According to the ECB’s Bank Lending Survey for October banks eased their credit standards in the last quarter, while their risk perceptions increased.
This apparent contradiction suggests that the 137 banks surveyed were at the margin competing for lower-quality business, hardly the sign of a healthy lending market. Furthermore, the detail showed enterprises were cutting borrowing for fixed investment sharply and required more working capital instead to finance inventories and perhaps to cover trading losses.
This survey follows bank lending statistics since the banking crisis to mid-2014, which are shown in the chart below (Source: ECB).
It is likely that some of the contraction in bank lending has been replaced with bond finance by the larger credit-worthy corporations, and Eurozone banks have also preferred buying sovereign bonds. Meanwhile, the Eurozone economy obviously faces a deepening crisis.
There are some global systemically important banks (G-SIBs) based in the Eurozone, and this week the Financial Stability Board (FSB) published a consultation document on G-SIBs’ capital ratios in connection with the bail-in procedures to be considered at the G20 meeting this weekend. The timing is not helpful for the ECB, because the FSB’s principle recommendation is that G-SIBs’ Tier 1 and 2 capital should as a minimum be double the Basel III level. This gives operational leverage of between 5 and 6.25 times risk-weighted assets, compared with up to 12.5 times under Basel III.
The FSB expects the required capital increase to be satisfied mostly by the issue of qualifying debt instruments, so the G-SIBs will not have to tap equity markets. However, since Eurozone G-SIBs are faced with issuing bonds at higher interest rates than the returns on sovereign debt, they will be tempted to scale back their balance sheets instead. Meanwhile bank depositors should note they are no longer at the head of the creditors’ queue when their bank goes bust, which could affect the non-G-SIB banks with higher capital ratios.
If G-SIBs can be de-geared without triggering a bank lending crisis the world of finance should eventually be a safer place: that’s the intention. Unfortunately, a bail-in of a large bank is unlikely to work in practice, because if an important bank does go to the wall, without the limitless government backing of a bail-out, money-markets will almost certainly fail to function in its wake and the crisis could rapidly become systemic.
Meanwhile, it might appear that the ECB is a powerless bystander watching a train-wreck in the making. Businesses in the Eurozone appear to only want to borrow to survive, as we can see from the October Bank Lending Survey. Key banks are now being told to halve their balance sheet gearing, encouraging a further reduction in bank credit. Normally a central bank would respond by increasing the quantity of narrow money, which the ECB is trying to do despite the legal hurdles in its founding constitution.
However, it is becoming apparent that the ECB’s intention to increase its balance sheet by up to €1 trillion may not be nearly enough, given that the FSB’s proposals look like giving an added spin to contraction of bank credit in the Eurozone.
[Editor’s Note: this piece, by Ivo Mosley, first appeared at http://defendinghistory.com/antisemitism-banking/69351]
A good deal of today’s nationalist and right-wing antisemitism rests upon the fantasy that “the Jews” control the world through finance and banking. Nor is the same fantasy entirely absent from left-wing antisemitism, which currently tends to concentrate itself on criticism of Israel.
The fact that some Jews are very good at banking is, apparently, enough to justify race-hate in the antisemite’s mind. Of course, a number of Jews are also prominent as scientists, civil rights activists, generals, hairdressers, actors, musicians, historians, etcetera, without anyone blaming science, civil rights, theatre, hairdressing, war, music, history, etcetera on “the Jews.” This highlights one of the traditional functions of antisemitism: if something is obviously bad, “the Jews” can be reached for as a scapegoat.
The object of this article is twofold: first, to analyze what is rotten in the world of capitalism and finance; second, to show that while it has nothing to do with “the Jews” as a people or as a tradition, it has everything to do with a tradition that for centuries excluded “the Jews.”
Capitalism and Predatory Capitalism
There are two stories about how capitalism is financed. One is commonly believed and accepted, but not true. The other is true, but hidden under veils of obscurity.
