“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.”
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)
(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:
(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
(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.
[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]
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’.
[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.
A recent report by the Official Monetary and Financial Institutions Forum (OMFIF) entitled Global Public Investor 2014 discussed the investment strategies of 400 government investors split into 157 central banks, 156 government pension funds and 87 sovereign wealth funds, with $29 trillion at their disposal. We normally assume that government pension and sovereign wealth funds are invested to maximise returns and are not used for political and economic purposes, but the same cannot be said of central banks.
According to the OMFIF report the principal reasons central banks are now investing in a wider range of assets include an appetite for higher returns in a low interest rate environment, and geopolitical reasons, whereby stakes in foreign corporations are acquired for strategic purposes. However, central banks are the conduit for a government’s financial management of an economy, and the function has been generally limited to setting interest rates, currency issuance and overseeing the expansion of bank credit. Foreign currency management and gold dealing have been grey areas, with these functions often managed by a government’s finance ministry in an exchange stabilisation fund. So a central bank investing in equities is clearly a case of mission-creep.
Perhaps we should not be surprised that the Peoples Bank of China through its $3.9 trillion State Administration of Foreign Exchange Fund is acquiring equity stakes in European and other companies, but we should note that central banks, such as the Swiss, Danish and Italians are also investing significant sums in equities. Other central banks yet to buy equities will be watching with interest, and analysing the potential benefits of equity investment as an ancillary tool for managing markets.
It will be far easier for the Fed, the ECB or the Bank of England to buy equities if the trail is already blazed by other smaller and respectable central banks. Perhaps an analyst at the Bank for International Settlements will open the door by writing paper on the subject. Given the abject failure of monetary policy to stimulate the major advanced economies, surely it is only a matter of time before our “animal spirits” are kept alive with this new tool.
Equity bulls are unlikely to complain. If the ECB can help recapitalise the eurozone’s banks by subscribing to capital issues, what’s not to like? If a failing industrial conglomerate is given a new lease of life by a share support scheme paid for by a central bank, think of all the jobs saved at no apparent cost! By issuing government currency to support industrial investment, Keynes’s dream explicitly stated in the conclusion to his General Theory can finally be realised, with the state replacing despised savers as the source of funding for industrial investment.
The acquisition of equities by central banks, government pension funds and sovereign wealth funds amounts to enormous power to sway markets the state’s way; all that’s required is a bit of inter-departmental cooperation and $29 trillion (and rising) can be fully utilised to this end. This intervention could increase until governments end up as significant shareholders in most major companies. Norway’s Government Pension fund alone is buying 5% of every major listed European company.
So do not under-estimate the potential scope for further government intervention. Politicians and crony-capitalists will relish this new state-sponsored capitalism, which promises to tame bear markets and enhance share options. Unfortunately such idealist thinking is in defiance of economic reality with all the eventual consequences that entails.
It isn’t often that a Bank of England Quarterly Bulletin starts “A revolution in how we understand economic policy” but, according to some, that is just what Money creation in the modern economy, a much discussed article in the most recent bulletin, has done.
In the article Michael McLeay, Amar Radia, and Ryland Thomas of the Bank’s Monetary Analysis Directorate seek to debunk the allegedly commonplace, textbook understanding of money creation. These unnamed textbooks, they claim, describe how the central bank conducts monetary policy by varying the amount of narrow or base money (M0). This monetary base is then multiplied out by banks, via loans, in some multiple into broader monetary measures (e.g. M4).
Not so, say the authors. They begin by noting that most of what we think of as money is actually composed of bank deposits. These deposits are created by banks when they make loans. Banks then borrow the amount of narrow or base money they require to support these deposits from the central bank at the base rate, and the quantity of the monetary base is determined that way. In short, the textbook argument that central bank narrow or base money creation leads to broad money creation is the wrong way round; bank broad money creation leads to central bank narrow money creation. The supposedly revolutionary connotations are that monetary policy is useless, even that there is no limit to the amount of money banks can create.
In fact there is much less to this ‘revolution’ than meets the eye. Economists and their textbooks have long believed that broad money is created and destroyed by banks and borrowers(1). None that I am aware of actually thinks that bank lending is solely or even largely based on the savings deposited with it. Likewise, no one thinks the money multiplier is a fixed ratio. It might be of interest as a descriptive datum, but it is of no use as a prescriptive tool of policy. All the Bank of England economists have really done is to describe fractional reserve banking which is the way that, these days, pretty much every bank works everywhere.
