[Editor’s Note: this piece, by Brendan Brown, first appeared at mises.org last year]
The slide of the yen since late summer has brought it to a level some 40 percent lower against the euro and US dollar than just two years go. Yet still Japan’s Prime Minister Shinzo Abe and his central bank chief Haruhiko Kuroda warn that they have not won the battle against deflation. That caution is absurd — all the more so in view of the fact that there was no deflation in the first place.
Some cynics suggest that Abe’s and Haruhiko’s battle cry against this phoney phantom is simply a ruse to gain Washington’s acquiescence in a big devaluation. But whatever the truth about their real intent, Japan’s monetary chaos is deepening.
Japanese Prices Have Been Stable
The CPI in Japan at the peak of the last cycle in 2007 was virtually at the same level as at the trough of the post-bubble recession in 1992, and up a few percentage points from the 1989 cycle peak. Hence, Japan alone has enjoyed the sort of price stability as might be enjoyed in a gold-standard world. Prices have fallen during recessions or during periods of especially-rapid terms-of-tradeimprovement or productivity growth. They have risen during cyclical booms or at times of big increases in the price of oil.
If price-indices in Japan were adjusted fully to take account of quality improvements they would have been falling slightly throughout, but that would also have been the case under the gold standard and was fully consistent with economic prosperity.
Such swings in prices are wholly benign. For example, lower prices during recession coupled with expectation of higher prices in expansion induce businesses and households to spend more. A valid criticism of the Japanese price experience of the past two decades has been that these swings have lacked vigour due to various rigidities. Particularly valid is the claim that price falls should have been larger during the post-bubble recession of 1990-93 and subsequent potential for recovery would have been correspondingly larger.
Prices in Japan did fall steeply during the Great Recession (2008-10) but the perceived potential for recovery was squeezed by the Obama Monetary Experiment (the Fed’s QE) which meant an immediate slide of the US dollar. It was in response to the related spike of the yen that Prime Minister Abe prepared his counter-stroke. This involved importing the same deflation-phobic inflation-targeting policies that the Obama Federal Reserve was pursuing. Washington could hardly criticize Tokyo for imitating its own monetary experiment.
Deflation and “The Lost Decade”
The architects of the Obama Monetary Experiment have cited as justification Japan’s “lost decade” and the supposed source in deflation. In fact, though, the only period during which the Japanese economy underperformed other advanced economies (as measured by the growth of GDP per capita) was from 1992-97. The underperformance of that period had everything to do with insufficient price and wage flexibility downward, the Clinton currency war, and the vast malinvestment wrought by the prior asset price inflation, coupled with a risk-appetite in Japan shrunken by the recent experience of bust.
Moreover, as time went on, from the early 1990s, huge investment into the Tokyo equity market from abroad compensated for ailing domestic risk appetites. Yes, Japan’s economy could haveperformed better than the average of its OECD peers if progress had been made in de-regulation, and if Japan had had a better-designed framework of monetary stability to insulate itself from the Greenspan-Bernanke asset price inflation virus of the years 2002-07. (The Greenspan-Bernanke inflation caused speculative temperatures in the yen carry trade to reach crazy heights.) But deflation was never an actual or potential restraint on Japanese prosperity during those years.
True, there was a monetary malaise. Japan’s price stability was based on chance, habit, and economic sclerosis rather than the wisdom of its monetary policy. It had been the huge appreciation of the yen during the Clinton currency war that had snuffed out inflation. Then the surge of cheap imports from China had worked to convince the Japanese public that inflation had indeed come to an end. Lack of economic reform meant that the neutral rates of interest remained at a very low level and so the Bank of Japan’s intermittent zero rate policies did not stimulate monetary growth.
The monetary system in Japan had no secure pivot in the form of high and stable demand for non-interest bearing high-powered money. In Japan the reserve component of the monetary base is virtually indistinguishable from a whole range of close substitutes and banks had no reason to hold large amounts of this (given deposit insurance and the virtual assurance of too-big-to-fail help in need). Monetary policy-making in Japan meant highly discretionary manipulation of short-term interest rates in the pursuance of fine-tuning the business cycle rather than following a set of rules for monetary base expansion.
The Yen After Abenomics
When Prime Minister Abe effected his coup against the old guard at the Bank of Japan there was no monetary constitution to flout. Massive purchases of long-dated Japanese government bonds by the Bank of Japan are lowering the proportion of outstanding government debt held by the public in fixed-rate form. But this is all a slow-developing threat given a gross government debt to GDP ratio of around 230 percent and a current fiscal deficit of 6 percent of GDP. Bank of Japan bond-buying has strengthened irrational forces driving 10-year yields down to almost 0.5 percent despite underlying inflation having risen to 1 percent per annum.
It is doubtless the possibility of an eventual monetization of government debt has been one factor in the slump of the yen. More generally, as the neutral level of interest rates in Japan rises in line with demographic pressures (lower private savings, increased social expenditure) one might fear that BoJ manipulation of rates will eventually set off inflation. Part of the yen’s slump, though, is due to a tendency for that currency to fall when asset price inflation is virulent in the global economy. This stems from the huge carry trade in the yen.
The yen could indeed leap when the global asset price-inflation disease — with its origins in Fed QE — moves to its next phase of steep speculative temperature fall. The yen is now in real effective exchange rate terms at the record low point of the Japan banking crisis in 1997 or the global asset inflation peak of 2007. So, the challenge for investors is to decide when the Abe yen has become so cheap in real terms that its hedge properties make it a worthwhile portfolio component.
2015 is already looking like a good year for those who believe that liberty is the fountainhead of human progress…
The financial markets are on a hair trigger as to when, and how quickly, the Fed will tighten and raise interest rates. Billions of dollars will be won or lost by investors on this wager.
For the rest of us, getting it right — as did Chairman Volcker and (during his first two terms), Greenspan is crucial to the creation of a climate of equitable prosperity in which jobs are created in abundance. 39 million jobs were created during the “Great Moderation.” We haven’t seen anything remotely like that since.
Getting it right is crucial to economic mobility — raises, bonuses, and promotions — to let us workers climb the ladder to decent affluence. Thus, just when to raise rates is much less important than the bedrock issue.
For over a decade now job creation has been poor. Poor, too, has been economic mobility. The left is very much on record as calling for extended ease — keeping interest rates down. The right has been critical over the Fed’s “zero interest rate policy.” Yet the real tug of war is over whether the Fed should follow a monetary rule or exercise discretion; and, if a rule is preferable, what rule?
Yellen has been on a campaign to demonstrate her empathy with workers. Less well known: this empathy is shared by many conservatives and libertarians. I, among others, find Yellen’s new openness to rank and file workers and activists a refreshing change of tone from that of the formerly hermetically sealed “Temple.” There are few matters on which I agree on with Sen. Sherrod Brown. This is one of them. As Sen. Brown told Politico:
“I love that Chair Yellen and three Fed governors actually had public meetings,” said Sen. Sherrod Brown of Ohio, an outspoken member of the Senate Democrats’ liberal wing, commending Yellen and her colleagues for recently meeting with progressive activists. “She wants to set a different tone there where they’re listening to the public and listening to people who have lost jobs, listening to people who have seen their life savings evaporate….
Yellen’s descent from Temple Mount to we plain people of the plane is a notable shift. It well accords, at least in style and possibly in substance, with the new populist spirit abroad in the land. It is imperative, however, that it prove substantive and not merely cosmetic. And substantive means an intellectual openness to a diversity of views.
