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Economics

Has Fractional-Reserve Banking Really Passed the Market Test?

[Editor's note: the following piece was originally published by World Dollar at zerohedge.com]

In 2003, Jörg Guido Hülsmann, a senior fellow of the Mises Institute, published the essay “Has Fractional-Reserve Banking Really Passed the Market Test?” in a Winter edition of The Independent Review. The key conclusion drawn was that it is the obfuscation of the difference between fractional-reserve IOUs and genuine money titles which preserves the the practice of fractional-reserve banking.

It is the belief of this author that this essay has not received the acclaim that it so richly deserves. Indeed, its implications for the future of money and banking are monumentous. If those who advance the Austrian School of economics, the Mises Institute and Zero Hedge most prominently among them, were to grant its ideas a great renaissance, the worldwide return to sound money may happen far sooner than most could have believed possible.

J.G. Hülsmann 
explains why “in a free market with proper product differentiation, fractional-reserve banking would play virtually no monetary role” (p.403). The incisive reason given is that genuine money titles are valued at par with money proper, while fractional-reserve IOUs + RP (Redemption Promise) would be valued below par, due to default risk.

Here is the deductive argument being made:

1.    Debt (IOUs + RP) is promised money.
2.    A promise has the risk of not being kept (default risk).
3.    Therefore, promised money, debt (IOUs + RP), is less valuable than genuine money titles (/money proper).

J.G. Hülsmann goes on to explain why the mispricing of fractional-reserve debt (IOUs + RP) persists. The reasons given include the outlawing of genuine money titles and deceptive language (“deposits”).  This author would like to add one more reason, namely the myth that the government could actually “guarantee” deposits in the event of a systemic run. Systemic runs mean, by definition, most if not all money proper exiting the fractional reserve banking system, meaning the money proper with which the “guarantees” could be fulfilled doesn’t exist, short of unprecedented levels of new money printing and financial repression. This point is acknowledged on p.22 of the otherwise unexceptional “The Chicago Plan Revisited” by Jaromir Benes and Michael Kumhof.

The history of fractional reserve banking is, then, defined by informational inefficiency. Market participants have failed to reflect the price differential between fractional reserve debt (IOUs + RP) and genuine money titles.

Let us now extend the deductive argument:

4.    Therefore, an arbitrage opportunity exists. All holders of Debt (IOUs + RP) have an economic incentive to make the redemption request for genuine money titles (/money proper).

Mervyn King, ex-governor of the Bank of England, once claimed that it is irrational to start a bank run, but rational to participate in one once it has started. While the second part of the claim is correct, the first is not. It is irrational not to start a bank run, due to the arbitrage opportunity that exists.

This, of course, holds the assumption that the market will become informationally efficient, and will therefore capitalise on the mispricing. But the holding of this assumption is only credible if this idea is spread. We live in a time with an unprecedented level of competing voices wanting to be heard, the unfortunate consequence of which is that we drown out the voices that are truly exceptional. It is no exaggeration to say that “Has Fractional-Reserve Banking Really Passed the Market Test?” may prove to be the most revolutionary essay in the history of monetary economics and banking, if only it  receives the level of appraisal and promotion it deserves.

On this matter, the reasons given for the persistence of the mispricing of fractional-reserve debt (IOUs + RP) are unsustainable in the long run. The lack of legal protection for genuine money titles is no more than a technicality, for there is nothing in practice that can sustainably prevent the existence of full reserve banks. Awareness that “deposits” are not actually money being held for safekeeping is a matter of educating the public, as is awareness that government’s deposit “guarantees” are not actually credible in the event of a systemic run.

If we assume, then, that fractional-reserve banking will come to its logical ending, there is good reason to believe that the shock will herald the endgame for fiat money. It is in fact the case that all fiat money is the liability of the central bank, which also carries the risk of non-repayment (default risk). This, again, means an arbitrage opportunity for market participants to withdraw the fiat money from the fiat money banking system. This confirms that the original basis for fiat money is destroyed, for its repayment to the central bank is not credible.

Finally, at long last, we have a worldwide return to sound money. Will there be a new 21st century Gold Standard? Will we recourse to cryptocurrencies such as Bitcoin? Will we see the rise of the Equal Opportunity Standard, with everyone in the world being issued once with an equal amount of World dollars? Or will there be another innovation to come? What we must defend, as proud advocates of freedom, is that the free market will decide. That governments finally learn to stop their oppressive, damaging interference with the monetary system.

Economics

How to Start Reforming the Federal Reserve Right Now

[Editor's Note: this piece, by Brendan Brown, was first published at mises.org]

First the good news. The House Financial Services Committee has held a hearing on “Legislation to Reform the Federal Reserve on its 100-year Anniversary.” The hearing focused on a bill introduced by Scott Garrett and Bill Huizenga which would require the Fed to provide Congress with a clear rule to describe the course of monetary policy. Now for the bad news. The rule is to be an equation showing how the Fed would adjust interest rates in response to changes in certain economic variables. And the star witness before the committee proposing his own version of such a rule is renowned neo-Keynesian economist, ex-Bush official Professor John B. Taylor.

Inputs into the so-called “Taylor Rule” involve key magnitudes such as “the neutral rate of interest” and “the natural rate of unemployment” as well as the “targeted rate of inflation.” One might have hoped that the Republicans by now would have realized that monetary reform should involve first and foremost jettisoning neo-Keynesian economics. Even the most talented Fed official cannot know the neutral level of interest rates (whether for short, medium, or long maturities) or the natural level of unemployment. And as to inflation targets, these should be scrapped in any monetary reform and replaced by the aim of monetary stability broadly defined to include absence of asset price inflation and a very long-run stable anchor to goods and services prices.

First, Set Interest Rates Free

An essential component of monetary reform should be setting interest rates free. This means no more official pegging or guidance of short-term interest rates and no attempt to manipulate in various ways long-term interest rates. Markets can do a better job of discovering the neutral rates of interest (across different maturities) and positioning market rates at any time relative to these so as to guide the economy along an equilibrium path than any set of well-informed and even well-meaning Fed officials. This is all on the big assumption that the reformers can design a monetary system around a suitable firmly placed pivot.

Under the gold standard the pivot was a fixed price for gold alongside the widespread use of gold coins. And so the amount of high-powered money in the world grew in line with the above ground stock of yellow metal, which occurred at a glacial, but flexible pace. The demand for high-powered money was itself a fairly stable function of income and wealth. And so the system was well-anchored. Yes, there were imperfections, including the advent of fractional-reserve banking which meant that the demand for high-powered money became less stable. Yet given the absence of deposit insurance and too-big-to-fail and only limited lender of last resort roles banks could be counted upon to have a strong demand for reserves (mainly in the form of gold) to back their deposits. Moreover the obligation to convert customers’ deposits into gold coin on request buttressed this demand for high powered money from the banks.

More Steps Toward Proper Reform

As a matter of practical politics the Republican Congressmen may well conclude that an imminent return to gold is unfeasible. But they could consider in the light of these considerations how best to re-secure the pivot to the US monetary system by creating high-powered money for which demand would be stable and the rate of increase in supply flexibly very low. The steps toward this end would include:

· Abolishing the payment of interest on bank reserves.

· Strict curtailment of lender of last resort function.

· Long-term abolition of deposit insurance.

· Fed withdrawal from creating liquidity in debt markets (no more eligible bills, repo-transactions, etc.).

· Issuance of large-denomination notes (adding to the demand for currency, a key component of high-powered money).

· A legal attack on monopoly power in the credit card business which results often in payers of cash not enjoying a discount.

In this suitably reformed system there would be a huge demand for high-powered money (whether in the form of currency or reserves held by the banks) highly distinct in function from any alternative assets. This demand would not depend on legislating artificially high reserve requirements which bank lobbyists would surely whittle down over time. That was the Achilles heel of the briefly successful monetarist experiment in Germany during the 1970s and early 1980s, as the bankers were finally able to bring political pressure toward lowering reserve requirements such that monetary base no longer was a secure pivot to the monetary system. Accordingly, the Bundesbank gradually shifted to explicit pegging of short-term interest rates albeit subject to a medium-term target for wider money supply growth.

Turning back to the US, even with the reforms suggested, there would still be the difficult question of how to determine the growth in supply of high-powered money. Without a gold connection there has to be some degree of discretionary control in this process, albeit constrained by a quantitative guide (such as an average 1 to 1.5-percent rate of expansion per annum, similar to the expansion rate of above ground gold over the past century) and ultimately constitutionally-embedded legal restrictions.

High-powered money as defined by such a monetary reform would be a far cry from the present situation where the size of the Federal Reserve balance sheet has been recording explosive growth for many years and where the main form of high-powered money, excess reserves, pays interest at above the market rate to the banks. The Republicans in their pursuance of monetary reform would do well to propose some initial steps which would prepare the way for bolder change at a later date with the aim of creating a stable supply and demand for high-powered money.

A key step would be the immediate suspension of interest payments on reserves (which only started in 2008) coupled with a rapid timetable for disposing of the Fed’s massive portfolio of long-term fixed-rate bonds. The Bernanke Fed, and now the Yellen Fed, has used this portfolio as a means of manipulating long-term interest rates (with this depending on an emperor’s new clothes effect whereby markets attach unquestioning importance to the Fed’s massive holdings in forming their expectations of bond prices) and of scaring investors into real assets so adding to the strength of their asset price inflation virus injections.