The familiar story is that citizens save up bits of money: banks gather up those bits of money and lend them to capitalists, who put them to good use for the benefit of all. This, however, is not what banks do – nor is it necessarily what capitalists do.
The unfamiliar, but true, story is that banks create money out of nothing when they lend to capitalists, who use the new money to purchase assets and/or labor, from which they expect to make a profit.
The first story needs no elaboration: as well as being untrue, it is simple and widely understood. The second needs to be explained, however, because though it is not so very complicated, it is unfamiliar to most people.
Economists generally avoid mentioning the fact that banks create money, but central bankers are happy to state it and even on occasion to try to explain it. The Bank of England website states simply: “Most money in the modern economy is in the form of bank deposits, which are created by commercial banks themselves.” And again: “The majority of money in the modern economy is created by commercial banks making loans.” The same article explains that this fact is not recognized by most economists: “rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.” (Quotes from the Bank of England Quarterly Bulletin, 2014/1.)
The way bankers create money today requires two things: a “magic trick” by which a small quantity of money held by the banker becomes a great deal of money in circulation; and laws which make the “’magic trick” not just legal, but binding on all citizens.
The “Magic Trick” of Banking
“A banker may accommodate his friends without the payment of money merely by writing a brief entry of credit; and can satisfy his own desires for fine furniture and jewels by merely writing two lines in his books,” wrote Tommaso Contarini, Venetian Banker and Senator in 1584.
The Encyclopedia Britannica of 1950 states firmly and definitively, “A bank does not lend money.” So just what does it do, when we think it is lending money? The answer is: it writes two numbers into a ledger, just as Tommaso Contarini did in 1584. Those numbers represent two equal-and-opposite claims, with a time lapse in between. The borrower gets a claim on cash belonging to the bank, which it can exercise immediately. The bank gets a delayed claim against the borrower, which it may exercise when the loan is due for repayment. In the meantime, the bank charges the borrower interest. When both claims have been exercised, the bank’s creation – the loan – disappears.
The claim which the bank creates for the borrower is called “credit.” “Credit” means “believes,” meaning whoever owns the claim believes they can get cash from the bank when they want it. This is where the “magic trick of banking”’ begins. If people believe they can get cash from a claim, they are happy to receive a claim in payment, so long as they too can use the claim to get cash from the bank. Joseph Schumpeter observes: “There is no other case in which a claim to a thing can, within limits to be sure, serve the same purpose as the thing itself: you cannot ride a claim to a horse, but you can pay with a claim to money.”
The second bit of the magic trick is for the banker to create many claims on the same bit of money – or, to put it another way, to create claims on money that isn’t there. Banks, naturally enough, want to maximize their profits, so they create as many claims as they think they can get away with, bearing in mind the regulators and people’s demand for cash. By creating fictitious claims a bank turns a billion, say, of cash into sixty billion, say, of credit.
The magic trick may seem somewhat technical in nature, but it has enabled bankers, with the active connivance of governments and capitalists, to replace money we can own with money we must rent off governments and banks. The effects of this substitution are immense, incalculable, far-reaching, all-pervasive (more on this later).
The Legal Underpinnings and Authority for Bank-Money
For a claim to pass from hand to hand as money, completing the “magic trick of banking,” one more thing is needed: the law must recognize it as a valid claim.
Normally, people are not allowed to create claims on property they don’t have. You can’t, for instance, create a claim on Buckingham Palace – unless you happen to own it. Nor can you mortgage your house sixty times over, and spend the money. Banks alone may do this kind of thing. Only banks (and “other depository institutions”) are authorized in law to create claims on property they do not have.
For centuries, banks operated in a legal grey area. Their activities were restricted to merchants, who understood the risks involved, and to what might be called the “higher criminal class” of rulers and potentates. Lending to princes often carried an interest rate of 100% — but still, most bank-crashes occurred when monarchs defaulted on their debts.
The watershed in banking history came during the decades on either side of 1700, when the English House of Commons, newly-all-powerful and consisting of rich men voted in by other rich men, wanted to exploit the fruits of bank-credit for their own devices of war and profit.