The right is not the party of Ebenezer Scrooge. The right is all for job creation and a rising tide lifting all boats. Yet Yellen has been connecting, so far exclusively, with the left. In her first year, Yellen visited a trade school and donned a welding mask (a terrific photo op, truly); toured a low income neighborhood before speaking, to wide note, at a Boston Fed conference where she advocated for the social safety net and social services (notably, mysteriously, not speaking about monetary policy); met with President Obama on the eve of the 2014 election; and recently took an unprecedented meeting with what Bloomberg.com called “labor and community organizers.”
It is my guess that Janet Yellen reaches out to the social-democratic left because it represents her native intellectual milieu. They speak her language. Many progressives simply find the right foreign, our language alien. (Memo to Yellen: If all I knew about my team was what I read from Paul Krugman I, too, would disdain me. The mainstream media portrayal of the right is a grotesque caricature. We’re not the way we are portrayed. We are, however, skeptical of the efficacy of central planning. For good reason. And, Dr. Yellen? America is a center right nation.)
Soon we shall stop guessing and find out if Janet Yellen truly is open to hearing a diversity of views … or whether this really is merely a “charm campaign.” One of the leading monetary integrity advocacy groups (and the lead gold standard advocacy group) on the center right, American Principles in Action, which I professionally advise, recently hand-delivered to the Fed a request to Madam Yellen that she meet with representatives of the right.
The letter, signed by 20 high profile figures on the right, stated:
This is to endorse the pending request by American Principles in Action’s Steve Lonegan for a meeting with you, Vice Chair Fischer, and others of your selection, to gather and exchange views with a delegation of monetary policy thought leaders from the center-right.
The left by no means has a monopoly on concern for unemployment and wage stagnation. To balance a meeting with a group composed of, as described by Bloomberg News, “labor and community organizers” with one of the leading representatives of the center right experts would honor that principle of “a diversity of views”. An evenhanded insight on achieving our shared goal of job creation and economic mobility would facilitate steps toward realization of this mutual objective.
The letter is noteworthy and may portend a significant shift in the discourse. The “money quote:” “The left by no means has a monopoly on concern for unemployment and wage stagnation.” This is a thematic development that Yellen would do well to encourage. The difference between members of the humanitarian left and humanitarian right is one of means, not ends.
All agree that money matters, and that the Fed is the fulcrum of the world’s monetary system. The left believes that discretion is the recipe for more equitable prosperity. The right believes that a monetary rule will yield greater equitable prosperity. Both cannot be right. Yet this is, and should be treated as, an empirical, not doctrinal, matter. It is not, at heart, a “left vs. right” issue.
In a way, it’s “Yellen vs. Volcker.” Contrast a statement by Madam Yellen with one made by former (and iconic author of the Great Moderation) Fed Chairman Paul Volcker, reprised in an earlier column:
Madame Yellen [at hearing of the House Financial Services Committee chaired by Chairman Jeb Hensarling earlier this year] stated that “It would be a grave mistake for the Fed to commit to conduct monetary policy according to a mathematical rule.” Contrast Madame Yellen’s protest with a recent speech by Paul Volcker in which he forthrightly stated: “By now I think we can agree that the absence of an official, rules-based cooperatively managed, monetary system has not been a great success. In fact, international financial crises seem at least as frequent and more destructive in impeding economic stability and growth. … Not a pretty picture.”
Not all rules are mathematical. There may be room for agreement implicit in Yellen’s statement.
There is no generic rule. And a bad rule, or a rule badly implemented, could be worse than no rule at all. If a rule is to be preferred, which rule?
There are contending schools of thought. These prominently include the Taylor Rule, NGDP targeting, inflation targeting, commodity price targeting, and the gold standard. Of the latter, Paul Volcker, not himself a proponent of the gold standard, once had this to say in his Foreword to Marjorie Deane and Robert Pringle’s The Central Banks (Hamish Hamilton, 1994):
It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less. By and large, if the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with ‘free banking.’
Which rule would most likely be optimal for fomenting equitable prosperity as well as price stability? Each regime has eloquent advocates.
It is, in fact, an open question.
Thus the safest path forward out of the uncharted territory in which we find ourselves appears to be the proposed Brady-Cornyn monetary commission introduced in the 113th Congress. It reportedly is certain to be re-introduced in the 114th.
The proposed commission, widely praised in the financial media, is designed to be strictly bipartisan and meticulously empirical. It is chartered to make an objective assessment of the real outcomes of the various rules now being propounded. While many commissions are designed to derail an issue, a monetary commission would be very much in order. Monetary policy is intricate and potent, not amenable to political towel-snapping-as-usual.
This proposed commission is not in at all inimical to the Fed. The Fed Chair gets an appointment of an ex-officio Commissioner to ensure that the monetary authorities have a dignified voice in the review process. The Treasury Secretary gets to appoint an ex-officio commissioner as well.
Politico has termed Yellen’s the “Toughest job in Washington.” This surely is apt. In taking a step away from her crystal ball and connecting with the rank and file Janet Yellen may have unleashed a healthy dynamic that could prove beneficial to making progress. But only if she listens to all sides. Moreover, the Commission would provide a civil buffer from the sobering reality that, as Politico reported, “Republican leaders and staff said in interviews that they plan to use their new dominance on both sides of Capitol Hill next year to target the Fed for much greater scrutiny, including aggressive hearings ….”
On the surface it’s a tug of war between raising and lowering interest rates. At root, it’s an argument about whether the Fed should be following a rule or making one up as it goes along. If Yellen proves open to a diversity of viewpoints, and if the Fed puts its benediction on the Brady-Cornyn monetary commission legislation, 2015 well could see the beginning of a move in the direction of credit both affordable and abundant that could rival for job creation the Great Moderation.
Originating at http://www.forbes.com/sites/ralphbenko/2014/12/15/the-yellen-tug-of-war/
A specter is haunting the world, the specter of two percent inflationism. Whether pronounced by the U.S. Federal Reserve or the European Central Bank, or from the Bank of Japan, many monetary central planners have declared their determination to impose a certain minimum of rising prices on their societies and economies.
One of the oldest of economic fallacies continues to dominate and guide the thinking of monetary policy makers: that printing money is the magic elixir for the creating of sustainable prosperity.
In the eyes of those with their hands on the handle of the monetary printing press the economic system is like a balloon that, if not “fully inflated” at a desired level of output and employment, should be simply “pumped up” with the hot air of monetary “stimulus.”
The Fallacy of Keynesian Macro-Aggregates
The fallacy is the continuing legacy of the British economist, John Maynard Keynes, and his conception of “aggregate demand failures.” Keynes argued that the economy should be looked at in terms of series of macroeconomic aggregates: total demand for all output as a whole, total supply of all resources and goods as a whole, and the average general levels of all prices and wages for goods and services and resources potentially bought and sold on the overall market.
If at the prevailing general level of wages, there is not enough “aggregate demand” for output as a whole to profitably employ all those interested and willing to work, then it is the task of the government and its central bank to assure that sufficient money spending is injected into the economy. The idea being that at rising prices for final goods and services relative to the general wage level, it again becomes profitable for businesses employ the unemployed until “full employment” is restored.