One suggestion for a rapid timetable would be the Treasury and Fed entering into a deal in which the long-term fixed-rate T-bonds held by the Fed would be converted into long-term floating rate debt and into short- or medium-term T-bills. This would mean less accounting profit under the present structure of yields for the Fed and a lower cost of borrowing for the Treasury. But who really cares about such bookkeeping between the federal government and its monetary agency? In turn the Treasury would announce a long-term timetable for raising the ratio of long-maturity fixed to floating rate debt in the overall total outstanding.

Rome was not made in a day. And the Republicans are certainly not in a position to legislate radical monetary reform. But that is no excuse for a careless decision by the would-be reformers to veer into a cul-de-sac under the misleading directions of Professor Taylor.

Economics

Bedtime for Bondo

 “By sacrificing quality an investor can obtain a higher income return from his bonds. Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds. While, taken as a whole, they may work out somewhat better in terms of overall return than the first-quality issues, they expose the owner to too many individual risks of untoward developments, ranging from disquieting price declines to actual default.”

  • Ben Graham, ‘The Intelligent Investor’.

They call them ‘junk bonds’ for a reason. They now constitute an offence against linguistic decency: ‘high yield’ no longer even is. Consider the chart below:

BofA Merrill Lynch High Yield Master II Index (spread vs US Treasuries)

High Yield Master II Index

(Source: BofA Merrill Lynch, St. Louis Federal Reserve)

(The index in question is a benchmark for the broad high yield bond market.) Not for nothing did the Financial Times report at the weekend that “Retail investors are getting increasingly nervous about high-yield bonds”.

They should also be getting increasingly nervous about government bonds. Consider, first, this chart:

                                                                                                                                                                             UK long bond yield

(Source: Thomson Reuters, Credit Suisse)

In the entire history of the UK Gilt market, yields have never been as low. This suggests that Gilt buyers at current levels are unlikely to enjoy an entirely blissful investment experience.

Just to round up this analysis of bond investor hyper-exuberance, consider this last chart, which puts interest rates (in this case, the UK base rate) in their historical context:

UK base rates, 1700 to 2014

UK Base Rates

(Source: The Bank of England, Church House)

(*The Bank Rate has comprised variously the Bank Rate, Minimum Lending Rate, Minimum Band 1 Dealing Rate, Repo Rate and Official Bank Rate.)

There is one (inverse) correlation in investment markets that is pretty much iron-clad. If interest rates go up, bond prices go down. This is entirely logical, since the coupon payments on bonds are typically fixed. If interest rates rise, that stream of fixed coupon payments loses its relative attractiveness. The bond price must therefore fall to compensate fixed coupon investors. So now ask yourself a question: in what direction are interest rates likely to go next ? Your answer may have some bearing on your preferred asset allocation.

Bond investors may be acting rationally inasmuch as they believe that central banks will keep interest rates “lower for longer”. But even more rational investors are now starting, loudly, to question the wisdom of central banks’ maintenance of emergency monetary stimulus measures, at least five years after the Global Financial Crisis flared up. Speaking at the ‘Delivering Alpha’ conference covered by CNBC, respected hedge fund manager Stanley Druckenmiller commented as follows:

“As a macro investor, my job for 30 years was to anticipate changes in the economic trends that were not expected by others – and therefore not yet reflected in securities prices. I certainly made my share of mistakes over the years, but I was fortunate enough to make outsized gains a number of times when we had different views from various central banks. Since most investors like betting with the central bank, these occasions provided our most outsized returns – and the subsequent price adjustments were quite extreme. Today’s Fed policy is as puzzling to me as during any of those periods and, frankly, rivals 2003 in the late-stages to early-2004, as the most baffling of a number of instances I have in mind. We at Duquesne [Capital Management] were mystified back at that time why the funds rate was one percent with the ‘considerable period’ attached to it, given the vigorous economic growth statistics available at the time. I recall walking in one day and showing my partners a bunch of charts of economics statistics of that day and asking them to take the following quiz: Suppose you had been on Mars the last five years and had just come back to planet Earth. I showed them five charts and I said, ‘If you had to guess, where would you guess the Federal funds rate was?’ Without exception, everyone guessed way north of one percent, as opposed to the policy at the time which was a verbal guarantee that they would stay at one percent for a ‘considerable period of time.’ So we were confident the Fed was making a mistake, but we were much less confident in how it would manifest itself. However, our assessment by mid-2005 that the Fed was fueling an unsustainable housing Bubble, with dire repercussions for the greater economy, allowed our investors to profit handsomely as the financial crisis unfolded. Maybe we got lucky. But the leadership of the Federal Reserve did not foresee the coming consequences as late as mid-2007. And, surprisingly, many Fed officials still do not acknowledge any connection between loose monetary policy and subsequent events..”

“I hope we can all agree that these once-in-a-century emergency measures are no longer necessary five years into an economic and balance sheet recovery. There is a heated debate as to what a ‘neutral’ Fed funds rate would be. We should be debating why we haven’t moved more meaningfully towards a neutral funds rate. If for no other reason, so the Fed will have additional weapons available if the outlook darkens again. Many Fed officials and other economists defend their current policies by claiming the economy is better than it would have been without their ongoing stimulus. No one knows for sure, but I believe that is logical and correct. However, I also believe if you’d asked the same question in 2006 – that the economy was better in 2004 to 2006 than it would have been without the monetary stimulus that preceded it. But was the economy better in total from 2003 to 2010 – without the monetary stimulus that preceded it? The same applies today. To economists and Fed officials who continually cite that we are better off than we would have been without zero rate policies for long, I ask ‘Why is that the relevant policy time frame?’ Five years after the crisis, and with growing signs of economic normalization, it seems time to let go of myopic goals. Given the charts I just showed and looking at economic history, today’s Fed policy seems not only unnecessary but fraught with unappreciated risk. When Ben Bernanke and his colleagues instituted QE1 in 2009, financial conditions in the real economy were in a dysfunctional meltdown. The policy was brilliantly conceived and a no-brainer from a risk/reward perspective. But the current policy makes no sense from a risk/reward perspective. Five years into an economic and balance sheet recovery, extraordinary money measures are likely running into sharply diminishing returns. On the other hand, history shows potential long-term costs can be quite severe. I don’t know whether we’re going to end with a mal-investment bust due to a misallocation of resources; whether it’s inflation; or whether the outcome will actually be benign. I really don’t. Neither does the Fed.”

No more charts. If these three don’t get the message across, nothing will.

The bond environment, ranging from high yield nonsense to government nonsense, is now fraught, littered with uncertainty and unexploded ammunition, and waiting nervously for the inevitable rate hike to come (or bracing for a perhaps messy inflationary outbreak if it doesn’t). There are clearly superior choices on a risk-reward basis; we think Ben Graham-style value stocks are the logical and compelling alternative.

Economics

Pulitzer’s Advice Applies To Krugman: “Put It Before Them…Above All, Accurately”

[Editor's Note: We will keep our readers apprised of developments in the exchange between Paul Krugman and The Cobden Centre regular Ralph Benko.] 

Professor Paul Krugman, in his New York Times blog last week, says my most recent column, about him, is “funny and scary.”  Last week’s column here inferred that Prof. Krugman is leaving Princeton in quiet disgrace.  It drew pretty wide attention.

It also drew over 150 comments. Many commentators merrily berated me. (Comes with the territory.)  The column, quite flatteringly, even drew a riposte from Prof. Krugman himself, in hisTimes blog, entitled Fantasies of Personal Destruction:

A correspondent directs me to a piece in Forbes about yours truly that is both funny and scary.

Yep, scurrying away with my tail between my legs, I am, disgraced for policy views shared only by crazy people like the IMF’s chief economist (pdf).

One thing I’ve noticed, though, is how many people on the right are drawn to power fantasies in which liberals aren’t just proved wrong and driven from office, but personally destroyed. Does anyone else remember this bit from the O’Reilly scandal?

“Look at Al Franken, one day he’s going to get a knock on his door and life as he’s known it will change forever,” O’Reilly said. “That day will happen, trust me. . . . Ailes knows very powerful people and this goes all the way to the top.”

And people wonder why I don’t treat all of this as a gentlemanly conversation.

English: Paul Krugman at the 2010 Brooklyn Boo...

English: Paul Krugman at the 2010 Brooklyn Book Festival. (Photo credit: Wikipedia)

Prof. Krugman’s prestige, and the immense influence provided him by the New York Times, gives his opinions enormous political weight.  What he writes has impact in liberal, and Democratic, quarters.  Yet he by no means is infallible.

The critique this columnist offered drew on commentaries by figures of real stature.  One of these is Niall Ferguson, economic historian, Harvard professor (and Senior Research Fellow of Jesus College, Oxford University, and Senior Fellow at the Hoover Institution, Stanford University).  The other commentary came from Paul Volcker who made a disparaging comment fairly interpreted as aimed at Prof. Krugman.

What’s really odd about Prof. Krugman’s Fantasies of Personal Destruction is its abrupt segue into likening my critique to a statement made by someone this columnist never met to someone this columnist never met. What could have motivated this non sequitur?

