberal philosophy. Its contributions to the cause of liberty have been considerable in a region dominated by socialist and populist worldviews.

Other important think tanks are CEDICE that does an extraordinary complex work in Venezuela, CREES in the Dominican Republic, IEEP in Ecuador and Fundación para el Progreso in Chile. This last one emerged as a classical liberal reaction against the dramatic rise that socialism and populism experienced over the last years. The Cato Institute has also a special concern with Latin America and permanently finds in these institutions support for organizing the “Cato University”, which brings together students from all over Latin America to learn classical liberalism and fee market economics from leading Latin American scholars.

Despite all these efforts, Latin America at large seems to be moving in the direction of populism and statism. The best and most alarming example is Chile. Long considered a bastion of free market reforms, the country has started a violent departure from the path of progress that followed the last three decades. The hegemony of left-wing and populist ideas has overwhelmed public opinion and caught pro market opinion leaders off guard. If the new statist trend is not stopped on time, the now most prosperous country in the region could follow an Argentinian type of institutional evolution in the next decades that would leave Latin America without a role model on sound economic policy.

Like in Europe and the United States, one of the central causes for the hegemony of statism in Latin America is the fact that most intellectuals and especially university professor are strong supporters of government intervention. This is extremely problematic in countries that are developing and require a wide consensus on policies needed for overcoming poverty. The free market movement in Latin America is still too weak to counterbalance this hegemony and achieve the shift in the intellectual climate of opinion necessary to move towards sound economic policies. It remains to be seen if in the long run the failure of statist ideas will allow once again for change that is desperately needed in the region. It that comes to happen, current pro market think tanks and intellectuals will play a decisive role in shaping the new institutional arrangements and in creating the public support for ensuring their survival.

Axel Kaiser is a Chilean public intellectual, financial columnist and writer dedicated to spreading classical liberalism in Latin America. He is also executive director of the think tank Fundación para el Progreso based in Santiago.