Over the decades since Keynes first formulated this idea in his 1936 book, The General Theory of Employment, Interest, and Money, both his supporters and apparent critics have revised and reformulated parts of his argument and assumptions. But the general macro-aggregate framework and worldview used by economists in the context of which problems of less than full employment continue to be analyzed, nonetheless, still tends to focus on and formulate government policy in terms of the levels of and changes in output and employment for the economy as a whole.
In fact, however, there are no such things as “aggregate demand,” or “aggregate supply,” or output and employment “as a whole.” These are statistical creations constructed by economists and statisticians, out of what really exists: the demands and supplies of multitudes of individual and distinct goods and services produced, and bought and sold on the various distinct markets that comprise the economic system of society.
The Market’s Many Demands and Supplies
There are specific consumer demands for different kinds and types of hats, shoes, shirts, reading glasses, apples, and books or movies. But none of us just demands “output,” any more than there is just a creation of “employment.”
When we go into the marketplace we are interested in buying the specific goods and services for which we have particular and distinct demands. And businessmen and entrepreneurs find it profitable to hire and employ particular workers with specific skills to assist in the manufacture, production, marketing and sale of the distinct goods that we as individual consumers are interested in purchasing.
In turn, each of these individual and distinct goods and services has its own particular price in the market place, established by the interaction of the individual demanders with the individual suppliers offering them for sale.
The profitable opportunities to bring desired goods to market results in the demand for different resources and raw materials, specific types of machinery and equipment, and different categories of skilled and lesser skilled individual workers to participate in the production processes that bring those desired goods into existence.
The interactions between the individual businessmen and the individual suppliers of these factors of production generate the prices for their purchase, hire or employment on, again, multitudes of individual markets in the economic system.
The “macro” economist and his statistician collaborator then proceed to add up, sum and averages all these different individual outputs, employments and specific prices and wages into a series of economy-wide measured aggregates.
But it should be fairly clear that in doing so all the real economic relationships in the market, the actual structure of relative prices and wages, and all the multitude of distinct and interconnected patterns of actual demands and supplies are submerged and lost in the macro-economic aggregates and totals.
Balanced Markets Assure Full Employment
Balanced production and sustainable employments in the economy as a whole clearly requires coordination and balance between the demands and supplies of all the particular goods and services in each of the specific markets on which they are bought and sold. And parallel to this there must be comparable coordination and balance between the businessmen’s demands for resources, capital equipment and different types of labor in each production sector of the market and those supplying them.
Such coordination, balance, and sustainable employment requires adaptation to the every-changing circumstance of market conditions through adjustment of prices and wages, and to shifts in supplies and demands in and between the various parts and sectors of the economy.
In other words, it is these rightly balanced and coordinated patterns between supplies and demands and their accompanying structures of relative prices and wages that assure “full employment” and efficient and effective use of available resources and capital, so entrepreneurs and businessmen are constantly and continuously tending to produce the goods we, the consumers, want and desire, and at prices that are covering competitive costs of production.
All this is lost from view when reduced to that handful of macro-aggregates of “total demand” and “total supply” and a statistical average price level for all goods relative to a statistical average wage level for all workers in the economy.
The Keynesian Government “Big Spender”
In this simplified and, indeed, simplistic view Keynesian-type view of things all that needs to be done from the government’s policy perspective is to run budget deficits or create money through the banking system to push up “aggregate demand” to assure a targeted rise in the general price level so profit-margins “in general” are widened relative to the general wage level so employment “in general” will be expanded.
We can think of government as a “big spender” who comes into a town and proceeds to increase “aggregate demand” in this community by buying goods. Prices for final output rise, profit margins are widened relative to the general wage level and other general cost-prices. Private businesses, in general, employ more workers, purchase or hire other inputs, and “aggregate supply” expands to a point of desired “full employment.”
The presumption on the part of the center bankers in targeting a rate of an average annual price inflation of two percent is that while selling prices are to be pushed up at this average annual rate through monetary expansion, the average level of cost prices (including money wages in general) will not rise or not by the same percentage increase as the average increase in the “price level.”
If cost prices in general (including money wages) were to rise at the same rate as the price level, there would be no margin of additional profits to stimulate greater aggregate output and employment.
Market Anticipations Undermine Keynes’ Assumptions
The fallacy in thinking that cost-prices in general will permanently lag behind the rate of increase in the price level of final goods and services was pointed out long ago, in 1898, by the famous Swedish economist, Knut Wicksell:
“If a gradual rise in prices, in accordance with an approximately known schedule, could be reckoned on with certainty, it would be taken into account in all current business contracts; with the result that its supposed beneficial influence would necessarily be reduced to a minimum.
“Those people who prefer a continually upward moving to a stationary price level forcibly remind one of those who purposely keep their watches a little fast so as to be more certain of catching their train. But to achieve their purpose they must not be conscious or remain conscious of the fact that their watches are fast; otherwise they become accustomed to take the extra few minutes into account, and so after all, in spite of their artfulness, arrive too late . . .”
The Government “Big Spender” Unbalances Markets
But the more fundamental error and misconception in the macro-aggregate approach is its failure to appreciate and focus on the real impact of changes in the money supply that by necessity result in an unsustainable deviation of prices, profits, and resources and labor uses from a properly balanced coordination, the end result of which is more of the very unemployment that the monetary “stimulus” was meant to cure.
Let’s revert to our example of the “big spender” who comes into a town. The townspeople discover that our big spender introduces a greater demand into the community, but not for “goods in general.” Instead, he announces his intention of building a new factory on the outskirts of the town.
He leases a particular piece of land and pays for the first few months rent. He hires a particular construction company to build the factory, and the construction company in turn increases its demand not only for workers to do the work, but orders new equipment, that, in turn, results in the equipment manufacturers adding to their workforce to fulfill the new demand for construction machinery.
Our big spender, trumpeting the wonders for the community from his new spending, starts hiring clerical staff and sales personal in anticipation of fulfilling orders once the factory is completed and producing its new output.
The new and higher incomes earned by the construction and machinery workers, as well as the newly employed clerical and sales workers raise the demand for various and specific consumer and other goods upon which these people want to spend their new and increased wages.
The businesses in the town catering to these particular increased consumer demands now attempt to expand their supplies and, perhaps, hire more retail store employees.
Over time the prices of all of these goods and services will start to rise, but not at the same time or to the same degree. They will go up in a temporal sequence that more or less tends to match the pattern and sequence of the changed demands for those goods and services resulting from the new money injected by the “big spender” into this community.
Inflationary Spending Has to Continue and Increase
Now, whether some of the individual workers drawn into this specific pattern of new employments were previously unemployed or whether they had to be attracted away from existing jobs they already held in other parts of the market, the fact remains that their continued employments in these particular jobs is dependent on the “big spender” continuing to inject and spend his new money, period-after-period of time, in the same way and in sufficient amounts of dollar spending to assure that the workers he has drawn into his factory project are not attracted to other employments due to the rise in all of these alternative or other demands, as well.
If the interdependent patterns of demands and supplies, and the structure of interconnected relative prices and wages generated by the big spender’s spending are to be maintained, his injection of new money into the community must continue, and at an increasing rate of spending if they are not be fall apart.
An alternative imagery might be the dropping of a pebble or stone into a pond of water. From the epicenter where the stone has hit the surface of the water a sequence of ripples will be sent out which will be reversed when the ripples finally hit the surrounding shore, and will then finally come to rest when there is no longer any new disturbances affecting the surface of the pond.
But if the pattern of ripples created are to be sustained, new pebbles or stones must be continuously dropped into the pond and with increasing force if the resulting counter-waves coming back from the shore are not to disrupt and overwhelm the ripple pattern moving out from the original epicenter.