But there’s an important point which the Bank’s article misses; banks do not create money, they create money derivatives. The narrow or base money issued by central banks comprises coins, notes, and reserves which the holder can exchange for coins and notes at the central bank. The economist George Reisman calls this standard money; “money that is not a claim to anything beyond itself…which, when received, constitutes payment”.
This is not the case with the broad money created by banks. If a bank makes a loan and creates deposits of £X in the process, it is creating a claim to £X of standard money. If the borrower makes a cheque payment of £Y they are handing over their claim on £Y of reserve money. The economist Ludwig von Mises called this fiduciary media, as Reisman describes it, “transferable claims to standard money, payable by the issuer on demand, and accepted in commerce as the equivalent of standard money, but for which no standard money actually exists”. They are standard money derivatives, in other words.
Banks know that they are highly unlikely to be called upon to redeem all the fiduciary media claims to standard money in a given period so, as the Bank of England economists explain, they expand their issue of fiduciary media by making loans; they leverage. Between May 2006 and March 2009 the ratio of M4 to M0, how many pounds of broad money each pound of narrow money was supporting, stood around 25:1.
But because central banks and banks create different things consumer preferences between the two, standard money or standard money derivatives, can change. In one state of affairs, call it ‘confidence’, economic agents are happy to hold these derivatives as substitutes for standard money. In another state of affairs, call it ‘panic’, those same economic agents want to swap their derivatives for the standard money it represents a claim on. This is what people were doing when they queued up outside Northern Rock. A bank run can be described as a shift in depositors’ preferences from fiduciary media to standard money.
Why should people’s preferences switch? In the case of Northern Rock people came to doubt that they would be able to actually redeem their fiduciary media for the standard money it entitled them to because of the vast over issue of fiduciary media claims relative to the standard money the bank held to honour them. Indeed, when Northern Rock borrowed from the Bank of England in September 2007 to support the commitments under its broad money expansion it increased the monetary base just as the Bank of England economists argue.
But there are limits to this. A bank will need some quantity of standard money to support its fiduciary media issue, either to honour withdrawals by depositors or settle accounts with other banks. If it perceives its reserves to be inadequate it will need to access new reserves. And the price at which it can access those reserves is the Bank of England base rate. If this base rate is relatively high banks will constrain their fiduciary media/broad money issue because the profits earned from making new loans will not cover the potential cost of the standard/narrow money necessary to support it. And if the base rate is relatively low banks will expand their fiduciary media/broad money issue because the standard/narrow money necessary to support it is relatively cheap.
Some commentators need to calm themselves. As the Bank of England paper says, the central bank does influence broader monetary conditions but it does so via its control of base rates rather than the control of the quantity of bank reserves. The reports of the death of monetary policy have been greatly exaggerated.
(1) “Banks create money. Literally. But they don’t do so by printing up more green pieces of paper. Let’s see how it happens. Suppose your application for a loan of $500 from the First National Bank is approved. The lending officer will make out a deposit slip in your name for $500, initial it, and hand it to a teller, who will then credit your checking account with an additional $500. Total demand deposits will immediately increase by $500. The money stock will be larger by that amount. Contrary to what most people believe, the bank does not take the $500 it lends you out of someone else’s account. That person would surely complain if it did! The bank created the $500 it lent you” – The Economic Way of Thinking by Paul Heyne, Peter Boettke, and David Prychitko, 11th ed., 2006, page 403. Perhaps the Bank of England economists need to read a better textbook?
The Bank of England
This article originally appeared in The Telegraph on 5 March 2014. It is reproduced by permission of the author.
Five years ago today, the Bank of England cut interest rates about as low as they can go: 0.5 percent. And there they have remained.
If rates have been rock bottom for five years, our central bankers have been cutting them for even longer. You need to go back almost nine years to find a time when real interest rates last rose. Almost a million mortgage holders have never known a rate rise.
And this is all a Good Thing, according to the orthodoxy in SW1. Sure, low rates might hit savers, who don’t get such good returns, but for home owners and businesses, it’s been a blessing.
Don’t just compare the winners with the losers, say the pundits. Think of the whole economy. Rates were set at rock bottom shortly after banks started to go bust. Slashing the official cost of borrowing saved the day, they say.
I disagree. Low interest rates did not save the UK economy from the financial crisis. Low interest rates helped caused the crisis – and keeping rates low means many of the chronic imbalances remain.