The Lord Chief Justice of the time, Sir John Holt, was supporting the traditional legal position that a claim on property was valid only if the claim was on a specific piece of property. Parliament passed an Act of Parliament (the Promissory Notes Act of 1704) to overrule him. Over the next three centuries, other countries followed the English example and “credit-creation” — creating claims on assets that don’t exist — is now authorized for bankers all across the world.
The Two Traditions: Money-Lending and Banking
Within the European tradition, Jews were long known as money-lenders. The relatively straightforward nature of money-lending, as a freely-negotiated contract between lender and borrower, was complicated by moral and social issues.
Usury (lending money at interest) was deplored in the Judeo-Christian tradition, but Jews were allowed (by their own religious laws and by self-interested Christian monarchs) to lend to non-Jews. A pattern was established: monarchs licensed Jewish money-lenders to lend to their subjects; agents of the monarch helped them collect their debts, then the monarch would rob the money-lenders of much of their profits. Throughout much of Europe, discriminatory laws forbade Jews to earn a living any other way. Although money-lending was a despised and hated occupation, it could make people very rich.
Meanwhile, banking — the creation of credit — was developing in an entirely separate tradition via the activities of merchants, exchange-dealers and civic banks. The tradition was Christian, protective of its own, and often openly antisemitic. When these early bankers “lent” money they were not lending hard cash, they were lending claims written into ledgers.
Failure to distinguish between banking and money-lending, and the superior social status of bankers (who being in close collusion with the State are liable to pick up honors as well as great wealth) have led many writers to claim that Jewish money-lenders were bankers, i.e. creators of credit. This in turn has fed the delusions of antisemitic pseudo-historians. In reaction to this false history, most serious historians of banking have found themselves making statements similar to this from Raymond de Roover: “Unlike the Christian moralists, the rabbis paid little attention to exchange dealings or cambium, because, as Yehiel da Pisa explains, this business was not practiced by Jews. This is further evidence that the latter confined their activities to money-lending on a small scale and that the leading international bankers, such as the Medici or the Fuggers, were all Christians. There is, therefore, nothing to support Sombart’s thesis according to which the Jews were the originators of international finance and the founders of modern capitalism.”
All this, of course, was a long time ago, and nowadays bankers are Anglo-Saxon, Chinese, African, Indian, Jewish, Christian, Islamic or whatever: assorted individuals who have no more consuming interest than to make lots of money.
What is Wrong With Creating Money as Fictitious Credit?
Bank-credit — money created as credit on assets that don’t exist — has many features that may be viewed as negative. It replaces money owned outright with money rented out, and is therefore (in the words of John Taylor of Virginia, 1753-1824) a “machine for transferring property from the people to capitalists.” Along the same lines, it allocates new money to borrowers on the mere promise of profit: as a result, much of it goes to inflating asset prices, again increasing inequality. It enables governments to borrow with little accountability, and to charge interest and repayment to “the people”: these charges make domestic labor more expensive, and therefore less competitive. It is created in large quantities during booms, and disappears during busts as loans are retired or “go bad,” thereby exacerbating business cycles. It encourages the production of arms and war by providing unaccountable finance to both governments and arms manufacturers, at the expense of their peoples. It encourages large concentrations of power in government, corporations, and individual “oligarchs,” reducing independence among citizens. It has an endogenous (inbuilt) insatiability: money drifts to the ownership of capitalists and only economic growth, state hand-outs and war (when governments create new money for working people rather than for banks) can supply consumer-money to the poor. The effects of this insatiability on the environment are literally devastating. It gives vast wealth to an elite who care only for making more money: the tastes of this elite have corrupted human culture. Lastly, because the process is not widely understood and is conducted largely in secret, it makes Western claims to political “democracy” dubious at best.
Given all this, it might be a good idea to contemplate reform, which would have to include (i) the replacement of credit money with digital money owned outright and (ii) withdrawal of the license allowed banks, to create claims on assets they don’t have.