The “Austrian” Analysis of Inflation
It is no doubt that this way of analyzing and understanding the dynamics of how monetary expansion affects market activities is more complex and complicated than the simplistic Keynesian-style of macro-aggregate analysis. But as the famous Austrian-born economist, Joseph A. Schumpeter emphasized:
“The Austrian way of emphasizing the behavior or decisions of individuals and of defining the exchange value of money with respect to individual commodities rather than with respect to a price level of one kind or another has its merits, particularly in the analysis of an inflationary process; it tends to replace a simple but inadequate picture by one which is less clear-cut but more realistic and richer in results.”
And, indeed, it is this “Austrian” analysis of monetary expansion and its resulting impact on prices, employment and production, especially as developed in the 20th century by Ludwig von Mises and Friedrich A. Hayek, that explains why the Keynesian-originated macro-aggregate approach is fundamentally flawed.
As Hayek once explained the logic of the monetary inflationary process:
“The influx of the additional money into the [economic] system always takes place at some particular points. There will always be some people who have more money to spend before the others. Who these people are will depend on the particular manner in which the increase in the money stream is being brought about . . .
“It may be spent in the first instance by government on public works or increased salaries, or it may be first spent by investors mobilizing cash balances for borrowing for that purpose; it may be spent in the first instance on securities, or investment goods, on wages or on consumers’ goods . . .
“The process will take very different forms according to the initial source or sources of the additional money stream . . . But one thing all these different forms of the process will have in common: that the different prices will rise, not at the same time but in succession, and that so long as the process continues some prices will always be ahead of others and the whole structure of relative prices therefore will be very different from what the pure theorist describes as an equilibrium position.”
An inflationary process, in other words, brings about distortions, mismatches, and imbalanced relationships between different supplies and demands, and the relationships between the structure of relative prices and wages that only last for as long as the inflationary process continues, and often only at an accelerating rate.
Or as Hayek expressed it on a different occasion:
“Any attempt to create full employment by drawing labor into occupations where they will remain employed only so long as the [monetary and] credit expansion continues creates the dilemma that either credit expansion must continue indefinitely (which means inflation), or that, when it stops unemployment will be greater than it would be if the temporary increase in employment had never taken place.”
The Inflationary “Cure” Creates More Market Problems
Once the inflationary monetary expansion ends or is slowed down, it is discovered that the artificially created supply and demand patterns and relative price and wage structure are inconsistent with non-inflationary market conditions.
In our example of the “big spender,” one day the townsfolk discover that he was really a con artist who had only phony counterfeit money to spend, and whose deceptive promises and temporary spending drew them into in all of those specific and particular activities and employments. They now find out that the construction projects began cannot be completed, the employments created cannot be maintained, and the investments started in response to the phony money the big spender injected into this community cannot be completed or continued.
Many of the townspeople now have to stop what they had been doing, and try to discover other demanders, other employers and other possible investment opportunities in the face of the truth of the big spenders false incentives to do things they should not have been doing from the start.
The unemployment and under utilization of resources that “activist” monetary policy by governments are supposed to reduce, in fact, set the stage for an inescapable readjustment period of more unemployment and temporary idle resources, when many of the affected supplies and demands have to be rebalanced at newly established market-based prices if employments and productions are to be sustainable and consistent with actual consumer demands and the availability of scarce resources in the post-inflationary environment.
Thus, recessions are the inevitable result from prior and unsustainable inflationary booms. And even the claimed “modest” and “controlled” rate of two percent annual price inflation that has become the new panacea for economic stability and growth in the minds of central bankers, brings in its wake a “wrong twist” to many of the micro-economic supply and demand and price-wage relationships that are the substance of the real economy beneath the superficial macro-aggregates.
Governments and their monetary central planners, therefore, are the cause and not the solution to the instabilities and hardships of inflations and recessions. To end them, political control and manipulation of the money and banking systems will have to be abolished.
[This piece first appeared here: http://www.epictimes.com/richardebeling/2014/12/the-false-promises-of-two-percent-price-inflation/]
“Except for US Treasuries, what can you hold ? US Treasuries are the safe haven. For everyone, including China, it is the only option.. Once you [Americans] start issuing $1 trillion – $2 trillion.. we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”
– Luo Ping, official at the China Banking Regulatory Commission, addressing an audience in New York in early 2009.
“This is a big change and it cannot happen too quickly, but we want to use our reserves more constructively by investing in development projects around the world rather than just reflexively buying US Treasuries. In any case, we usually lose money on Treasuries, so we need to find ways to improve our return on investment.”
– Unnamed senior Chinese official, cited in an FT article, ‘Turning away from the dollar’, 10th December 2014.
The Commentary will shortly be off for its winter break. We wish all clients and readers a merry Christmas and a peaceful and prosperous New Year. See you in 2015.
“Mutually assured destruction” was a doctrine that rose to prominence during the Cold War, when the US and the USSR faced each other with nuclear arsenals so populous that they ensured that any nuclear exchange between the two great military powers would quickly lead to mutual overkill in the most literal sense. Notwithstanding the newly dismal relations between the US and Russia, “mutually assured destruction” now best describes the uneasy stand-off between an increasingly indebted US government and an increasingly monetarily frustrated China, with several trillion dollars’ worth of foreign exchange reserves looking, it would now appear, for a more productive home than US Treasury bonds of questionable inherent value. Until now, the Chinese have had little choice where to park their trillions, because only markets like the US Treasury market (and to a certain extent, gold) have been deep and liquid enough to accommodate their reserves.
The FT article, by James Kynge and Josh Noble, points to three related policy developments on the part of the Chinese authorities:
1) China’s appetite for US Treasury bonds is on the wane;
2) China is ramping up its overseas development programme for both financial and geopolitical reasons;
3) The promotion of the renminbi as a global currency “is gradually liberating Beijing from the dollar zone”.
The US has long enjoyed what Giscard d’Estaing called the “exorbitant privilege” of issuing a currency that happens to be the global reserve currency. The FT article would seem to suggest that the days of exorbitant privilege may be coming to an end – to be replaced, in time, with a bi-polar reserve currency world incorporating both the US dollar and the renminbi. (The euro might be involved, if that demonstrably dysfunctional currency bloc lasts long enough.) Here’s a quiz we often wheel out for prospective clients:
1) Which country is the world’s largest sovereign miner of gold ?
2) Which country doesn’t allow an ounce of that gold to be exported ?
3) Which country has advised its citizenry to purchase gold ?
Three questions. One answer. In each case: China. Is it plausible that, at some point yet to be determined, a (largely gold-backed) renminbi will either dethrone the US dollar or co-exist alongside it in a new global currency regime ? We think the answer is yes, on both counts.
Meanwhile the US appears to be doing everything in its power to hasten the relative decline of its own currency. There is a new ‘big figure’ to account for the size of the US national debt, which now stands at some $18 trillion. That only accounts for the on-balance sheet stuff. Factor in the off-balance sheet liabilities of the US administration and pretty soon you get to a figure (un)comfortably north of $100 trillion. It will never be paid back, of course. It never can be. The only question is which poison extinguishes it: formal repudiation, or informal inflation. Perhaps we, or future generations, get both.
So the direction of travel of two colossal ‘macro’ themes is clear (the insolvency of the US administration, and its replacement on the geopolitical / currency stage by that of the Chinese). The one question neither we, nor anybody else, can answer precisely is: when ?