To see why, cast your mind back to 1997 and Gordon Brown’s decision to allow the Bank of England to set interest rates independent of any ministerial oversight.
Why did Chancellor Brown make that move? Fear that populist politicians did not have enough discipline. Desperate to curry favour with the electorate, ministers might show themselves to be mere mortals, slashing rates as an electoral bribe.
The oppostite turned out to be the case. Since independence, those supermen at the central bank set rates far lower than any minister previously dared. And the results of leaving these decisions to supposedly benign technocrats at the central bank has been pretty disastrous.
Setting interest rates low is simply a form of price fixing. Set the price of anything – bread, coffee, rental accommodation – artificially low and first you get a glut, as whatever is available gets bought up.
Then comes the shortage. With less incentive to produce more of those things, the supply dries up. So, too, with credit.
With interest rates low, there is less incentive to save. Since one persons savings mean another’s borrowing, less saving means less real credit in the system. With no real credit, along comes the candyfloss variety, conjured up by the banks – and we know what happened next. See Northern Rock…
When politicians praise low interest rates, yet lament the lack of credit, they demonstrate an extraordinary, almost pre-modern, economic illiteracy.
Too many politicians and central bankers believe cheap credit is a cause of economic success, rather than a consequence of it. We will pay a terrible price for this conceit.
Low interest rates might stimulate the economy in the short term, but not in a way that is good for long-term growth. As I show in my paper on monetary policy, cheap credit encourages over-consumption, explaining why we remain more dependent than ever on consumer- (and credit-) induced growth.
Cheap credit cannot rebalance the economy. By encouraging over-consumption, it leads to further imbalances.
Think of too much cheap credit as cholesterol, clogging up our economic arteries, laying down layer upon layer of so-called “malinvestment”.
“Saved” by low rates, an estimated one in 10 British businesses is now a zombie firm, able to service its debts, but with no chance of ever being able to pay them off.
Undead, these zombie firms can sell to their existing customer base, keeping out new competition. But what they cannot do is move into new markets or restructure and reorganise. Might this help explain Britain’s relatively poor export and productivity performance?
What was supposed to be an emergency measure to get UK plc through the financial storm, has taken on an appearance of permanence. We are addicted to cheap credit. Even a modest 1 per cent rate rise would have serious consequences for many.
Sooner or later, interest rates will have to rise. The extent to which low interest rates have merely delayed the moment of reckoning, preventing us from making the necessary readjustments, will then become painfully evident.
We are going to need a different monetary policy, perhaps rather sooner than we realise.
“Sir, Martin Sandbu writes: “We should not worry about inflation – if we strip out volatile or policy-driven elements, it stands at 1.5%, according to Citigroup”, (“Carney has not yet bent the markets to his will”, August 14.)
“Please arrange for Mr Sandbu to cancel the policies concerned and to prevent the volatile situations encountered. When was the last time inflation was 1.5% ? This comment is as meaningless as my saying: “If savings rates were 5%, then I could afford two more holidays a year.” They aren’t, and I can’t.”
- Letter to the editor of the Financial Times, from Mr Charles Kiddle, Gateshead, UK.
King Cnut The Great, more commonly known as Canute, was a king of Denmark, England, Norway and parts of Sweden (thanks Wikipedia !). He is likely to be known to any English schoolchildren still being educated for two specific things: extracting Danegeld – a form of protection racket – from the citizenry, and for the possibly apocryphal story that once, from the shoreline, he ordered back the sea. Over to Wikipedia:
Henry of Huntingdon, the 12th-century chronicler, tells how Cnut set his throne by the sea shore and commanded the tide to halt and not wet his feet and robes. Yet “continuing to rise as usual [the tide] dashed over his feet and legs without respect to his royal person. Then the king leapt backwards, saying: ‘Let all men know how empty and worthless is the power of kings, for there is none worthy of the name, but He whom heaven, earth, and sea obey by eternal laws.’ He then hung his gold crown on a crucifix and never wore it again “to the honour of God the almighty King”. This incident is usually misrepresented by popular commentators and politicians as an example of Cnut’s arrogance.