Most people familiar with the reality of bank-credit also profit from it. Reason gives way to self-interest in human affairs, so enlightenment and reform are hardly to be expected from among the powers-that-be. As for antisemitism, mental disease is also resistant to reason, so the targets of criticism in this essay are unlikely to be affected by the contents of this article. However, the majority of humanity have strong reasons to desire both financial reform and less racial hate and I hope this essay has made a small contribution to those ends by shedding light on a topic that is not at present widely understood.
Recent evidence points increasingly towards global economic contraction.
Parts of the Eurozone are in great difficulty, and only last weekend S&P the rating agency warned that Greece will default on its debts “at some point in the next fifteen months”. Japan is collapsing under the wealth-destruction of Abenomics. China is juggling with a debt bubble that threatens to implode. The US tells us through government statistics that their outlook is promising, but the reality is very different with one-third of employable adults not working; furthermore the GDP deflator is significantly greater than officially admitted. And the UK is financially over-geared and over-dependent on a failing Eurozone.
This is hardly surprising, because the monetary inflation of recent years has transferred wealth from the majority of the saving and working population to a financial minority. A stealth tax through monetary inflation has been imposed on the majority of people trying to earn an honest living on a fixed salary. It has been under-recorded in consumer price statistics but has occurred nonetheless. Six years of this wealth transfer may have enriched Wall Street, but it has also impoverished Main Street.
The developed world is now in deep financial trouble. This is a situation which may be coming to a debt-laden conclusion. Those in charge of our money know that monetary expansion has failed to stimulate recovery. They also know that their management of financial markets, always with the objective of fostering confidence, has left them with market distortions that now threaten to derail bonds, equities and derivatives.
Today, central banking’s greatest worry is falling prices. The early signs are now upon us, reflected in dollar strength, as well as falling commodity and energy prices. In an economic contraction exposure to foreign currencies is the primary risk faced by international businesses and investors. The world’s financial system is based on the dollar as reserve currency for all the others: it is the back-to-base option for international exposure. The trouble is that leverage between foreign currencies and the US dollar has grown to highly dangerous levels, as shown below.
Plainly, there is great potential for currency instability, compounded by over-priced bond markets. Greece, facing another default, borrows ten-year money in euros at about 6.5%, while Spain and Italy at 2.1% and 2.3% respectively. Investors accepting these low returns should be asking themselves what will be the marginal cost of financing a large increase in government deficits brought on by an economic slump.
A slump will obviously escalate risk for owners of government bonds. The principal holders are banks whose asset-to-equity ratios can be as much as 40-50 times excluding goodwill, particularly when derivative exposure is taken into account. The stark reality is that banks risk failure not because of Irving Fisher’s debt-deflation theory, but because they are exposed to a government debt bubble that will inevitably burst: only a two per cent rise in Eurozone bond yields may be sufficient to trigger a global banking crisis. Fisher’s nightmare of bad debts from failing businesses and falling loan collateral values will merely be an additional burden.
Macro-economists refer to a slump as deflation, but we face something far more complex worth taking the trouble to understand.
The weakness of modern macro-economics is it is not based on a credible theory of prices. Instead of a mechanical relationship between changes in the quantity of money and prices, the purchasing power of a fiat currency is mainly dependent on the confidence its users have in it. This is expressed in preferences for money compared with goods, and these preferences can change for any number of reasons.
When an indebted individual is unable to access further credit, he may be forced to raise cash by selling marketable assets and by reducing consumption. In a normal economy, there are always some people doing this, but when they are outnumbered by others in a happier position, overall the economy progresses. A slump occurs when those that need or want to reduce their financial commitments outnumber those that don’t. There arises an overall shift in preferences in favour of cash, so all other things being equal prices fall.