There are other statements that beg the response: when Government bond yields have already entered a ‘twilight zone’ of practical irrelevance to rational and unconstrained investors. But when do they go into reverse ? When will the world’s most frustrating trade (‘the widow-maker’, i.e. shorting the Japanese government bond market) start finally to work ? When will investors be able to enter or re-enter stock markets without having to worry about the malign impact of central bank price support mechanisms (a polite way of describing asset price boosterism and state-sanctioned inflationism) ?
Here’s another statement that begs the response: when ? The US stock market is already heavily overvalued by any objective historical measure. When is Jack Bogle, the founder of the world’s largest index-tracking business, Vanguard, going to acknowledge that advocating 100% market exposure to one of the world’s most expensive markets, at its all-time high, might amount to something akin to “overly concentrated investment risk” ? Barron’s Magazine asks broadly the same question.
Lots of questions, and not many definitive answers. Some suggestions, though:
- At the asset class level, diversification – by geography, and underlying asset type – makes more sense than ever, unless you strongly believe you can anticipate the actions and intentions of central banking bureaucrats throughout the world. Warren Buffett once said that wide diversification was only required when investors do not understand what they are doing. We would revise that statement to take into account the unusual risks at play in the global macro-economic arena today: wide diversification is precisely required when central bankers do not understand what they are doing.
- Expanding on the diversification theme, explicit value (“cheapness”) today only exists meaningfully in the analytically less charted territories of the world. @RobustCap highlights the discrepancy between valuations in the US stock market versus those of Russia, China and emerging Europe. There are clearly ‘fundamental’ and corporate governance reasons that account for some of this discrepancy, but in our view certainly not the entirety of it. Some examples:
Country C.A.P.E. P/E P/B
North America 23.8 20.2 2.7x
Russia 5.2 6.8 0.7x
China 17.2 6.9 1.1x
Austria 6.8 43.4 0.9x
In emerging and ‘challenged’ markets, there are always reasons not to invest. Nevertheless, price is what you pay and value is what you get.
- Some form of renminbi exposure makes total sense as part of a diversified currency portfolio.
- US equities should be selected, if at all, with extreme care; ditto the shares of global mega-cap consumer brands, where valuations point strongly to the triumph of the herd.
- And whatever their direction of travel in the short to medium term, US Treasuries at current levels make no sense whatsoever to the discerning investor. The same holds for Gilts, Bunds, JGBs, OATs.. Arguments about Treasury yields reverting to a much lower longer term mean completely ignore a) the overwhelming current and future oversupply, and b) the utter lack of endorsement from one of their largest foreign holders. Foreign holders of US Treasuries, you have been warned. The irony is that many of you are completely price-insensitive so you will not care.
- There are other reasons to be fearful of stock market valuations, notably in pricey western markets, over and above concerns over the debt burden. As Russell Napier points out in his latest ‘The Solid Ground’ piece,
“In 1919-1921, 1929-1932, 2000-2003, 2007-2009 it was not a resurgence in wages, Fed-controlled interest rates or corporate taxes which produced a collapse in corporate profits and a bear market in equities. On those four occasions equity investors suffered losses of 32%, 85%, 41% and 51% respectively despite the continued dormancy of labour, creditors and the state. It was deflation, or the fear of deflation, which cost equity investors so much. There is a simple reason why deflation has always been so damaging to corporate profits and equity valuations: it brings a credit crisis..
“Investors forget at their peril what can happen to the credit system in a highly leveraged world when cash-flows, whether of the corporate, the household or the state variety, decline. In a deflationary world credit is much more difficult to access, economic activity slows and often one very large institution or country fails and creates a systemic risk to the whole system. The collapse in commodity prices and Emerging Market currencies in conjunction with the general rise of the US$ suggests another credit crisis cannot be far away. With nominal interest rates already so low, monetary remedies to a credit seizure today would be much less effective. Such a shock, after five and a half years of QE, might suggest that the patient does not respond to this type of medicine.”
- And since Christmas fast approaches, we can’t speak to the merits of frankincense and myrrh, but gold, that famous “6,000 year old bubble”, has always been popular, but rarely more relevant to the investor seeking a true safe haven from forced currency depreciation and an ever vaster mountain of unrepayable debt.
Some economists such as Nobel Laureate Paul Krugman hold that during an economic slump it is the duty of the government to run large budget deficits in order to keep the economy going. On this score given that during 2011 to 2014 the rate of growth of real gross domestic product (GDP) hovered at around 2% many experts are of the view that the budget deficit, which stood at $483 billion in 2014, wasn’t large enough.
According to this way of thinking if overall demand in the economy weakens on account of a weakening in consumer outlays then the government must step in and boost its spending in order to prevent overall demand from declining. Note that government outlays in 2014 stood at $3.5 trillion against $1.788 trillion in 2000 – an increase of 96%.
Nobel Laureate in economics Paul Krugman and other commentators are of the view that a widening of the budget deficit in response to larger government outlays can be great news for the economy.
Furthermore, they hold that there is very little empirical evidence that budget deficits are stifling economic growth as such. If anything, they hold it can only benefit an economy once it falls below its average growth path. In contrast the opponents of this view hold that a widening in the budget deficit tends to be monetized and subsequently leads to a higher inflation.
Also a widening in the budget deficit tends to crowd out the private sector and this stifles economic growth, so it is held. So from this perspective a government must avoid as much as possible a widening in the budget deficit. In fact the focus should always be on achieving a balanced budget.
We suggest that the goal of fixing the budget deficit as such, whether to keep it large or trying to eliminate it altogether, could be an erroneous policy. Ultimately what matters for the economy is not the size of the budget deficit but the size of government outlays – the amount of resources that government diverts to its own activities. Note that contrary to Krugman we hold that an increase in government outlays is bad news for the economy.
Observe that a government is not a wealth generating entity – the more it spends the more resources it has to take from wealth generators. This in turn undermines the wealth generating process of the economy. This means that the effective level of tax is the size of the government and nothing else. For instance, if the government plans to spend $3 trillion and funds these outlays by means of $2 trillion in taxes there is going to be a shortfall, labeled as a deficit, of $1 trillion. Since government outlays have to be funded it means that in addition to taxes the government has to secure some other means of funding such as borrowing or printing money, or new forms of taxes.
The government is going to employ all sorts of means to obtain resources from wealth generators to support its activities. Hence what matters here is that government outlays are $3 trillion, and not the deficit of $1 trillion.
For instance, if the government would have lifted taxes to $3 trillion and as a result would have a balanced budget, would this alter the fact that it still takes $3 trillion of resources from wealth generators? We hold that an increase in government outlays sets in motion an increase in the diversion of wealth from wealth generating activities to non-wealth generating activities. It leads to economic impoverishment. So in this sense an increase in government outlays to boost the overall economy’s demand should be regarded as bad news for the wealth generating process and hence to the economy.
Contrary to commentators such as Krugman, the IMF and various Fed officials, we suggest that a cut in government outlays should be seen as great news for wealth generators. It is of course bad news for various artificial forms of life that emerged on the back of increases in government outlays.
There has been no greater threat to life, liberty, and property throughout the ages than government. Even the most violent and brutal private individuals have been able to inflict only a mere fraction of the harm and destruction that have been caused by the use of power by political authorities.
The pursuit of legal plunder, to use Frédéric Bastiat’s well-chosen phrase, has been behind all the major economic and political disasters that have befallen mankind throughout history.