This story may be apocryphal. While the contemporary Encomium Emmae has no mention of it, it would seem that so pious a dedication might have been recorded there, since the same source gives an “eye-witness account of his lavish gifts to the monasteries and poor of St Omer when on the way to Rome, and of the tears and breast-beating which accompanied them”. Goscelin, writing later in the 11th century, instead has Cnut place his crown on a crucifix at Winchester one Easter, with no mention of the sea, and “with the explanation that the king of kings was more worthy of it than he”. Nevertheless, there may be a “basis of fact, in a planned act of piety” behind this story, and Henry of Huntingdon cites it as an example of the king’s “nobleness and greatness of mind.” Later historians repeated the story, most of them adjusting it to have Cnut more clearly aware that the tides would not obey him, and staging the scene to rebuke the flattery of his courtiers; and there are earlier Celtic parallels in stories of men who commanded the tides..
The encounter with the waves is said to have taken place at Thorn-eye (Thorn Island), or Southampton in Hampshire. There were and are numerous islands so named, including at Westminster and Bosham in West Sussex, both places closely associated with Cnut. According to the House of Commons Information Office, Cnut set up a royal palace during his reign on Thorney Island (later to become known as Westminster) as the area was sufficiently far away from the busy settlement to the east known as London. It is believed that, on this site, Cnut tried to command the tide of the river to prove to his courtiers that they were fools to think that he could command the waves. Conflictingly, a sign on Southampton city centre’s Canute Road reads, “Near this spot AD 1028 Canute reproved his courtiers”.
Cnut did exist, even if his mythologised battle with Nature was a fabrication. And for anyone who thinks that politicians are capable of learning from disastrous policy failures, the following lesson from history is also instructive. Explicitly linking economic policy and monetary policy rates to unemployment rates is not an innovation of either Ben Bernanke’s Fed or Mark Carney’s Bank of England. As Ferdinand Lips points out in his ‘Gold Wars’ (hat-tip to The Real Asset Company’s Will Bancroft):
With the passage of [the US Employment Act of 1946], the US government officially declared war on unemployment and promised to maintain full employment regardless of cost. Thus, it hoped to eliminate the business cycle and to prevent the country from ever sinking to the economic depths of the 1930s.
In the 1950s and the 1960s a weekly column in Barron’s called “The Trader” was written by a certain Mr. Nelson. Week after week, he untiringly drew readers’ attention to the consequences the Employment Act had on the purchasing power of the currency..
One would have thought that economic central planning would have been somewhat discredited after the Soviet empire collapsed in 1989, in favour of free markets. That message has yet to get to the US Federal Reserve or the Bank of England. But the Soviet experience is doubly instructive, in that it shows just how long a fatally dysfunctional system can last in the face of its obvious, existential, contradictions and absurdities.
Our thesis is that we are perilously close to the disorderly end-stage of a 40 year experiment in money and unfettered credit. That experiment started when US President Nixon took the US dollar off gold in 1971, and in the process created a global unbacked fiat currency system for the first time in world history. The history of paper currencies is instructive, too. Not one has ever lasted. Fast forward 40 years.. Texan fund manager Kyle Bass points out that total credit market debt now stands at some 360% of global GDP. For an individual country to maintain a debt to GDP ratio of 250% is consistent with that country deficit-spending its way through a war – such as was the position for the UK in 1945. For the entire world (read: notably the western world) to be loaded with such an untenable debt burden today suggests that something has gone catastrophically wrong with our banking and credit system.
We don’t know what the future holds but, crucially, our investment process does not explicitly require us to, and we have engineered it such that our process carries a degree of insurance against our own overconfidence as asset management fiduciaries. The market can be directed, coerced, bribed, manipulated, distorted and pummelled, but we don’t believe it can ever be completely destroyed – despite the best efforts of central bankers. There is early evidence that bond market vigilantes have had enough with QE and other desperate policy manoeuvrings, and are voting with their feet. If bond yields continue to rise, think very carefully about your exposure to market risk in all its other forms. We have, and are positioned accordingly.
In the current context, if Cnut did ever order back the tide, whether he did so to instruct his courtiers or to display his arrogance over the forces of nature is somewhat moot. The great physicist Richard Feynman made a similar admonition to NASA after the 1986 space shuttle disaster ending up killing seven crew members. In his infamous warning to a bureaucracy seemingly overtaken by ‘spin’, he said in his conclusion to the Challenger report,
For a successful technology, reality must take precedence over public relations, for Nature cannot be fooled.