Perhaps some psychological force is at work? Prof. Krugman, echoing a clever critique by Keynes, himself has invoked Freud as key to understanding proponents of the gold standard.  Freud,speculating on subconscious associations between excrement and money, referenced the Babylonian doctrine that “gold is the feces of Hell.” Thus, implies Prof. Krugman, proponents of a gold standard are stuck in an infantile “anal-retentiveness.”

Keynes, perhaps not getting it quite right, alludes to Freud in Auri Sacra Fames(September 1930):

Dr. Freud relates that there are peculiar reasons deep in our subconsciousness why gold in particular should satisfy strong instincts and serve as a symbol.

It presumably is this to which Prof. Krugman obscurely alludes in a blog entitled The She-Devil of Constitution Avenue:

I’ve been saying for a long time that we aren’t having a rational argument over economic policy, that the inflationista position is driven by politics and psychology rather than anything the other side would recognize as analysis. But this really proves it beyond a shadow of a doubt; if you really want to understand what’s going on here, the Austrian you need to read isn’t Friedrich Hayek or Ludwig von Mises, it’s Sigmund Freud.”

Put aside the demonstrable fact of Prof. Krugman’s consistently sloppy conflation of gold investors and gold standard proponents.  Put aside his failure to engage with the arguments of the many gold standard proponents not predicting imminent virulent inflation.  (Such as this writer.)

Eruditely ridiculing gold proponents as, well, full of s*** is clever. It likely will tickle those readers who find monkeys flinging poo at each other hilarious.  Ridicule is much easier, and cheaper, than grappling with scholarly analyses such as that from the Bank of England which provided, in 2011, Financial Stability Paper No. 13, a genuinely interesting critique of the real world performance of fiduciary currency.

That paper is a rigorous analysis of the empirical performance of the fiduciary Federal Reserve Note standard in comparison to the Bretton Woods gold-exchange standard and the classical gold standard.  It does not, at least not explicitly, advocate for either predecessor standard.  It simply assesses that the Federal Reserve Note standard in practice has proved substantially worse than its predecessors (and calls for the exploration of a rule-based system).  A thoughtful response by Prof. Krugman to this paper would be far more interesting, and edifying, than sly scatological insults.

One of the wittier of the commentators to last week’s column accused me of impudence.  Guilty as charged.  This writer confesses to having committed, in broad daylight, an act of lèse-majesté against the Great and Imperious Krugman.  My critics are right to point out that this columnist is a minor figure.  Still, do consider: the counsels of integrity to Pinocchio by the tiny Talking Cricket proved, in the end, well founded.   One, also, could wish that more of Prof. Krugman’s defenders would tender more persuasive arguments (say, fact-based) than their many variants of “How dare you!”

In responding to my column Prof. Krugman states that “many people on the right are drawn to power fantasies in which liberals aren’t just proved wrong and driven from office, but personally destroyed.”   Given Prof. Krugman’s vilification of his adversaries this could be dismissed as rich with irony. Yet there may be more to say.

Prof. Krugman has introduced the great Sigmund Freud into the conversation.  Thus it might be fair to say that his consistently rude denigration of his adversaries appears to be what Freud called “projection” (“in which humans defend themselves against unpleasant impulses by denying their existence in themselves, while attributing them to others“).

Consider Prof. Krugman’s public admission that he does not regularly read that which he presumes to criticize.  Prof. Krugman states forthrightly:

Some have asked if there aren’t conservative sites I read regularly. Well, no.

Carefully reading one’s opponents’ arguments is not a requisite in life. Yet critiquing arguments one has not thoroughly assimilated is lazy, louche, intellectually slovenly, and — one might fairly infer — unacceptably beneath the standards of, say, Princeton University.

Prof. Krugman dismisses me as “funny and scary.”  My several columns pointing out the errors of fact and unsupportable interpretations in his op-eds had been — and surely again will fall — beneath his notice.  Still, inaccurately presenting that which one is criticizing is just bad journalism.  Readers  should be able to rely on editors to assure that a columnist is shooting straight.

As many of my commentators correctly point out I do not command (nor do I presume to deserve) the elite social status of Prof. Krugman. Yet had Prof. Krugman taken even a moment to aim before he fired he could have discovered a right winger who has offered many respectful words, and, when warranted, praise for Barack Obama,Hillary ClintonElizabeth WarrenGeorge SorosMoveOn.org, and Occupy Wall Street (among others with whom he has disagreements).  There’s no agenda of “personal destruction.”

If Prof. Krugman had dug a little deeper he might have discovered that my columns routinely are informed by The New York Review of Books, the New Yorker, theAtlantic Monthly, and, yes, the New York Times, all of which I read regularly, usually with pleasure.  He would discover that my use of  them is not, by and large, to ridicule but to learn and, when in disagreement, to present their claims fairly and dispute them honestly.

Scary stuff?  Prof. Krugman, if you find the words of this extremely minor pixel-stained wretch “scary” … what does that say?  Perhaps speaking truth to power is scary … to those with power? Yet let me speak a little truth to the powerful, and indispensable,New York Times.

The Nobel Prize in Economics is one of the greatest laurels bestowed in that field.  Should Prof. Krugman be permitted to rest on this laurel?  Joseph Pulitzer’s directive still applies: “Put it before them… above all, accurately….”

It is not the purpose of this column to see Paul Krugman driven from his virtual office within the paragovernmental New York Times.  This columnist makes only a modest call for the Times to assign an editor to fact check his work and help him refrain from reckless disregard for the truth.

Economics

Is Paul Krugman Leaving Princeton In Quiet Disgrace?

Professor Paul Krugman is leaving Princeton.  Is he leaving in disgrace?

Not long, as these things go, before his departure was announced Krugman thoroughly was indicted and publicly eviscerated for intellectual dishonesty by Harvard’s Niall Ferguson in a hard-hitting three-part series in the Huffington Post, beginning here, and with a coda in Project Syndicateall summarized at Forbes.com.  Ferguson, on Krugman:

Where I come from … we do not fear bullies. We despise them. And we do so because we understand that what motivates their bullying is a deep sense of insecurity. Unfortunately for Krugtron the Invincible, his ultimate nightmare has just become a reality. By applying the methods of the historian – by quoting and contextualizing his own published words – I believe I have now made him what he richly deserves to be: a figure of fun, whose predictions (and proscriptions) no one should ever again take seriously.

Princeton, according to Bloomberg News, acknowledged Krugman’s departure with an extraordinarily tepid comment by a spokesperson. “He’s been a valued member of our faculty and we appreciate his 14 years at Princeton.”

Shortly after Krugman’s departure was announced no less than the revered Paul Volcker, himself a Princeton alum, made a comment — subject unnamed — sounding as if directed at Prof. Krugman.   It sounded like “Don’t let the saloon doors hit you on the way out.  Bub.”

To the Daily Princetonian (later reprised by the Wall Street Journal, Volcker stated with refreshing bluntness:

The responsibility of any central bank is price stability. … They ought to make sure that they are making policies that are convincing to the public and to the markets that they’re not going to tolerate inflation.

This was followed by a show-stopping statement:  “This kind of stuff that you’re being taught at Princeton disturbs me.”

Taught at Princeton by … whom?

Paul Krugman, perhaps?  Krugman, last year, wrote an op-ed for the New York Times entitled  Not Enough Inflation.  It betrayed an extremely louche, at best, attitude toward inflation’s insidious dangers. Smoking gun?

Volcker’s comment, in full context:

The responsibility of the government is to have a stable currency. This kind of stuff that you’re being taught at Princeton disturbs me. Your teachers must be telling you that if you’ve got expected inflation, then everybody adjusts and then it’s OK. Is that what they’re telling you? Where did the question come from?

Is Krugman leaving in disgrace? Krugman really is a disgrace … both to Princeton and to the principle of monetary integrity. Eighteenth century Princeton (then called the College of New Jersey)president John Witherspoon, wrote, in his Essay on Money:

Let us next consider the evil that is done by paper. This is what I would particularly request the reader to pay attention to, as it was what this essay was chiefly intended to show, and what the public seems but little aware of. The evil is this: All paper introduced into circulation, and obtaining credit as gold and silver, adds to the quantity of the medium, and thereby, as has been shown above, increases the price of industry and its fruits.

“Increases the price of industry and its fruits?”  That’s what today is called “inflation.”

Inflation is a bad thing.  Period.  Most of all it cheats working people and those on fixed incomes who Krugman pretends to champion.  Volcker comes down squarely, with Witherspoon, on the side of monetary integrity. Krugman, cloaked in undignified sanctimony, comes down, again and again, on the side of … monetary finagling.

Krugman consistently misrepresents his opponents’ positions, constructs fictive straw men, addresses marginal figures, and ignores inconvenient truths set forward by figures of probity such as the Bank of England and theBundesbankthoughtful work such as that by Member of Parliament (with a Cambridge Ph.D. in economic history) Kwasi Kwarteng, and, right here at home, respected thought leaders such as Steve Forbes and Lewis E. Lehrman (with whose Institute this writer has a professional affiliation).