Shifts in these preferences are almost always the result of past and anticipated state intervention, which replaces the randomness of a free market with a behavioural bias. But this is just one factor that sets price relationships: confidence in the purchasing power of government-issued currency must also be considered and will be uppermost in the minds of those not facing financial difficulties. This is reflected by markets reacting, among other things, to the changing outlook for the issuing government’s finances. If it appears to enough people that the issuing government’s finances are likely to deteriorate significantly, there will be a run against the currency, usually in favour of the dollar upon which all currencies are based. And those holding dollars and aware of the increasing risk to the dollar’s own future purchasing power can only turn to gold and subsequently those goods that represent the necessities of life. And when that happens we have a crack-up boom and the final destruction of the dollar as money.
So the idea that the outlook is for either deflation or inflation is incorrect, and betrays a superficial analysis founded on the misconceptions of macro-economics. Nor does one lead to the other: what really happens is the overall preference between money and goods shifts, influenced not only by current events but by anticipated ones as well.
Recently a rising dollar has led to a falling gold price. This raises the question as to whether further dollar strength against other currencies will continue to undermine the gold price.
Let us assume that the central banks will at some time in the future try to prevent a financial crisis triggered by an economic slump. Their natural response is to expand money and credit. However, this policy-route will be closed off for non-dollar currencies already weakened by a flight into the dollar, leaving us with the bulk of the world’s monetary reflation the responsibility of the Fed.
With this background to the gold price, Asians in their domestic markets are likely to continue to accumulate physical gold, perhaps accelerating their purchases to reflect a renewed bout of scepticism over the local currency. Wealthy investors in Europe will also buy gold, partly through bullion banks, but on the margin demand for delivered physical seems likely to increase. Investment managers and hedge funds in North America will likely close their paper-gold shorts and go long when their computers (which do most of the trading) detect a change in trend.
It seems likely that a change in trend for the gold price in western capital markets will be a component part of a wider reset for all financial markets, because it will signal a change in perceptions of risk for bonds and currencies. With a growing realisation that the great welfare economies are all sliding into a slump, the moment for this reset has moved an important step closer.
The U.S. financial system faces a major, growing, and much under-appreciated threat from the Federal Reserve’s risk modeling agenda—the “Fed stress tests.” These were intended to make the financial system safe but instead create the potential for a new systemic financial crisis.
The principal purpose of these models is to determine banks’ regulatory capital requirements—the capital “buffers” to be set aside so banks can withstand adverse events and remain solvent.
Risk models are subject to a number of major weaknesses. They are usually based on poor assumptions and inadequate data, are vulnerable to gaming and often blind to major risks. They have difficulty handling market instability and tend to generate risk forecasts that fall as true risks build up. Most of all, they are based on the naïve belief that markets are mathematizable. The Fed’s regulatory stress tests are subject to all these problems and more. They:
- ignore well-established weaknesses in risk modeling and violate the core principles of good stress testing;
- are overly prescriptive and suppress innovation and diversity in bank risk management; in so doing, they expose the whole financial system to the weaknesses in the Fed’s models and greatly increase systemic risk;
- impose a huge and growing regulatory burden;
- are undermined by political factors;
- fail to address major risks identified by independent experts; and
- fail to embody lessons to be learned from the failures of other regulatory stress tests.
The solution to these problems is legislation to prohibit risk modeling by financial regulators and establish a simple, conservative capital standard for banks based on reliable capital ratios instead of unreliable models. The idea that the Fed, with no credible track record at forecasting, can be entrusted with the task of telling banks how to forecast their own financial risks, displacing banks’ own risk systems in the process, is the ultimate in fatal conceits. Unless Congress intervenes, the United States is heading for a new systemic banking crisis.
[Editor’s Note: the full document published by the Cato Institute can be found here]
Low interest rates contribute to weak labour markets
In the latter part of August, the cream of the world’s central bankers convened at the annual Kansas City Fed gathering at Jackson Hole, Wyoming. Every year the Conference has a theme. Last year’s was Quantitative Easing (QE): when and how it would end. This year’s topic was unemployment, under the rather grandiose title “Re-Evaluating Labour Market Dynamics”.