For Feynman, and for Cnut, it was Nature. For us, it is the markets. Modern critics of the central banks, like ourselves, would suggest that we now have a modern equivalent of Cnut’s Danegeld, in the form of punitively low interest rates, rates which are being kept artificially low to try and resurrect a borderline insolvent banking system which is still content to pay significant executive bonuses and, in some instances, even dividends (to shareholders foolish enough to own common stock issued by banks whose fundamental value cannot be remotely assessed on any sensible economic basis). The economy, in other words, is being held hostage to cater to narrow and largely unreconstructed banking interests. At the same time, the farce of “forward guidance” – the pledge to keep interest rates unchanged until there is tangible evidence of economic recovery, almost irrespective of the latent inflationary pressure being stoked up – is being revealed as farce by Gilt yields that have risen by over 100 basis points since May (and the same holds for US Treasuries). Despite the king’s orders, in other words, the tide continues to come in.
A version of this article was previously published at The price of everything.
From 2006 the Bank of England’s Annual Report has declared the quantity of gold in its custody, including the UK’s own 310 tonnes. Prior to that date a diminishing quantity of on-balance sheet gold (sight accounts) was recorded in the audited accounts, which then disappeared. This tells us that sight accounts (where the BoE acts as banker and not custodian) were dropped. This is sensible, because the BoE is no longer directly liable to other central banks while gold prices are rising.
Of course, the BoE doesn’t hold just central banks’ gold; it also holds gold on behalf of LBMA members. However, LBMA storage at the BoE is probably a fairly small part of the total, because the bulk of settled transactions are in unallocated accounts where the underlying owner does not own physical metal, and the majority of transactions are closed even before settlement is due. Furthermore LBMA members have their own storage facilities or use independent vaults. So to all intents we can regard the BoE’s custody gold as owned by central banks.
It should be borne in mind London is the most important market for physical delivery, particularly for central banks. For this reason most central banks buy, sell, swap or lease their monetary gold in London. The exceptions are Russia, China and the central Asian states who have been the main buyers of gold – always from their own mine output – and do not ship this gold to London; and having substantial foreign reserves from trade surpluses, they have no requirement to do so.
To add to our analytical difficulties, the custody figures presented are net of gold being leased, because leased gold is delivered out of custody. We know that the BoE encourages its central bank customers to pay for its expensive storage charges by earning leasing income, thanks to an unguarded admission from the Austrian central bank last year that it had defrayed its storage costs this way, and a Bundesbank statement that it withdrew gold from London rather than pay high storage fees. The BoE’s custody total is therefore a net figure, with significant quantities of gold out on lease and not actually in custody. However, we can derive some interesting information given the headline custody numbers and some reasonable assumptions.
We can therefore draw up a tentative table as follows:
The approach is to start with the declared gold in custody and subtract what we reasonably know exists to see what’s left. On reasonable assumptions (described in the notes to the table) we can account for all but 467 tonnes of the gold in the BoE’s custody in March 2006. However, remember this is a composite figure, because the BoE leases custodial gold by agreement with its customers – the majority of which will have been delivered out of custody to the market. We have no way of knowing whose gold is actually leased, but at least we more or less know what should be there.
We also know that the gold owned by the central banks represented in the table above plus that of Russia, China, the central Asian states and the US, totalled 12,361 tonnes in March 2006 according to the IMF/WGC statistics. The remaining central banks which are certain to keep gold in London between them owned 18,377 tonnes. To suggest that they had only 467 tonnes of this at the BoE is only true in the sense that some of their gold is out on lease. We can only speculate how much on the basis of what portion of 18,377 tonnes we would expect to be stored in London, but a figure in excess of 5,000 tonnes seems highly likely.
By March this year, the quantity of gold in custody had mysteriously risen from 3,532 tonnes to 6,284 tonnes, leaving a balance not-accounted-for in our table of 2,888 tonnes. Over the intervening years, western central banks officially sold 1,184 tonnes, most of which will have probably passed through the BoE’s vaults. This gold flow is not reflected in custody figures in the table.
The custody ledger is therefore more complicated than its face value. Gold is being leased and has gone out of the door. Gold is being held and not leased, and yet more gold has been shipped in from other centres to be sold, leased or swapped. The amount disclosed by the BoE is effectively a “float”: a net figure comprised of larger amounts. We can therefore assume that despite the rise in custodial gold, gold from the BoE vault has also been supplied to the market.