Professor Krugman, on July 7, 2014, undertook to issue yet another of his fatwas on proponents of the classical gold standard.  His New York Times op-ed, Beliefs, Facts and Money, Conservative Delusions About Inflation, was brim full of outright falsehoods and misleading statements. Krugman:

In 2010 a virtual Who’s Who of conservative economists and pundits sent an open letter to Ben Bernanke warning that his policies risked “currency debasement and inflation.”  Prominent politicians like Representative Paul Ryan joined the chorus.

Reality, however, declined to cooperate. Although the Fed continued on its expansionary course — its balance sheet has grown to more than $4 trillion, up fivefold since the start of the crisis — inflation stayed low.

Many on the right are hostile to any kind of government activism, seeing it as the thin edge of the wedge — if you concede that the Fed can sometimes help the economy by creating “fiat money,” the next thing you know liberals will confiscate your wealth and give it to the 47 percent. Also, let’s not forget that quite a few influential conservatives, including Mr. Ryan, draw their inspiration from Ayn Rand novels in which the gold standard takes on essentially sacred status.

And if you look at the internal dynamics of the Republican Party, it’s obvious that the currency-debasement, return-to-gold faction has been gaining strength even as its predictions keep failing.

Krugman is, of course, quite correct that the “return-to-gold faction has been gaining strength.” Speculating beyond the data thereafter Krugman goes beyond studied ignorance.  He traffics in shamefully deceptive statements.

Lewis E. Lehrman, protege of French monetary policy giant Jacques Rueff, Reagan Gold Commissioner, and founder and chairman of the Lehrman Institute, arguably is the most prominent contemporary advocate for the classical gold standard.  Lehrman never rendered a prediction of imminent “runaway inflation.”  Only a minority of classical gold standard proponents are on record with “dire” warnings, certainly not this columnist.  So… who is Krugman talking about?

Of the nearly two-dozen signers of (a fairly mildly stated concern) open letter to Bernanke which Krugman cites as prime evidence, only one or two are really notable members of the “return-to-gold faction.” Perhaps a few other signers might have shown some themselves in sympathy the gold prescription. Most, however, were, and are, agnostic about, or even opposed to, the gold standard.

Indicting gold standard proponents for a claim made by gold’s agnostics and opponents is a wrong, cheap, bad faith, argument.  More bad faith followed immediately.   Whatever inspiration Rep. Paul Ryan draws from novelist Ayn Rand, Ryan is by no means a gold standard advocate.  And very few “influential conservatives” (unnamed) “draw their inspiration” from Ayn Rand.

Nor are most proponents of the classical gold standard motivated by a fear that paper money is an entering wedge for liberals to “confiscate your wealth and give it to the 47 percent.”  A commitment to gold is rooted, for most, in the correlation between the gold standard and equitable prosperity.  Income inequality demonstrably has grown far more virulent under the fiduciary Federal Reserve Note regime — put in place by President Nixon — than it was, for instance, under the Bretton Woods gold+gold-convertible-dollar system.

Krugman goes wrong through and through.  No wonder Ferguson wrote: “I agree with Raghuram Rajan, one of the few economists who authentically anticipated the financial crisis: Krugman’s is “the paranoid style in economics.” Krugman, perversely standing with Nixon, takes a reactionary, not progressive, position. The readers of the New York Times really deserve better.

Volcker is right. “The responsibility of any central bank is price stability.” Krugman is wrong.

Prof. Krugman was indicted and flogged publicly by Niall Ferguson. Krugman thereafter announced his departure from Princeton.  On his way out Krugman, it appears, was reprimanded by Paul Volcker.  Krugman has been a disgrace to Princeton.  Is he leaving Princeton in quiet disgrace?

Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/07/14/is-paul-krugm

Economics

Monetary discord

Last Monday’s Daily Telegraph carried an interview with Jaime Caruana , the General Manager of the Bank for International Settlements (the BIS). As General Manger, Caruana is CEO of the central banks’ central bank. In international monetary affairs the heads of all central banks, with the possible exception of Janet Yellen at the Fed, defer to him. And if any one central bank feels the need to obtain the support of all the others, Caruana is the link-man.

 

His opinion matters and it differs sharply from the line being pushed by the Fed, ECB, BoJ and BoE. But then he is not in the firing line, with an expectant public wanting to live beyond its means and a government addicted to monetary inflation. However, he points out that debt has continued to increase in the developed nations since the Lehman crisis as well as in most emerging economies. Meanwhile the growing sensitivity of all this debt to rises in interest rates is ignored by financial markets, where risk premiums should be rising, but are falling instead.

From someone in his position this is a stark warning. That he would prefer a return to sound money is revealed in his remark about the IMF’s hint that a few years of inflation would reduce the debt burden: “It must be clearly resisted.”

There is no Plan B offered, only recognition that Plan A has failed and that it should be scrapped. Some think this is already being done in the US, with tapering of QE3. But tapering is having little monetary effect, being replaced by the expansion of the Fed’s reverse repo programme. In a reverse repo the Fed gives the banks short-term US Government debt, paid for by drawing down their excess reserves. The USG paper is used as collateral to back credit creation, while the excess reserves are not in public circulation anyway. Therefore money is created out of thin air by the banks, replacing money created out of thin air by the Fed.

Interestingly Caruana dismisses deflation scares by saying that gently falling prices are benign, which places him firmly in the sound money camp.

But he doesn’t actually “come out” and admit to being Austrian in his economics, more an acolyte of Knut Wicksell, the Swedish economist, upon whose work on interest rates much of Austrian business cycle theory is based. This is why Caruana’s approach towards credit booms is being increasingly referred to in some circles as the Mises-Hayek-BIS view.

With the knowledge that the BIS is not in thrall to Keynes and the monetarists, we can logically expect that Caruana and his colleagues at the BIS will be placing a greater emphasis on the future role of gold in the monetary system. Given the other as yet unstated conclusion of the Mises-Hayek-BIS view, that paper currencies are in a doom-loop that ends with their own destruction, the BIS is on a course to break from the long-standing policy of preserving the dollar’s credibility by supressing gold.

Caruana is not alone in these thoughts. Even though central bankers in the political firing line only know expansionary monetary policies, it is clear that influential opinion in many quarters is building against them. It is too early to talk of a new monetary regime, but not too early to talk of the current one’s demise.

Economics

Is there room for Austrian ideas at the top table?

[Editor's note: now that Steve Baker MP is on the Treasury Select Committee, it should be of interest to all Austrianists, and those interested in monetary reform in general, to re-visit Anthony Evans and Toby Baxendale's 2008 paper on whether there is room for Austrian ideas at the top table. Within the paper they also reference William White, of the BIS, who has made several comments in the past that are sympathetic to the Austrian School. The recent BIS Annual Report, at least relative to individual, national central banks, shows some consideration of the distorting effects of monetary policy, and the cleansing effects of liquidation (note that the BIS does not face the same political pressures as supposedly independent national central banks).  It will be of major importance to followers of the Austrian School around the world to follow the progress of Steve as things develop. Below is the introduction to the paper, the paper in its entirety can be downloaded here aje_2008_toptable]

 

Introduction

 

At a speech in London in 2006 Fynn Kydland surveyed ‘the’ three ways in which governments can achieve credible monetary policy: the gold standard, a currency board or independent central banks. After taking minimal time to dismiss the first two as either outdated or unsuitable for a modern, prosperous economy the majority of the speech was focused on the latter, and the issue of independence. However, the hegemony of this monetary system belies the relative novelty of its use. Indeed the UK presents an especially peculiar history, given the genesis of independence with the New Labour government of 1997. A decade is a short time and two large coincidences should not be ignored. First, independence has coincided with an unprecedented period of global growth, giving the Monetary Policy Committee (MPC) a relatively easy ride. Second, the political system has been amazingly consistent with the same government in place throughout, and just two Chancellors of the Exchequer (Gordon Brown and Alistair Darling). These two conditions have meant that from its inception the UK system of central bank independence has not been properly tested.

Our main claim in this article is that monetary policy has converged into a blend of two theoretical approaches, despite there being three established schools of thought. We feel that there is room at the top table of policy debate for more explicit attention to Austrianideas, and will survey emerging and prevailing attention amongst policy commentary.

 

Troubling times to be a central banker

 

Current economic conditions are proving to be of almost universal concern. In the UK general price levels are rising (with the rise in the consumer price index (CPI) hitting 3.8% and in the retail price index reaching 4.6% in June 2008) whilst output growth is falling (with GDP growth slowing to 0.2% in quarter two 2008), raising the possibility of stagflation. This comes after a serious credit crunch that has led to the nationalisation of Northern Rock and an estimated £50 billion being used as a credit lifeline. Most of the prevailing winds are global and are related to two recent financial bubbles. From late 2000 to 2003 the NASDAQ composite index (of primarily US technology stocks) lost a fifth of its value. This was followed with a bubble in the housing market that burst in 2005/06 leading to a liquidity crisis concentrated on sub-prime mortgages. Although the UK has fewer sub-prime lendings, British banks were exposed through their US counterparts and it is now widely acknowledged that a house price bubble has occurred (the ratio of median house prices to median earnings rising steadily from 3.54 in 1997 to 7.26 in 2007) and that a fall in prices is still to come. Also worrying, we see signs that people are diverting their wealth from financial assets altogether and putting them into hard commodities such as gold or oil.