Ms Yellen, chair of the Federal Reserve, seemed at last to acknowledge one of this Newsletter’s recurring concerns; namely, that official unemployment data mislead because they ignore the number of citizens so disaffected with prospects that they no longer register as looking for work. She is warming towards a new Fed Board developed Labour Market Conditions Index (LMCI) which takes account of workforce participation rates and various other measures. She considers LMCI a better indicator of employment market strength or weakness than the raw unemployment percentage number. By this measure, unemployment is still substantially above the pre-crisis level. Accordingly, Ms Yellen remains concerned about the present strength of the US recovery:
“the recent behavior of both nominal and real wages point to weaker labor market conditions than would be indicated by the current unemployment rate”;
Nonetheless, she indicated that interest rates would rise if future, stronger than expected, labour market data were reported.
Similar concerns are now paramount among UK central bankers. The Bank of England now overtly links its ‘forward guidance’ about the timing of interest rate increases to evidence of growth in wage levels.
The ECB’s President Mario Draghi had absorbed the summer’s deterioration in European data suggesting that another slowdown is underway. Only this time, it is impacting primarily the core, France and Italy, and even Germany. Finance Minister Schaeuble recently said that ‘the ECB have already done enough’ so Germany is firmly against more stimulus at this stage.
President Draghi’s speech put labour market worries at the forefront of Europe’s problems. In Europe there was a second surge in unemployment 3 years after the financial crisis. From early 2011, when it became apparent that a number of countries would, without bailouts, default or renege on sovereign debt, heavy job losses drove up the Eurozone average to levels that have only recently topped out. Draghi took the opportunity of the profile of this occasion once again to express doubts whether unleashing QE in the Eurozone would make any difference to labour market conditions, because national governments have failed to implement substantive structural reforms. Like a physical trainer addressing a group of failed slimmers after 3 years of group therapy, he berated that he has done all he could do in the group sessions, those dissatisfied with their progress should look to themselves.
Although these presentations reveal doubts among leading central bankers that near zero interest rate policies (ZIRP) may not result in economic stimulus, there is still a gulf between these doubts and the scepticism about ZIRP policies, doubt that have been strongly expressed by the Bank for International Settlements (see our July Newsletter).
An even stronger counter view is beginning to gather mainstream support; namely, that ZIRP is a primary cause of the continuing weak labour market conditions. The reasoning is as follows. By reducing the cost of borrowing money substantially below its ‘market’ level, capital goods for businesses have become disproportionately cheap compared with the cost of employing people. When weighing up the cost/ benefit of, say, installing a machine to sell tickets in train stations compared with employing staff to do the same job, low interest rates reduce the cost of the machine option. Businessmen make such decisions using discounted cash flow analysis, whereby future costs are assessed a present value using average market interest rates over the term. So ZIRP has a double whammy effect; not only is the borrowing cost of the machine lower, but by applying a discount rate of close to zero to the employee option, the present value cost of the stream of wages is increased. This may go some way towards explaining the trend of low to moderate-income jobs being replaced by machines in areas such as supermarket checkout services as well as transport ticketing.
This is a classic “misallocation” as per Austrian economics. It follows that, when rates rise, firms will find their overall operations burdened by excessive (now expensive) capital equipment. What they will then want are more productive employees. However, the lack of skilled workers–those out of the labour force for several years tend to be less productive–will make competition for skilled labour intense, wage pressures will rise, and the combination of excess capital capacity and rising wage pressures will intensify the stagflation we have already seen to date (see our July Newsletter).
Concerns about Repo Market Disruptions.
In August, concerns were reported that the US repo market, one of the largest engines of liquidity in global capital markets, was experiencing disruptions to its otherwise smooth functioning owing to a reduction in repo activity by banks. Banks explained this by citing increased capital costs under the recently introduced Leverage Ratio (see our February Newsletter).