It is extraordinary that the BoE on behalf of other central banks has been arranging leasing contracts for gold that seems unlikely to return. The lessees may from time to time have been able to buy back the bullion to deliver to the lessor and re-deposited it back with the BoE; but most of bullion goes to India, China or South East Asia from whence it never returns. This may have been less of a problem before Chinese demand took off, people began buying ETFs, and there was a growing supply of scrap. But this has not been the case for several years now, and the remaining leasing agreements must have to be rolled forward, leaving central bank customers of the BoE semi-permanent creditors of bullion banks.
One can only surmise that the central banking community of North America and Europe see gold as an increasing embarrassment. Nevertheless it is hard to understand why central banks continue to lease gold, particularly after the banking crisis when central banks must have become more aware of systemic risks and the possibility their lessees might go bankrupt. More recently, leasing will have almost certainly been a source of finance for cash-strapped eurozone states, and might help explain how they have survived in recent months. However, this cannot go on for ever.
Since the Cyprus debacle
We now turn to the last column dated June this year. The figure for custodial gold of 4,977 tonnes is “at least 400,000 400-ounce bars” taken from tour-note 2 of the new virtual tour of the gold vaults on the BoE’s website. Tour-note 3 gives us the date the information was collated as June this year. This compares with the figure at February 28 from the BoE’s Annual Report of the equivalent of 505,117 bars. So it appears that at least 100,000 bars have disappeared in about four months.
Is the difference of 100,000 bars a mistake? The wording suggests not. The Bank appears to have thought that if it said in the virtual tour, “over 400,000 bars in custody” it would be sufficiently vague to be without meaning; but it is so much less than the figure in the Annual Report dated only four months earlier that it is unlikely to be a mistake. We must therefore conclude that they meant what they said, and that some 1,300 tonnes has left the vault since 1 March.
We now consider where this gold has gone. Gold demand in Europe began to accelerate after the Cyprus debacle at a time when Chinese and Indian demand was also growing rapidly. Meanwhile mine production was steady and scrap sales in the West were diminishing. This was leading to a crisis in the markets, with the bullion banks caught badly short. Hence the need for the price knock-down in early April.
The price knock-down appears to have been engineered on the US futures market, triggering stop-loss orders and turning a significant portion of ETF holders bearish. However, the lower price of gold spurred unprecedented demand for physical gold from everywhere, considerably in excess of ETF sales. The fact the gold price did not stage a lasting recovery tells us that someone very big must have been supplying the market from mid-April onwards, and therefore keeping the price suppressed.
So now we have the answer. The BoE sold about 1,300 tonnes into the London market, which given the explosion in demand for physical at lower prices looks about right.
This leaves us with two further imponderables. It seems reasonable given the acceleration in global demand that the bulk of the gold supplied by the BoE has gone to the non-bank sector around the world. In which case, the bullion banks in London still have substantial uncovered liabilities on their customers’ unallocated accounts, on top of the leases being rolled. The second is a question: how much of the remaining 1,580 tonnes not-accounted-for last month been sold since June?
Conflating these two imponderables, unless the BoE can ship in some more gold sharpish, there is unlikely to be enough available to supply the market at current prices and bail out the bullion banks in London, so they must still be in trouble. The supply of gold for lease seems to have diminished, because the Gold Forward Rate has gone persistently negative indicating a shortage.
It appears the leasing scheme, whereby central bank gold is supplied into the market, has finally backfired. Prices have risen over the period being considered and leased gold has disappeared into Asia at an accelerating rate never to return. While the bullion banks operating in the US futures market have got themselves broadly covered, the bullion banks in London appear to have passed up on the opportunity to gain protection from rising bullion prices.
The final and fatal mistake was to misjudge the massive demand unleashed as the result of price suppression. This was a schoolboy-error with far-reaching consequences we have yet to fully understand.
This article was previously published at GoldMoney.com.
Via City A.M., Bank official: Bond bubble is the biggest threat to financial stability | City A.M..
OUTSPOKEN Bank of England official Andrew Haldane warned yesterday that the bursting of a bond bubble is the biggest threat to the world’s financial stability.
Haldane, the Bank’s executive director of financial stability, told the Treasury Select Committee that central banks’ massive asset-buying programmes have created significant risks.
“If I were to single out what for me would be the biggest risk to global financial stability right now, it would be a disorderly reversion in government bond yields globally,” Haldane told the MPs.