Although academic attention to developing new models is high, there seems to be a request on the part of central bankers for less formal theory building and more empirical evidence.

Alan Greenspan has ‘always argued that an up-to-date set of the most detailed estimates for the latest available quarter are far more useful for forecasting accuracy than a more sophisticated model structure’ (Greenspan, 2007), which N. Gregory Mankiw interprets to mean ‘better monetary policy . . . is more likely to follow from better data than from better models’. But despite the settled hegemony of theoretical frameworks, there is a genuine crisis in some of the fundamental principles of central bank independence. Indeed three points help to demonstrate that some of the key tenets of the independence doctrine are crumbling.

 

Monetary policy is not independent of political pressures

 

The UK government grants operational independence to the Bank of England, but sets the targets that are required to be hit. This has the potential to mask inflation by moving the goalposts, as Gordon Brown did in 1997 when he switched the target from the retail price index (RPIX) to the narrower CPI. Although the relatively harmonious macroeconomic conditions of the first decade of UK independence has created little room for conflict, the rarity of disagreement between the Bank of England and Treasury also hints at some operational alignment. On the other side of the Atlantic the distinction between de facto and de jure independence is even more evident, as Allan Meltzer says,

The Fed has done too much to prevent a possible recession and too little to prevent another round of inflation. Its mistake comes from responding to pressure from Congress and the financial markets. The Fed has sacrificed its independence by yielding to that pressure.’

 

Monetary policy is not merely a technical exercise

 

The point of removing monetary policy from the hands of politicians was to provide a degree of objectivity and technical competence. Whilst the Treasury is at the behest of vested interests, the Bank of England is deemed impartial and able to make purely technical decisions. In other words, the Treasury targets the destination but the Bank steers the car. But the aftermath of the Northern Rock bailout has demonstrated the failure of this philosophy. As Axel Leijonhufvud says,

monetary policy comes to involve choices of inflating or deflating, of favouring debtors or creditors, of selectively bailing out some and not others, of allowing or preventing banks to collude, no democratic country can leave these decisions to unelected technicians. The independence doctrine becomes impossible to uphold [italics in original].’

As these political judgments are made, there will be an increasing conflict between politicians and central bankers.

 

Inflation targeting is too simplistic

 

The key problem with the UK is that a monetary system of inflation targeting supposes that interest rates should rise to combat inflation, regardless of the source. Treating inflation as the primary target downplays conflicting signals from elsewhere in the economy. In an increasingly complex global economy it seems simplistic at best to assume such a degree of control. We have seen productivity gains and cheaper imports that should result in falling prices, but a commitment to 2% inflation forces an expansionary monetary policy. As Joseph Stiglitz has said, ‘today inflation targeting is being put to the test – and it will almost certainly fail’. He believes that rising commodity prices are importing inflation, and therefore domestic policy changes will be counterproductive. We would also point out the possibility of reverse causation, and instead of viewing rising oil prices as the cause of economic troubles, it might be a sign of capital flight from financial assets into hard commodities (Frankel, 2006). Underlying this point is a fundamental fallacy that treats aggregate demand as being the main cause of inflationary pressure. This emphasis on price inflation rather than monetary inflation neglects the overall size of the monetary footprint, which is ‘the stock of saved goods that allow entrepreneurs to invest in more roundabout production’ (Baxendale and Evans, 2008). It is actually the money supply that has generated inflationary pressures.

The current challenges have thus led to an increasingly unorthodox use of policy tools, with the British government making up the rules as it went along over Northern Rock, and the Fed going to the ‘very edge’ of its legal authority over Bear Stearns. Paul Volcker made the accusation that ‘out of perceived necessity, sweeping powers have been exercised in a manner that is neither natural nor comfortable for a central bank’, McCallum’s rule and Taylor’s rule fall by the wayside as the New York Times screams out, ‘It’s a Crisis, and Ideas Are Scarce’.

 

 

Economics

Money, Macro and Markets

It was something of an irony last week when the idiots savants who constitute the upper ranks of the ineffable current incarnation of the IMF decided briefly to forgo their penchant for the politics of the Montagnard – more inflation, higher wages, death to the speculators, les aristocrats à la lanterne, that sort of thing – in favour of those of the ancien régime. Specifically, this took the form of updated proposals for a ‘Visa’ of the kind twice instituted in early 18th century France; the first to try to clear up the fiscal mess which was the principle legacy of the military vainglory of the just departed Sun King and a second time to mop up after that QE disaster of its time, John Law’s infamous ‘System’.

 

Sorting the participants into five classes whose activities were deemed to have been increasingly speculative – and hence liable to more swingeing penalties – those in charge of the Visa saw to it that the bigger players (or at least those bigger players unable to use their royal connections to secure themselves an indemnity) suffered haircuts, retrospective tax assessments, forcible debt extensions, property confiscation – and, in one or two cases, a salutary trip to the Bastille.

 

Jump forward three centuries and in its latest position paper on sovereign debt ‘resolution’ the IMF is drooling about dipping, in a not wholly dissimilar fashion, into people’s pension funds and insurance policies – since these are seen to be easy targets – as well as about imposing arbitrary prolongations of tenor on outstanding securities should the state’s chronic mismanagement end up rendering it temporarily unable to entice sufficient new or repeat suckers into enabling the maintenance of its naked fiscal Ponzi scheme.

 

As the reader may be aware, we are all for adopting a stance of unsentimental realism when it comes to facing problems of over-indebtedness and, further, that we have long bemoaned the readiness of governments to swell their own commitments in the aftermath of financial crises, not just because of the inherent cronyism and inequity which riddles most TBTF assistance packages, but because sovereign debt is intractable in a way that private sector obligations generally are not. We are, therefore, more than happy to see all breaches of contract – which is what the unpayability of a debt involves – dealt with in as clinical and judicial way as possible, no matter whether these failures are misjudgements, examples of malfeasance, of ‘acts of god’. Moreover, we are exceedingly happy to see anything which reminds people that, despite the modern fiction of the ‘risk-free’ rate which attaches to them, Leviathan’s IOUs have always been among the least trustworthy of all pledges to pay.

 

However, that principal is not what is at issue here, but what does gall is the IMF’s glib reliance on the sneaky, archly legalistic, announce-it-once-the-banks-are-closed repudiation of existing agreements by a borrower which has not only promoted itself as the one true guardian of the people’s well-being, but which has frequently given its subjects precious little choice but to trust a goodly part of the surplus they have wrung from their already sorely-taxed income to those same instruments whose terms the state is now unilaterally amending in its favour.

 

As yet one more example of the sinister creed of ‘Gemeinnutz geht vor Eigennutz’, this betrays the classic statist proclivity to view all notionally private property as really belonging to the Collective, even if this is rarely expressed so clearly today as it was when last elevated into a central tenet of axe-and-bundle political theory in the 1920s and 30s.

 

‘What’s yours is only truly so to the extent that we, the functionaries of the Hive, do not decide that we have a better use for it and so do not exercise what we insist is our prior claim to it, ‘ they imply, though a little more disingenuously than heretofore. Having ignited an all too short-lived burst of outrage at last year’s more overt Visa proposal to go for a straight confiscation of 10% of ‘wealth’, this latest business of simply denying people an exit route has the poisonous virtue of being more subtle in its operation and therefore of being more likely to pass into effect all unremarked, even if the effect upon those being locked in would be broadly equivalent in many respects.

 

Moreover, for all the weasel words uttered in the Fund’s blueprint about limiting moral hazard, the plan explicitly endorses what it archly terms the ‘reprofiling’ measure on the grounds that it serves to deliver a ‘larger creditor base’ into the meat-grinder and hence helps limit damage to ‘longer-term creditors who would have otherwise had to shoulder the full burden of the debt reduction’ As an added bonus, stiffing one’s existing creditors in place of begging a payday loan from Uncle IMF ‘…increases the chances of a more rapid return to the market, as the debt stock will be less burdened by senior claims’ – i.e., those emanating from the IMF itself. A third, tacit advantage would be that since the IMF would not be not committing an actual monies, there need be no debate among its members about the implementation of such a programme, while the softening of the criteria calling for its use from one where the state’s finances are categorically ‘unsustainable’ to one where there is a mere inability to rule out the arrival of such a contingency drastically lowers the nuclear threshold.

 

One might object that the very knowledge that such steps could be taken would be enough to destroy any residual element of ‘sustainability’ with which a given sovereign’s budget might otherwise be imbued. If people became aware that in buying a 3-month T-bill (and buying it at vanishingly small rates of interest at that) they were also selling their overlords a 30-year put, or that the YTW calculation of their security really ought to include the chance of a 10% principal reduction, would they not try to incorporate this in its price, thereby pushing up yields and so aggravating any incipient funding difficulties? Might they, indeed, not halt their discretionary purchases altogether and so advance rather than retard the onset of the crisis?