Government Spending Equals Plundering People
We often forget the fundamental
truth that governments have nothing
to spend or redistribute that they do not first take from society’s producers. The fiscal history of mankind is nothing but a long, uninterrupted account
of the methods governments have devised for seizing the income and wealth of their citizens and subjects.
Parallel to that same sad history must be an account of all the attempts by the victims of government’s legal plunder to devise counter-methods to prevent or at least limit the looting of their income and wealth by those in political power.
Every student who takes an economics course learns that governments have basically three methods for obtaining control over a portion of the people’s wealth: taxation, borrowing, and inflation––the printing of money.
It was John Maynard Keynes who pointed out in his 1919 book, The Economic Consequences of the Peace:
“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they also confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some . . .
“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
Limiting Government with the Gold Standard
To prevent the use of inflation by governments to attain their fiscal ends, various attempts have been made over the last 200 years to limit the power of the State to print money to cover its expenditures. In the nineteenth and early twentieth centuries the method used was the gold standard. The idea was to place the creation of money outside the control of government.
As a commodity, the amount of gold available for both monetary and non-monetary uses is determined and limited by the same market forces that determine the supply of any other freely traded good or service: the demand and price for gold for various uses relative to the cost and profitability of mining and minting it into coins or bullion, or into some other commercial form.
Any paper money in circulation under the gold standard was meant to be money substitutes––that is, notes or claims to quantities of gold that had been deposited in banks and that were used as a convenient alternative to the constant withdrawing and depositing of gold coins or bullion to facilitate everyday market exchanges.
Under the gold standard, the supply of money substitutes in circulation was meant to increase and decrease to reflect any changes in the quantity of gold in a nation’s banking system. The gold standard that existed in the late nineteenth and early twentieth centuries never worked as precisely or as rigidly as it is portrayed in some economics textbooks. But, nonetheless, the power of government to resort to the money printing press to cover its expenditures was significantly limited.
Governments, therefore, had to use one of the two other methods for acquiring their citizens’ and subjects’ income and wealth. Governments had to either tax the population or borrow money from financial institutions.
But as a number of economists have pointed out, before World
War I many of the countries of North
America and western and central Europe operated under an “unwritten
fiscal constitution.” Governments, except during times of national emergency, were expected to more or less
balance their budgets on an annual
If a national emergency
(such as a war) compelled a government to borrow money to cover its
unexpected expenditures, it was expected to run budget surpluses to
pay off any accumulated debt when the emergency had passed.
This unwritten balanced-budget rule was never rigidly practiced either, of course. But the idea that needless government debt was a waste and a drag on the economic welfare of a nation served as an important check on the growth of government spending.
When governments planned to do things, the people were more or less explicitly presented with the bill. It was more difficult for governments to promise a wide variety of benefits without also showing what the taxpayer’s burden would be.
World War I Destroyed the Gold Standard
This all changed during and after World War I. The gold standard was set aside to fund the war expenditures for all the belligerents in the conflict. And John Maynard Keynes, who in 1919 had warned about the dangers of inflation, soon was arguing that gold was a “barbarous relic” that needed to be replaced with government-managed paper money to facilitate monetary and fiscal fine-tuning.
In addition, that unwritten fiscal constitution which required annual balanced budgets was replaced with the Keynesian conception of a balanced budget over the phases of the business cycle.
In practice, of course, this set loose the fiscal demons. Restrained by neither gold nor the limits of taxation, governments around the world went into an orgy of deficit spending and money creation that led some to refer to a good part of the twentieth century as the “age of inflation.”
Politicians and bureaucrats could now far more easily offer short-run benefits to special-interest groups through growth in government power and spending, while avoiding any mention of the longer-run costs to society as a whole, in their roles as taxpayers and consumers.
The Counter-Revolution Against Keynesianism
Beginning in the late 1960s and 1970s a counter-revolution against Keynesian economics emerged, especially in the United States, which came to be identified with Milton Friedman and monetarism.
To restrain government’s ability to create inflation, Friedman proposed a “monetary rule”: the annual increase in the money supply should be limited to the average annual increase in real output in the economy. Put the creation of paper money on “automatic pilot,” and governments would once more be prevented from using the printing press to capriciously cover their expenditures.
But in the years after receiving the Nobel Prize in economics in 1984, Friedman had second thoughts about the effectiveness of his monetary rule. He stated that Public Choice theory – the use of economic theory to analyze the logic and incentives in political decision-making – persuaded him that trying to get central banks to pursue a monetary policy that would serve the long-run interest of society was a waste of time.
Just like the rest of us, politicians, bureaucrats, and central bankers have their own self-interested goals, and they will use the political power placed at their disposal to advance their interests.
Said Friedman: “We must try to set up institutions under which individuals who intend only their own gain are led by an invisible hand to serve the public interest,” He also concluded that after looking over the monetary history of the twentieth century, “Leaving monetary and banking arrangements to the market would have produced a more satisfactory outcome than was actually achieved through government involvement.”
Separating Money from Government Control
Though Milton Friedman was unwilling to take his own argument that far, the logical conclusion of his admission that the control of money can never be trusted in the hands of the government is the need to separate money creation from the State. What is required is the denationalization of money, or in other words, the establishment of monetary freedom in society.
Under a regime of monetary freedom the government would no longer have any role in monetary and banking affairs. The people would have, to use a phrase popularized by the Austrian economist F. A. Hayek, a “choice in currency.” The law would respect and enforce all market-based, consensual contracts regardless of the currency or commodity chosen by the market participants as money. And the government would not give a special status to any particular currency through legal-tender laws as the only “lawful money.”
Monetary freedom encompasses what is known as “free banking.” That is, private banks are at liberty to accept deposits in any commodity money or currency left in their trust by depositors and to issue their own private banknotes or claims against these deposits.
To the extent these banknotes and claims are recognized and trusted by a growing number of people in the wider economic community, they may circulate as convenient money substitutes. Such private banks would settle their mutual claims against each other on behalf of their respective depositors through private clearinghouses that would have international connections as well.
Few advocates of the free market have included the privatization of the monetary system among their proposed economic policy reforms. The most notable advocate of monetary freedom and free banking in the twentieth century was the Austrian economist Ludwig von Mises, who demonstrated that as long as governments and their central banks have monopoly control over the monetary system inflations and the business cycle are virtually inevitable, with all of their distorting and devastating effects.
But the last 30 years have seen the emergence of a body of serious and detailed literature on the desirability and workability of a fully private and competitive free-banking system as an alternative to government central banking.
Self-Interest and Monetary Freedom
Its political advantage is that it completely removes all monetary matters from the hands of government. However effective the old gold standard may have been before the First World War, it nonetheless remained a government-managed monetary system that opened the door to eventual abuse.
Furthermore, a free-banking system fulfills Milton Friedman’s recommendation that the monetary order should be one that harnesses private interest for the advancement of the public interest through the “invisible hand” of the market process.
The interests of depositors in a reliable banking system would coincide with the self-interest of profit-seeking financial intermediaries. A likely unintended consequence would be a more stable and adaptable monetary system than the systems of monetary central planning the world labors under now.
Of course, a system of monetary freedom does not do away with the continuing motives for government to grow and spend. Even limits on the government’s ability to create money to finance its expenditures does not preclude fiscal irresponsibility, with damaging economic consequences for a large segment of the population through deficit spending and growing national debt.