“We’ve intentionally blown the biggest government bond bubble in history. We need to be vigilant to the consequences of that bubble deflating more quickly than we might otherwise have wanted.”
It’s at once terrifying and wonderful to see the conversation about the economic crisis move in this direction. Terrifying because it looks increasingly like those of us who have been talking about the massive economic disruption caused by central banks are correct. Wonderful because at last the Bank’s most courageous official has made this explicit.
The FT recently reported on its front page, “Some of the smartest money in America is getting out of US government debt.” Unfortunately, big players in markets like central banks cause herding. It therefore remains to be seen whether it is possible for the bond bubble to deflate slowly.
In any event, interest rates will rise unless central banks take yet further action. The medium term consequences for our system of money, the welfare state and society are likely to be profound.
This article was previously published at SteveBaker.info.
Once upon a time the pound sterling ruled the world of finance. Today it has been relegated to a less regal status, displaced by the U.S. dollar over the course of the twentieth century. Not only is very little international trade performed in sterling these days, but there are new doubts that it will remain the exclusive currency on the British mainland.
With the looming vote on Scottish independence comes the threat that an independent Scotland will introduce its own currency.
Once upon a time, English as a language was a little known form of communication, largely isolated to the British Isles. Starting at about the same time as the spread of sterling as the universal money throughout the world, English set off on the route to global dominance. Today there are about 350 million native English speakers, but this number is dwarfed by the masses that use it as a lingua franca - their second or even third language.
Considering their common pedigree, one may ask why the currency is now a second-rate citizen in the world of international finance while the language is going stronger than ever.
Historians commonly attribute the rise of the English language to the rise of Pax Britannica throughout the 19th century. This period did see the English economy rise to great stature and expand its scope to the point where the sun never set on the British Empire. However, other great European economies also flourished and encompassed many foreign lands. The Spanish Empire at its pinnacle included more square miles than the British (though never as many people). Both France and Germany had sizable colonies. Even the Russians, it can be argued, held huge “colonies” in the form of the Soviet Bloc.
Alternatively one could say that the rise of the United States (complete with its dominant media industry) assured the rise of the English language. Yet this too seems to put the cart before the horse. Much of America was settled by non-English speakers (Spaniards in the south-west, French in the South-east and Northern European Germans, Scandinavians and Dutch in the upper mid-west). English was emerging as the linguistic force to be reckoned with before the ascendance of the U.S. as a world super power, which really only happened after World War I.
Instead, the rise of the English language can be largely explained by its decentralized nature. It is true that English grammar is quite simple relative to other languages, especially its Romance and Germanic brethren. Yet if anything this would normally incentivize Romance and German speakers to streamline their own grammatical rules to make adoption easier. In most languages this is not possible due to their extreme form of centralization. French and Spanish, as examples, require linguistic changes to be approved by the centralized governing body (L’Académie Française in France, and the Real Academia Española in Spain). Changes are almost impossible as they must go through the usual bureaucratic approval process as other changes to legislature.
It is no surprise that French and Spanish as languages are slow to adopt to changes, in much the same way as their legal systems are outdated and move only at a snail’s pace. Lacking any centralised authority, anyone was able to use English, but more importantly, they could change it as they saw fit. Changes and new words occurred spontaneously as a response to market demands, not to the pen of a bureaucrat. This form of crowd sourcing allowed the English language to be modified as it spread around the globe and incorporate the intricacies of daily life and the existing languages of its newfound locals.
By contrast, the British pound sterling has suffered from centuries of centralised mismanagement. Since the creation of the Bank of England in 1694, the venerable old lady has done what she can to diminish the pound sterling on an ongoing basis. While the First World War was devastating in many respects for Britain, one of the longest lasting effects was the decoupling of the pound from gold. This shift left the once proud currency open to continual and unabated inflation at the hands of the Bank of England, with the result that it is now worth a fraction of what it was just a century prior.
In international finance people use the language that makes trade easiest, as well as the money that best facilitates its dealings. A decentralized language system has proven an overwhelming success as it is now the standard around the globe. The centralized monetary system has been mismanaged to the point where few outside of the country elect for sterling in their affairs. With the Scottish independence vote approaching it is questionable how many people within the United Kingdom want to continue using it.
If George Osborne stays up at night wondering what the future will be for the pounds his Treasury manages perhaps he would do best to take a lesson from British history. The English language became a world standard without the oversight of Parliament – perhaps it is time to recognise the same can be true for the pound sterling as well.