 

Given that they are each, in their own way, subject to the compulsions of so-called ‘prudential’ regulations with regard to the assets they must hold to ensure their solvency and liquidity, would such ‘captives’ as the banks, pension funds, and insurers thus be left the only buyers outside of the ever-eager to oblige central bank? A moment’s consideration of what could happen to the most fragile of these – the already–impaired banks – if their assets were suddenly to suffer another sizeable mark down as a result of state defalcation shows why the IMF wants the universe of the afflicted to be as all-inclusive as possible. That way, however large the absolute loss might be, the percentage loss to each holder could be conveniently minimized as the poor individual innocent was once again mulcted to provide a subsidy for the rich, corporate players whose fate is so closely entwined with that of their overlords.

 

Thus, under the terms of this new wheeze, we might imagine a day when the following missive drops onto the doormat of the Forgotten Men and Women up and down the country

 

“Dear Grandma and Grandad, thank you for making the valiant effort over these past decades to achieve a measure of self-reliance in your dotage and for allowing us jacks-in-office full use of your savings in the meanwhile as both a means to fulfil our political ambitions and as a way to act out our own economically-illiterate and usually illiberal prejudices at the expense of you and yours.”

 

“Sadly, it transpires that we have not only wasted a goodly part of your savings, but we have greatly added to the host of irredeemable promises which we made to you, in the form of a mountain of even more pressing pledges issued to the Biggest of Big Fish in the financial markets. So that we do not entirely dissuade these latter sophisticates from again indulging our follies at the earliest opportunity, we shall now have to ask you to share – and thereby greatly to reduce – their pain.”

 

“Be assured, however, that the loss for which you have my heartfelt sympathy will patriotically ensure that we can continue to live well beyond our means. In this way your sacrifice will see to it that the least possible harm will come to any of us in the political classes (a.k.a. the agents of your misfortune), to our army of placemen, patronage-seekers, and dole-gatherers, or to our plutocratic enablers for – as the IMF puts it – ‘…resources that would otherwise have been paid out to creditors will have been retained [to] reduce [our] overall financing needs.’ Nor will we have to suffer the indignity of modifying our existing approach overmuch by actually only spending money on the things for which you, in true democratic fashion, have openly voted the taxes since – here let me cite those marvellous chaps in Washington, once again – ‘resources could be efficiently employed to allow for a less constraining adjustment path.’, i.e., to allow one demanding as little fundamental ‘adjustment’ as possible.”

 

“I feel confident you will join me in looking forward with some enthusiasm to the next, inevitable ‘reprofiling’, just as soon as we can arrange to overspend enough to make one necessary once again. Should I have already laid down the heavy burden of selfless public service by the time this comes about and gone instead to my just reward as a highly-paid ‘consultant’ to a global investment bank, I would urge you to give your full support to my successor, of whatever political stripe he or she may be. In such an event, there will, of course, be precious little different in the treatment you receive at the hands of any of the mainstream parties as currently constituted”

 

Yours Insincerely, The Minister of Finance.

 

It is all too easy at present to make fun of the IMF, though in so doing we should bear in mind that such ridicule is perhaps the only weapon we have in our fight to prevent it from lending a spurious air of rationality to the worst predilections of our national nomenklatura.

 

A case in point is that, at the conclusion of its periodic, Article IV review of the economic condition of the homeland of so many of those in the upper reaches of the Fund, the website prominently carried the triumphant banner, “France: Policies on the Right Track.”!

 

Truly, you could not make this up. For a slightly less self-justificatory assessment, one only has to trawl briefly through the Bloomberg series or consult the most recent verdict of the official ‘auditor’ of the nation, the Cours de Comptes.

 

There it becomes readily apparent that while the two decades prior to the first oil shock saw Real GDP, ex-government trend upward at a 5.5% annualized rate, and the next three decades managed 2.3% compound, the last seven years have seen no progress made whatsoever. Similarly, real capital formation by non-financial business has decelerated from 7.5% to 2.9% to zero over those same divisions of time. Exports stand at close to a 6 ½ year low and two-way trade at the weakest in more than three years. Industrial output – a whisker off the worst since the rebound from the GFC – lies 13% below its peak and hence no higher than it first reached in 1988

 

Government expenditures, meanwhile, have swollen to a record 58% of overall GDP, 80% of private, with taxes some 4-5% behind. These are levels only exceeded in the EU by Finland, Denmark, Greece, and Slovenia. The EU-calibrated debt:GDP ratio has risen by 30% of GDP since the Crash and by 12% since 2010 alone (that latter a slippage of 15% compared to the German pathway from an almost identical starting point). Here, fast approaching €2 trillion outright, it stands at 94% of overall GDP and therefore at 120% of that of the private component out of whose income that debt must be ultimately serviced.

 

Yes, policies are indeed on the right track, assuming that track itself is an economic highway to hell.

 

Given the foregoing, it was of note that the Governor of the Banque de France, Christian Noyer, insisted over the weekend that it might be highly counter-productive to speculate publicly about any programme of even partial debt repudiation.

 

“This all corresponds to a somewhat contrived definition of sustainability and ignores the highly disruptive effects… besides, it relies on a very pessimistic growth outlook,” he argued. “Once one starts not to pay ones debts, borrowing becomes very expensive and the impact on growth greatly exceeds that of managing a gentle reduction in debt.”

 

The only problem with such a judgement is that M. Noyer’s preferred – if sometimes implicit – remedy is for a reinforcement of the policies which have so signally failed France over the past several years – viz., further extreme monetization of assets (to include equities, if need be) and a weaker currency.

 

As a result, we find ourselves ensnared in nest of Keynesian paradoxes and economic canards. We need more investment, we are told, but the only means we can imagine to stimulate it is to lower interest rates. We understand that debt levels are too high, but we are so terrified that they might actually begin to be reduced that we subsidize profligacy as the default option of policy. We fret that prices of assets are rising as a result, not the price of labour (which we implicitly want to increase so we can reduce debt ratios, rather than debt itself) and in order to offset a form of inequality we ourselves have engendered, we stultify an economy already overburdened with rules and regulations with that en vogue form of top-down, baby-with-the-bathwater interference we style ‘macroprudential’ policy.

 

We want to see more people in work, on the one hand we work manfully to introduce ingenious tax and benefit ‘wedges’ which act to discourage marginal job seekers and, on the other, we call for the cost of labour to be raised through higher minimum wage rates (and or plain-old monetary inflation). We decry the fact that businesses will not hire while lowering the prospective economic returns to such hiring by seeking to tax profits more heavily.

 

The reality is that it does not have to be like this. The curse of macroeconomics is that it takes what should be a crude metalanguage which merely attempts the convenient shorthand of describing an impossibly complex but largely self-organising whole using a few, hopefully representative general features and attempts to elevate it into a rigorous, cybernetic control system to be twiddled and fiddled by the fingers of Philosopher Kings. Given this assertion, let us try instead to work from the other – the microeconomic – end and see if we can shed a little light on this dark and dismal scene.

 

If Robinson Crusoe wishes to survive his enforced sojourn on his remote island, he must only engage in such activities as provide him with a flow of the needs – at their most elementary, sustenance and shelter – that is at minimum no smaller than their accomplishment costs him in the expenditure of time and effort. The more astute he is in doing this, the more alert and adaptable he is in going about it, the wider will be the margin of success he enjoys, the more rapidly his most essential requirements will be satisfied, and the sooner he can move on to meeting a broader range of desires and to building up a precautionary reserve against misfortune.

 

It should then be obvious that, when Friday washes up over the reef, Crusoe – unless driven by an inexhaustible fund of potentially-self-endangering altruism – will not be able to offer his new companion an ongoing share in his accomplishments, free access to his stock of implements, or the instant ability to draw upon his, Crusoe’s, hard-won skill and understanding if Friday does not at the very least act in a manner which exacts no net toll of Crusoe (including the unseen one of foregoing better opportunities for gain in their use elsewhere). In fact, he would be unlikely to take the risk of depleting his own scarce resources and of squandering his finite energies if Friday does not contribute something beyond such a bare material parity, the which surplus he, Crusoe, will be able to use to increase the future possibilities open for the two of them to exploit.

 

If we stop to think about it clearly, Crusoe’s surplus income – and let us not be shy to call this his profit – is what enables him firstly to improve his own standard of living (to invest) and eventually to afford Friday the means with which to leapfrog away from the perils and privation of shipwrecked destitution to the more secure and less impoverished existence he may lead if he contracts to work under the guidance of Crusoe’s entrepreneurial instincts while utilising some of Crusoe’s already-produced stock of capital. For this, Friday earns himself the right to avail himself of an agreed proportion of the goods (the income) they generate through their mutual collaboration. Once more, it is Crusoe who rightly accedes to and disposes of any subsequent excess which he by his craft, and they two by their sweat, can conjure out of the unforgiving surroundings of their savage little world.

 

Assuming Crusoe to be as diligent in his way as Friday is in his, the generation of each successive surplus will allow Crusoe progressively to improve the quality, quantity, and variety of means they each can employ, so that Friday, as well as he, can enjoy those better returns on his effort which accrue from the fact that his capital endowment has risen, those better returns being what we call a higher real wage.