Before considering this further, since repo transactions can be confusing, let us set out an example. A repo counterparty, say an investment fund, might hold a 5-year US Treasury bond. There has traditionally been a deep and liquid market enabling the fund to enter into a contract with, say, a bank to sell and buy back the bond, usually on a very short-term basis (overnight). However, medium term funding can be obtained by rolling the position every day. The sale and repurchase price are pre-agreed, the differential constitutes the return to the provider of cash. Banks have been encouraged to play the role of repo cash provider (otherwise known as Reverse repo Counterparty) as the market for derivatives, particularly interest rate swaps (IRS), has grown.
Thus it can be seen that not only have banks been lured to the repo market by the modest net interest income generated by being the repo cash provider against very low credit risk, but also because repos provide a steady source of government bonds that are useful for other hedging activities of the bank itself.
So why are they now pulling back? Even though the Basel Capital weighting applied to banks’ holdings of non-defaulted government bonds is zero, such holdings are indeed caught by the Leverage Ratio. Therefore, there will be a cost from the new rule’s effective date of 1 January 2015.
But is the pullback entirely attributable to new regulations, as claimed in the mainstream press? We are not so sure. There also appears to be a shortage of available collateral (Treasury bonds) in the maturities most popular with market participants. Perhaps this results from the Federal Reserve’s mopping up of so much of the US Treasury security market via its QE programme. The result is that banks providing cash into the transaction in which the underlying security is becoming scarce (e.g. 5 years), now expect to make a negative return on the loan of the cash. The loss would materialize if the price they will have to pay in the market to buy back the bond for delivery back to the counterparty has risen owing to scarcity. In these circumstances, it is hardly surprising that banks would prefer to deposit their cash with the Federal Reserve at a better rate of return and without the negative Leverage ratio consequences.
Under normal market conditions, repo provides a cheap and easy way to releverage an asset. If trend described in the previous paragraph persists, does it presage the start of wholesale reductions in systemic leverage? We doubt it. The thrust of ‘legal’ financial innovation, especially since the outbreak of the crisis, has been for banks to find new ways of leverage through collateral transformation, swapping collateral with each other in ways that either slip by, or are tacitly approved by regulators. One such example is asset rehypothecation, which we discussed in our January Newsletter.
Finally, is this repo market disruption an ‘unintended consequence’ of the new Leverage Ratio regulations? The prevailing view appears to be negative. A small number of senior US Reserve bank governors have long memories of the 2008 crisis, and fear a recurrence of the repo market seizure. Sceptics may take the view that those bank governors are overly focussed on the symptoms of that crisis rather than on its cause. As has been amply documented, at the peak of the crisis (before any talk of bailouts), repo and other markets froze up because a number of insolvent counterparties reneged on obligations to deliver cash or collateral, triggering a collapse in confidence upon which these interbank markets rely. Shrinking the repo market will not prevent a recurrence of system wide crisis when such insolvency worries resurface.
[Editor’s note: Please find the IREF Newsletter here]
[Editor’s note: this article, by Robert Batemarco, first appeared at Mises.org]
John Tamny recently wrote a piece at Forbes titled, “The Closing of the Austrian School’s Economic Mind” in which he critiqued certain claims made in Frank Hollenbeck’s Mises Daily article, “Confusing Capitalism with Fractional Reserve Banking.”
Tamny goes far beyond taking Hollenbeck to task, asserting that many modern Austrian economists have certain views of monetary policy that are at odds with much of the rest of the contribution of the Austrian School. Tamny’s biggest point of disagreement with Austrians is over the low regard with which many Austrians hold the practice of fractional reserve banking. In so doing, he makes several arguments which cannot stand up to critical scrutiny.
The crux of the Austrian position is that the practice of fractional reserve banking gives ownership claims to the same funds to more than one person. The person depositing the funds clearly has a property claim to those funds. Yet when a loan is made from those funds, the borrower now has a claim to the same funds. Two or more people owning the same funds is what makes bank runs possible. The existence of deposit insurance since the 1930s has minimized the number of these runs, in which multiple owners sought to claim their funds at the same time. The deposit insurance that prevents bank runs really amounts to a pre-emptive bailout of the banks. As this is a special privilege, rather than a natural development of the market, it follows that restrictions on fractional reserve banking would be a libertarian validation of the market rather than the statist interference that Tamny claims it to be.