Monetary Freedom and a Philosophy of Liberty
In the long run, the only way to limit the growth of government spending and power over society is to change political and ideological thinking. As long as many people want government to use its power to tax and regulate to benefit them at the expense of others, it will retain its power and continue to grow.
Monetary and fiscal reform is ultimately inseparable from the rebirth and implementation of a philosophy of freedom that sees government limited to the protection of each individual’s right to his life, liberty, and honestly acquired property.
As Ludwig von Mises expressed it ninety years ago in the aftermath of the First World War and during the Great German Inflation of the early 1920s:
“What is needed first and foremost is to renounce all inflationist fallacies. This renunciation cannot last, however, if it is not firmly grounded on a full and complete divorce of ideology from all imperialist, militarist, protectionist, statist, and socialist ideas.”
If the belief in and desire for personal and economic liberty can gain hold and grow once more in people’s hearts and minds, monetary freedom and fiscal restraint will eventually come by logical necessity.
[Editor’s note: this piece first appeared here http://www.epictimes.com/richardebeling/2014/12/the-case-for-monetary-freedom-and-free-banking/]
There is a significant risk that the financial effects of the collapse in the oil price could spread through the financial system. Already there must have been significant transfers of value through OTC derivative markets, whose gross notional value is about $700 trillion. Roughly $300 trillion of this is with the top US banks as counterparty. A minority of this is with credit default swaps, but if there is problem here, it could easily spread to other derivative categories through counterparty risk.
Remember that the US economy is $17 trillion, so we are talking figures of a far greater magnitude than that.
We have had these scares in the past, notably with AIG, and the Lehman crisis, and also with the Eurozone crisis when Greece, Spain, Portugal and Italy were insolvent together. We could be on the verge of another such crisis, this time triggered by the collapse in the price of crude oil.
For me one event we cannot ignore is a clause slipped into the omnibus finance bill passed by Congress last week, whereby the FDIC, which insures small bank deposits in the event of a bank failure, will also take on responsibility for derivative contracts. The only possible reason this has been slipped in must be because the Wall Street banks are worried about counterparty risk for derivatives, which is totally beyond any individual bank’s control.
The fact that this is the subject of urgent legislation (the wording was put together by Citi and adopted word for word) instead of a more considered approach confirms to me that we have a real problem on our hands.
Parliamentary committees are not especially noted for entertainment, but the November Treasury Select Committee hearing on the Bank of England’s Inflation Report is a refreshing exception. The fun starts on p. 30 of the transcript of the hearings with Steve Baker MP and Bank of England Governor Mark Carney light-heartedly jousting with each other.
Steve begins by asking Dr. Carney if the Bank is all model-driven. To quote from the transcript:
Dr Carney: No. If we were all model driven, then you would not need an MPC.
Q81 Steve Baker: All right. But we do have plenty of models floating around.
Dr Carney: I presume you feel we do need an MPC, Mr Baker?
Steve Baker: I think you know I think we don’t.
Dr Carney: I just thought we would get that read into the record.
[KD: First goal to Dr. Carney, but looks to me like it went into the wrong net.]
Steve Baker: I want to turn to a criticism by Chris Giles in The Financial Times of the model for labour market slack, which called it a nonsense. If I may I will just share a couple of quotes with you. He said that, according to a chart in the inflation report, the average-hours gap hit a standard deviation of -6, and this is something we would expect to happen once in 254 million years. He also said that the Bank of England is again implying the recent recession, as far as labour market participation is concerned, was worse than any moment in 800 times the period in which homo sapiens have walked on the earth. How will the Bank reply to a criticism as strident as this one?
[KD: The article referred to is Chris Giles, “Money Supply: Why the BoE is talking nonsense”, Nov 17 2014: http://ftalphaville.ft.com/2014/11/17/2045002/moneysupply-why-the-boe-is-talking-nonsense/#]
Dr Carney: Since you asked, let me reply objectively. Calculations such as that presume that there is a normal distribution around the equilibrium rate. Let me make it clear. First off, what is the point of the chart? The chart is to show a deviation relative to historic averages. It is an illustrative chart that serves the purpose of showing where the slack is relative to average equilibrium rates, just to give a sense of relative degrees of slack. That is the first point. The second point is that the calculation erroneously, perhaps on purpose to make the point but erroneously, assumes that there is a normal distribution around that equilibrium rate. So in other words to say that there is a normal distribution of unemployment outcomes around a medium-term equilibrium rate of 5.5%. So it is just as likely that something would be down in the twos as it would be up in the eights. Well, who really believes that? Certainly not the MPC and I suspect not the author of that article. It also ignores that the period of time was during the great moderation for all of these variables as well, so it is a relatively short period. These are not normal distributions. You would not expect them. You would expect a skew with quite a fat tail. So using normal calculations to extrapolate from a chart that is there for illustrative purposes is—I will not apply an adjective to it—misleading and I am not sure it is a productive use of our time.
Q82 Steve Baker: That is a fantastic answer. I am much encouraged by it, because it does seem to me it has been known for a long time that it is not reasonable to use normal distributions to model market events and yet so much mathematical economics is based on it.
[KD: Carney’s is an excellent answer: one should not “read in” a normal distribution to this chart, and the Bank explicitly rejects normality in this context.
Slight issue, however: didn’t the Bank’s economists use the normality assumption to represent the noise processes in the models they used to generate the chart? I am sure they did. One wonders how the charts would look if they used more suitable noise processes instead? And just how robust is the chart to the modelling assumptions on which it is based?]
Dr Carney: People do it because it is simple—it is the one thing they understand—and then they apply it without thinking, which is not what the MPC does.
Steve Baker: That is great. I can move on quickly. But I will just say congratulations to the Bank on deciding to commission anti-orthodox research because I think this is going to be critical to drilling into some of these problems.
Dr Carney: Thank you.
[KD: Incredulous chair then intervenes.]
Q83 Chair: To be clear, the conclusion that we should draw from this is that we should look at all economic models with a very high degree of scepticism indeed.
Dr Carney: Absolutely.
[KD: So you heard it from the horse’s mouth: don’t trust those any of those damn models. Still incredulous, the chair then intervenes again to seek confirmation of what he has just heard.]
Chair: Can I just add that it is an astonishing conclusion? I do not want to cut into Steve Baker’s questions, but is that the right conclusion?
Dr Carney: Absolutely. Models are tools. You should use multiple ones. You have to have judgment, you have to understand how the models work and particularly, if I may underscore, dynamic stochastic general equilibrium forecasting models, which are the workhorse models of central banks. What they are useful for is looking at the dynamics around shocks in the short term. What they are not useful for is the dynamics further out where—
[KD: Dr. Carney reiterates the point so there can be no confusion about it. So let me pull his points together: (1) He “absolutely” agrees that “we should look at all economic models with a very high degree of scepticism.” (2) He suggests “You should use multiple [models]”, presumably to safeguard against model risk, i.e., the risks that any individual model might be wrong. (3) He endorses one particular – and controversial – class of models, Dynamic Stochastic General Equilibrium (DSGE) models as the “workhorse models” of central banks, whilst acknowledging that they are of no use for longer-term forecasting or policy projections.
I certainly agree that none of the models is of any longer-term term use, but what I don’t understand is how (1), (2) and (3) fit together. In particular, if we are to be skeptical of all models, then why should we rely on one particular and highly controversial, if fashionable, class of models, never mind – and perhaps I should say, especially – when that class of models is regarded as the central banks’ workhorse. After all, the models’ forecast performance hasn’t been very good, has it?