 

It is all very well to bewail the fact that, in the modern world, the admirably rugged individual, Crusoe, has been transformed into that bête noire of the scribbling and scriptwriting classes – the faceless and vaguely sinister Crusoe Incorporated – and it may equally be a matter of unthinking dogma that ‘profit’ like ‘property’ is theft, but the truth remains that what applied to our pairing of Lost-prequel cast members still applies in the disembodied world of distributed shareholding and managerial agency: profit is both the sign of entrepreneurial success and the seedcorn of capital provision; labour will only be – can only be – hired if the value of its product exceeds the cost of its retention; and the more capital each worker has at his disposal (including the kind contained between his ears), the greater will be the likely worth of his product and hence the more lavish his reward.

 

There are no short cuts on offer. Or perhaps none which bear up to the test of self-sustainability. Thus, the would-be macro-puppeteers of the kind characterised by Deputy BOE Governor Jon Cunliffe when he waxed metaphorical in a recent speech about how the Old Lady’s duty was to ‘steer’ the economy ‘at the highest speed that can be achieved… down a winding road’ can be seen both to seriously overate their powers to do good and to vastly underestimate their proclivity to do harm.

 

Allow a man the scope both to make and keep a profit (to win receipts greater than costs, adjusted for the passage of time); place no restrictions on the terms of the mutually-beneficial, freely-contracted co-operation into which he enters with less adventurous, but no less assiduous, persons as he seeks to do so; do as little as possible to add to the costs of any such contract (monetary manipulation herein included) and thus to dissuade either party from entering into it; subject our man to no deterrent to ploughing the fruits of this cycle’s endeavours back into the attempt to make those of the next more succulent and more plentiful and, by and large, though failures will occur and frauds will not be unknown, all those involved will flourish – even if they happen to live in a France where, the last we heard, the laws of economics still applied and where it was not the people who were failing but those who ruled over them.

 

But let us not to be too unfair to the worthies who reside among the splendours of the Elysée, the Matignon, or Bercy: as the Cours de Comptes points out, the performance of their counterparts on the other side of the Channel has in many ways been just as unimpressive.

 

The UK, after all, still runs a deficit of around ₤100 billion a year, 6% of total and 8% of private sector GDP. Net debt of more than ₤1.4 trillion amounts to 85% of overall and 110% of private GDP (even without counting in the obligations pertaining to the bailed-out banks) and has doubled in five years, tripled in nine. Total spending has risen by a half since 2005, climbing 5% of pGDP in that time to reach a very lofty 52.5% – and this despite all the bleating about swingeing ‘austerity’. The ₤650 billion which comprises that churn amounts to around ₤200, or more than 31 hours of minimum wage pay, per week for every man, woman, and child in the country. Not entirely unrelated is the fact that the current account gap yawns as wide as ₤75 billion a year, equivalent to what is fast approaching a post-war record of 4.5% of total, 6% of private GDP.

 

Here, too, the optimists have been somewhat deceived by their hopes of undergoing a true economic revival. Though the series is bumpy, manufacturing output in May appears to have stalled, suffering its largest drop since the harsh winter of 2013 and leaving overall industrial production barely 3.5% off 2012′s 27-year lows and still having 80% of its GFC losses to make up.

 

Despite the glaringly obvious construction that the UK is once more undergoing a lax money, too-low interest rate, classic, Tory Chancellor pre-election boom – all about non-tradables, a housing mania, an excess of imports, and plagued with soft-budget government incontinence – the myopically GDP-fixated macromancers cannot resist becoming ecstatic at the results.

 

Jack Meaning, a research fellow at the highly-regarded National Institute of Economic and Social Research, for example, was quoted this week in the broadsheets in full Trumpet Voluntary mode:-

 

“The outlook is very positive,” he exulted. “Growth now is very much entrenched, and given all the positive data that has come out, it looks like growth is here to stay.”

 

Hmmmm! While it is true that the Carney-Osborne duumvirate will do nothing to restrict access to the punch bowl (a) before the Scottish Independence referendum; (b) before the UK General Election next spring ; and (c) if it can be managed, before our beloved Governor quits (in 2017?) to leave his palm print on the pavement of Grauman’s Chinese Theater en route to what is rumoured to be his apotheosis at the pinnacle of the Canadian Liberal Party hierarchy, the longer this particular locomotive of ‘growth’ progresses along its current track, the more certain we can be that it will terminate in the same, drear Vale of Tears where all its predecessors have hit the buffers.

 

As for the US – where policy has retrogressed through some sort of Phillips Curve warping of the space-time continuum to make un(der)employment the only real matter of concern – well, let’s not get too bogged down in the to and fro about Birth:Death adjustments, the household versus the establishment survey, competing explanations for a falling participation rate, part-time versus full-time job issues and all the rest of the minutiae.

 

Taking the data at face value, private sector jobs (adding agriculture and self-employed to the establishment total) seem to have risen over the whole of the last four years by a remarkably steady 180k a month, 1.8% a year, for a cumulative 870k gain which is pretty much in tune with the simultaneous official estimate of 910k in population growth. While similar to the pace mapped out in the 2003/07 expansion (then 210k and 1.6% off a higher base), this is one of the slower episodes in the last half century. If we calculate the real wage fund (2.1% outright and 1.4% per capita) or real private GDP (3.0% outright and 2.3% per capita) we get similar results: the US private sector has been expanding reasonably, if a little tardily, in real terms though it has also been more obviously lagging in nominal ones.

 

Why no faster rebound? Certainly not because interest rates are too high, or government outlays too parsimonious, or because the ‘low-hanging fruit’ of human progress has been well and truly plucked to leave us the unpalatable choice between ‘secular stagnation’ and an invigorating burst of warfare.

 

Read the Crusoe paragraphs again: incentives matter, especially at the margin. And among the many perverse incentives to limit hiring we have, just as in the 1930s, a whole host of programmatic and regulatory barriers to take into account – extended benefits, changes to health care, access to classification as ‘disabled’, unemployment insurance rules, and so on.

 

Though America is not as sorely afflicted with these hindrances as are many Western nations, it is not hard to see that the sort of work done by Richard Vedder and Lowell Galloway, by Lee Ohanian, by Robert Higgs, and lately by Casey Mulligan all come back to the same basic conclusion: that for the micro-economics of job-creation to take hold, the legal and institutional framework must not only be conducive to fostering the hope of gain among those seeking to employ both capital and labour (including their own), but it must be straightforward to negotiate and stable in its composition. Neither constant bureaucratic tampering, nor wrenching shifts in fiscal or monetary policy – with all the wilder swings they transmit via the financial markets through which they act – can contribute much that is positive, for all the arrogance of the Colossi who never cease to promulgate them.

Economics

Where is the US$ heading against major currencies?

Within the framework of our econometric model the key variable that drives a currency rate of exchange is the relative money supply rate of growth between respective economies. On this score our analysis shows that since October 2011 the money growth differential is currently favourable for the US$ against major currencies. Various key US data continue to display strength. We hold that on account of a downtrend in the growth momentum of AMS since October 2011 economic activity is likely to come under pressure in the months ahead. Meanwhile the growth momentum of the Euro-zone consumer price index has likely bottomed in May. We hold that a fall in the lagged growth momentum of German AMS is behind the weakening in some of the recent key German data. The S&P500 index could weaken for a few months before bouncing back. By next year our model expects the S&P500 to follow a declining path. According to our model the yield on the 10-year US T-Note is forecast to follow a declining path during 2015.

 

Prospects for US$ against the Euro

At the end of June the price of the Euro in US$ terms closed at 1.369 versus 1.363 in May – an increase of 0.4%. The yearly rate of growth of the price of the Euro stood at 5.3% against 4.9% in May. After closing at 13.6% in October 2011, the money growth differential (expressed in terms of our AMS) between the US and the Euro-zone settled at 0.7% in April.  On account of long time lags we suggest that for the time being the effect of a rising differential between June 2010 and October 2011 is likely to dominate the scene. As time goes by the effect from a fall since October 2011 is expected to assert itself. (The US$ should strengthen).

The simulation of the model against the actual data is on the chart on the left below. Based on our model we expect the price of the Euro in US$ terms to close at 1.37 by March before settling at 1.36 in December next year.

Shostak1

Prospects for the British pound (GBP) against the US$

The price of the GBP in US$ terms closed at the end of June at 1.71 versus 1.675 at the end of May – an increase of 2.1%. Year-on-year the rate of growth climbed to 12.4% in June from 10.2% in the month before. The money growth differential fell from 10.4% in October 2011 to 0.6% in April.

We have employed our model to assess the future trend of the rate of exchange. The model simulation against the actual is presented on the left below. We expect the effect from the declining growth differential of money supply to gain strength as time goes by. By December next year the £Sterling-USD rate of exchange could settle at 1.66. 

Shostak2

Prospects for the A$ against the US$

At the end of June the price of the A$ in US$ terms closed at 0.943 – an increase of 1.3%. The yearly rate of growth jumped to 3.2% from minus 2.7% in May. After closing at 15.5% in April 2012 the money growth differential between the US and Australia fell to minus 8.1% in April this year. Note that between January 2011 and April 2012 the yearly rate of growth was trending up.

According to our model (see the simulation on the left below) based on a declining money growth differential the A$ could come under pressure as time goes by. By June next year the Australian $ could close at 0.896 before settling at 0.91 by December next year.

Shostak3

Prospects for the Yen against the US$

The price of the US$ in Yen terms closed at the end of June at 101.3 – a fall of 0.5% from May. Year-on-year the rate of growth of the price of US$ rose to 2.2% from 1.3% in May. The money growth differential between the US and Japan fell from 12.8% in August 2011 to 3.9% in January 2013. There after the yearly rate of growth followed a horizontal path closing at 4.6% in May this year.

The simulation of the model is presented on the left below (see chart). According to the model the price of the US$ could increase to 102.3 by March before falling to 101.5 by May. Afterwards the price is forecast to follow a sideways movement closing at 101.2 by December 2015.

Shostak4

Prospects for the CHF against the US$

The price of the US$ in CHF terms closed at 0.887 at the end of June – a fall of 0.9% from May when it increased by 1.7% from April. The yearly rate of growth of the price of the US$ in CHF terms stood at minus 6.2% against minus 6.3% in May. The money growth differential between the US and Switzerland climbed to 4.8% in April 2013 from minus 6% in August 2012. This strong increase in the differential is providing strong support to the CHF against the US$ – note also that the differential fell sharply to minus 2.8% in April from 3.1% in January this year.

The simulation of the model against the actual data is presented on the left below (see chart). According to our model the price of the US$ in CHF terms is forecast to settle at 0.890 by December this year. By September next year the price is forecast to fall to 0.83 before stabilizing at 0.834 by December 2015.

Shostak5

Focus on US economic indicators

Manufacturing activity in terms of the ISM index eased slightly in June from May. The index closed at 55.3 versus 55.4 in May. Based on the lagged growth momentum of real AMS we suggest that the ISM index is likely to follow a declining path. The growth momentum of light vehicle sales has eased in June from May. The yearly rate of growth stood at 6.9% in June against 8.3% in the previous month. Our monetary analysis points to a likely further softening ahead in light vehicle sales.

The growth momentum of manufacturing orders eased in May from April. Year-on-year the rate of growth fell to 2.4% from 5.1%. Based on the lagged growth momentum of AMS we can suggest that the growth momentum of manufacturing orders is likely to follow a declining trend. Also, the growth momentum of expenditure on construction eased in May from April with the yearly rate of growth softening to 6.6% from 7.9%. Using the lagged yearly rate of growth of AMS we hold that the growth momentum of construction expenditure is likely to come under pressure ahead.

Shostak6

US employment up strongly above expectations in June

Seasonally adjusted non-farm employment increased by 288,000 in June after rising by 224,000 in the month before. That was above analysts’ expectations for an increase of 215,000. The growth momentum of employment has strengthened last month. Year-on-year 2.495 million jobs were generated in June after 2.408 million in the prior month. Using the lagged manufacturing ISM index we can suggest that from July the growth momentum of US employment is likely to visibly weaken (see chart). The diffusion index of employment in the private sector one month span, which increased to 64.8 in June from 62.9 in May is forecast to follow a declining trend in the months to come (see chart).

 

Manufacturing employment increased by 16,000 last month after rising by 11,000 in May. Based on the lagged growth momentum of real AMS we expect the growth momentum of manufacturing employment to come under pressure in the months to come. In the meantime, the unemployment rate stood at 6.1% in June against 6.3% in May, while the number of unemployed declined by 325,000 last month to 9.474 million.

Shostak7

Focus on non US economic indicators

Manufacturing activity has eased slightly in Australia in June from May. The manufacturing purchasing managers index (PMI) fell to 48.91 from 49.22 in May. Based on the lagged growth momentum of Australian real AMS we suggest that the Australian PMI is likely to be well supported ahead. The yearly rate of growth of the EMU consumer price index (CPI) stood at 0.5% in June the same as in May. Using the lagged growth momentum of EMU AMS we hold that the yearly rate of growth of the EU CPI is likely to strengthen ahead.

Year-on-year the rate of growth of German factory orders in real terms fell to 5.8% in May from 6.6% in April. Using the lagged growth momentum of German real AMS we can suggest that the yearly rate of growth of German factory orders is likely to weaken further in the months ahead. Meanwhile, the Swiss manufacturing PMI rose to 53.96 in June from 52.54 in the month before. According to the lagged growth momentum of Swiss real AMS the Swiss PMI is likely to display volatility (see chart).

Shostak8

Prospects for the CRB commodity price index

At the end of June the CRB commodity price index closed at 308.22 – an increase of 0.9% from May when it fell by 1.3%. The growth momentum of the index has strengthened with the yearly rate of growth rising to 11.8% in June from 8.4% in May.

 

The CRB index to its 12-month moving average ratio eased to 1.0546 in June from 1.055 in the month before.

 

 

We have employed our model to assess the future course of the CRB index (see chart). The model is driven by the state of US and Chinese economic activity and by US monetary liquidity.

 

According to our large scale econometric model the CRB index is forecast to close at 303 by November before jumping to 316 in February. There after the index is forecast to follow a slightly declining path closing by December at 312.

Shostak9

S&P500 up on the week

The S&P500 added 0.55% on Thursday to close at 1,985.43. For the week the index climbed 1.25%. The stock price index rallied after strong employment report for June with the employment rising by 288,000 against the consensus for an increase by 215,000. Against the end of June the stock price index advanced 1.3% whilst year-on-year the rate of growth eased to 17.8% from 22% in June. The S&P500 to its 12 month moving average ratio has eased to 1.0833 from 1.0843 in June.

 

We have employed our large scale econometric model to assess the future course of the stock price index. Within the model’s framework the S&P500 is driven by our measure of monetary liquidity and by the state of US industrial production. (See the actual versus the model data on the left below). According to our model the S&P500 index could weaken for a few months before bouncing back. By next year our model “expects” the S&P500 to follow a declining path. 

Shostak10

US long – term Treasuries yields up against the end of June

On Thursday US Treasuries fell – pushing 10-year note yields to the highest in two months in response to a strong June employment report. This lifted bets that the US central bank may consider raising interest rates sooner than previously thought. The yield on the 10-year T-Note rose one basis point to close at 2.64% against 2.53% at the end of June. Two-year note yield rose three basis points to 0.51%. Traders pushed up their bets for a June rate increase to 49% from 44% and 33% at the end of May. The yield spread between the 10 year and the 2 year T-note stood at 2.13% versus 2.08% in June.

 

The “TED” spread stood at 0.222% against 0.205% in June. We have employed our econometric model to establish the future direction of the yield on the 10-year T-Note. In the model’s framework the yield on the 10-year T-note is driven by monetary liquidity, by the state of US economic activity and by price inflation (see chart on the left below).  According to our model the 10-year yield is forecast to follow a declining path during 2015.

Shostak11

Economics

Time for change in the London bullion market

[Editor’s note: The Cobden Centre is happy to republish this commentary by Alasdair Macleod, the original can be found here.]

 

The London bullion market is an over-the-counter unregulated market and has had this status since the mid-1980s. The disadvantage of an OTC market being unregulated is that change often ends up being driven by a cartel of members promoting their own vested interests. Sadly, this has meant London has not kept pace with developments in market standards elsewhere.

 

The current row is focused on the twice-daily gold fix. The fix has been giving daily reference prices for gold since 1919, useful in the past when dealing was unrecorded and over-the-counter by telephone. The London gold fix could be described as an antiquated deal-based version of the LIBOR fix that has itself been discredited.

 

It was with this in mind that the House of Commons Treasury Committee called witnesses before it to give evidence on the matter on 2nd July. This dramatically exposed the inconsistences in the current situation, and was summed up by the Chairman Andrew Tyrie as follows: “Is there any reason we should not be treating this as an appalling story?”

 

These were strong words and his question remains hanging over the heads of all involved. It would be a mistake to think the Financial Conduct Authority which was given a rough ride by the Committee can ignore this “appalling story”. The FCA will almost certainly seek significant reforms, and reform means greater market transparency and no fix procedure that does not comply with IOSCO’s nineteen principles.

 

The current fix is thought to comply with only four of them, which is a measure of how things have moved on while the London bullion market has stood still. London effectively remains a cartel between bullion banks and the Bank of England (BoE). It has worked well for London in the past, because the BoE has used its position as the principal custodian of central bank gold to enhance liquidity. And when bailouts are required, the Bank has provided them behind closed doors.

 

The world has moved on. IOSCO has provided a standard for behaviour not just to cherry-pick, but as a minimum for credibility. China, which we routinely deride for the quality of official information, has a fully functioning gold bullion market which provides turnover and delivery statistics, as well as trade by the ten largest participants by both volume and bar sizes. China has also tied up mine output in Asia, Australia and Africa which now bypasses London completely. Dubai also has ambitions to become a major physical market, being in the centre of middle-eastern bullion stockpiles and with strong links into the Indian market.

 

Even Singapore sees itself servicing South East Asia and becoming a global centre. These realities are reflected in the 995 LBMA 400oz bar being outdated and being replaced by a new Asian 1kg 9999 standard, with refiners working overtime to affect the transition. London cannot possibly meet these global challenges without major reform.

 

Central banks are now net buyers of bullion, withdrawing liquidity from the London market instead of adding to it. With the FCA as one of its new responsibilities, the ability of the BoE to act as ringmaster in the LBMA is changing from an interventionist to a regulatory role. If it is to retain the physical gold business, London’s standards, on which users’ trust is ultimately based, must be of the highest order with the maximum levels of information disclosure.