The discussion then goes from the ridiculous to the sublime:]
Chair: I am just thinking about all those economists out there whose jobs have been put at risk.
Dr Carney: No, we have enhanced their jobs to further improve DSG models.
Steve Baker: We are all Austrians now.
[A little later, Steve asks Sir Jon Cunliffe about the risk models used by banks.]
Q84 Steve Baker: Sir Jon, before I move too much further down this path, can I ask you what would be the implications for financial stability and bank capital if risk modelling moved away from using normal distributions?
Sir Jon Cunliffe: Maybe I will answer the question another way. It is because of some of the risks around modelling, the risk-weighted approach within bank capital, that we brought forward our proposals on the leverage ratio. So you have to look at bank capital through a number of lenses. One way of doing is to have a standardised risk model for everyone and there is a standardised approach and it works on, if you like, data for everybody that does not suit any particular institution and the bigger institutions run their own models, which tend to have these risks in them. Then you have a leverage ratio that is not risk-weighted, and therefore takes no account of these models, and that forms a check. So with banks, the best way to look at their capital is through a number of different lenses.
[KD: Sir Humphrey is clearly a very good civil servant: he responds to the question by offering to answer it in a different way, but does not actually answer it. The answer is that we do not use a non-normal distribution because doing so would lead to higher capital requirements but that would never do as the banks would not be happy with it: they would then lobby like crazy and we can’t have that. Instead, he evades the question and says that there are different approaches with pros and cons etc. etc. – straight out of “Yes, Minister”.
However, notwithstanding that Sir Jon didn’t answer the question on the dangers of the normal distribution, I would also ask him a number of other (im)pertinent questions relating to bad practices in bank risk management and bank risk regulation:
1. Why does the Bank continue to allow banks to use the discredited Value-at-Risk (or VaR) risk measure to help determine their regulatory capital requirements, a measure which is known to grossly under-estimate banks true risk exposures?
The answer, of course, is obvious: the banks are allowed to use the VaR risk measure because it grossly under-estimates their exposures and no-one in the regulatory system is willing to stand up to the banks on this issue.
2. Given the abundant evidence – much of it published by the Bank itself – that complex risk-models have much worse forecast performance than simple models (such as those based on leverage ratios), then why does the Bank continue to allow banks to use complex and effectively useless risk models to determine their regulatory capital requirements?
I would put it to him that the answer is the same as the answer to the previous question.
3. Why does the Bank continue to rely on regulatory stress tests in view of their record of repeated failure to identify the build-up of subsequently important stress events? Or, put it differently, can the Bank identify even a single instance where a regulatory stress test correctly identified a subsequent major problem?
Answer: The Northern Rock ‘war game’. But even that stress test turned out to be of no use at all, because none of the UK regulatory authorities did anything to act on it.
In the meantime, perhaps I can interest readers in my Cato Institute Policy Analysis “Math Gone Mad”, which provides a deeper – if not exactly exhaustive but certainly exhausting – analysis of these issues:
“What will futurity make of the Ph.D. standard ? Likely, it will be even more baffled than we are. Imagine trying to explain the present-day arrangements to your 20-something grandchild a couple of decades hence – after the Crash of, say, 2016, that wiped out the youngster’s inheritance and provoked a central bank response so heavy-handed as to shatter the confidence even of Wall Street in the Federal Reserve’s methods.
“I expect you’ll wind up saying something like this: “My generation gave former tenured economics professors discretionary authority to fabricate money and to fix interest rates. We put the cart of asset prices before the horse of enterprise. We entertained the fantasy that high asset prices made for prosperity, rather than the other way around. We actually worked to foster inflation, which we called ‘price stability’ (this was on the eve of the hyperinflation of 2017). We seem to have miscalculated.”
– Excerpt from James Grant’s November 2014 Cato speech. Hat-tip to Alex Stanczyk.
You can be for gold, or you can be for paper, but you cannot possibly be for both. It may soon be time to take a stand. The arguments in favour of gold are well known, and just as widely ignored by the paperbugs, who have a belief system at least as curious because its end product is destined to fail – we just do not know precisely when. The price of gold is weakly correlated to other prices in financial markets, as the last three years have clearly demonstrated. Indeed gold may be the only asset whose price is being suppressed by the monetary authorities, as opposed to those sundry instruments whose prices are being just as artificially inflated to offer the illusion of health in the financial system (stocks and bonds being the primary financial victims). Beware appearances in an unhinged financial system, because they can be dangerously deceptive. It is quite easy to manipulate the paper price of gold on a financial futures exchange if you never have to make delivery of the physical asset and are content to play games with paper. At some point that will change. Contrary to popular belief, gold is supremely liquid, though its supply is not inexhaustible. It is no-one’s liability – this aspect may be one of the most crucial in the months to come, as and when investors learn to start fearing counterparty risk all over again. Gold offers a degree of protection against uncertainty. And unlike paper money, there are fundamental and finite limits to its creation and supply.
What protection ? There is, of course, one argument against gold that seems to trump all others and blares loudly to sceptical ears. Its price in US dollars has recently fallen. Not in rubles, and not perhaps in yen, of course, but certainly in US dollars. Perhaps gold is really a currency, then, as opposed to a tiresome commodity ? But the belief system of the paperbug dies hard.
The curious might ask why so many central banks are busily repatriating their gold ? Or why so many Asian central banks are busily accumulating it ? It is surely not just, in Ben Bernanke’s weasel words, tradition ?
If you plot the assets of central banks against the gold price, you see a more or less perfect fit going back at least to 2002. It is almost as if gold were linked in some way to money. That correlative trend for some reason broke down in 2012 and has yet to re-emerge. We think it will return, because 6,000 years of human history weigh heavily in its favour.
Or you can put your faith in paper. History, however, would not recommend it. Fiat money has a 100% failure rate.
Please note that we are not advocating gold to the exclusion of all else within the context of a balanced investment portfolio. There is a role for objectively creditworthy debt, especially if deflation really does take hold – it’s just that the provision of objectively creditworthy bonds in a global debt bubble is now vanishingly small. There is a role for listed businesses run by principled, decent management, where the market’s assessment of value for those businesses sits comfortably below those businesses’ intrinsic worth. But you need to look far and wide for such opportunities, because six years of central and commercial banks playing games with paper have made many stock markets thoroughly unattractive to the discerning value investor. We suggest looking in Asia. There is a role for price momentum strategies which, having disappointed for several years, though not catastrophically so, now appear to be getting a second wind, from the likes of deflating oil prices, periphery currencies, and so on.
As investors we are all trapped within a horrifying bubble. We must play the hand we’ve been dealt, however bad it is. But there are now growing signs of end-of-bubble instability. The system does not appear remotely sound. Since political vision in Europe, in particular, is clearly absent, the field has been left to central bankers to run amok. The only question we cannot answer is: precisely when does the centre fail ? The correct response is to recall the words of the famed value investor Peter Cundill, when he confided in his diary:
“The most important attribute for success in value investing is patience, patience, and more patience. THE MAJORITY OF INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.”
But the absence of patience by the majority of investors is fine, because it leaves more money on the table for the rest of us. The only question remaining is: in what exact form should we hold that money ?
Be patient, and do please set aside thirty minutes to listen to James Grant’s quietly passionate and wonderfully articulate Cato Institute speech. It will be time well spent.