His inability to see that fractional reserves lead to two or more people having claim to the same funds at the same time leads him to deny the logic of the money multiplier. To quote him:
The problem is that the very notion of a “money multiplier” is a logical impossibility; one that dies of its illogic rather quickly if analyzed in the lightest of ways. … To the Austrians, money can be multiplied. Bank A takes in $1,000, lends $900 to Bank B, then Bank B lends $810 to Bank C, only for Bank C to lend $729 to Bank D, etc. Pretty soon $1,000 has been “multiplied” many times over as the credit is passed around.
The notion of the money multiplier is by no means uniquely Austrian. I learned it forty years ago from the Paul Samuelson textbook and from the Fed publication Modern Money Mechanics. It is also the centerpiece of the monetary system chapter of virtually every textbook right up to Paul Krugman’s most recent edition. Indeed, the nature of the process is one of the most uncontroversial propositions in economics — a good definition of an uncontroversial economic proposition being one on which both Murray Rothbard and Paul Krugman are in substantive agreement. Indeed, if there were no money multiplier, one would be at a loss to explain why, until QE1 in 2008, M1 was a 1.6 times size of the monetary base, having historically been even higher. Nor would the required reserve ratio, a tool of monetary policy that became too powerful to be used after 1937, have any effect on the money supply in the absence of the money multiplier effect.
What is controversial about the money multiplier is not its existence, but whether or not it creates distortions in the economy. The distortions introduced into the economy by fractional reserve banking, and to an even greater extent by central banking, comprise the central element of Austrian business cycle theory. The basic idea is that the creation of money (which is also credit, since that new money is loaned into existence) increases the supply of loanable funds and lowers market interest rates without increasing the supply of voluntary saving. This misleads investors into believing that more resources have been made available by savers for investment projects than actually have been made available. Thus, projects are started on too big a scale since many investors try to exercise a claim on the same productive resources. In so doing, they will bid up the resource prices, slashing the profitability of many of these investment projects. This is the real goods sector counterpart of bank runs in the monetary sector. Since there is no real goods sector counterpart to deposit insurance, firms will run short of the resources necessary to profitably complete their investment projects, exposing them as malinvestments and turning boom to bust.
Tamny disputes the above claims, largely on the basis of what seems to me an idiosyncratic definition of credit. He states that, “credit can’t be multiplied. Period. For every individual who attains credit successfully, there must be a saver willing to give up near-term access to the economy’s resources.” This statement is informed by the valuable insight that lending money to those who wish to buy goods they could not otherwise afford does not create additional goods. Where the equivocation arises is in his use of the word credit to describe the goods that credit permits one to buy. I believe this eccentric use of that word is what leads to many of Tamny’s disagreements with the Austrians. Here is Exhibit A:
Perhaps another logical response to this line of thinking is the housing boom that took place in the 2000s. Wasn’t the latter most certainly a function of easy credit? Let’s be serious. To believe it was, that low rates set by the Fed were what made housing credit easy is to believe that rent control renders apartments abundant. But it doesn’t, nor were low rates decreed by the Fed the driver of the housing boom.
Austrians agree that making loans more available than the market would make them does not make more goods available. But there is the illusion of more resources in the short run because the credit-creation process does initially commandeer resources from those whose money decreases in value through the Cantillon Effect. Unfortunately, many entrepreneurs seeking to expand their operations act on this illusion. Only when the new money reaches those whose money lost its value initially and they re-assert their demand, does the inability of new credit to create new goods become obvious.
The last critique Tamny makes that I will discuss here is his implication that Austrian support for 100 percent reserves on demand deposits would make it impossible for borrowers to borrow from savers in order to lend those savings out. This is wrong. Austrians have no problem with savers buying the bonds of a firm seeking additional financing, nor with their buying stock, either directly from the company or its investment bank through an IPO or on the secondary market where it helps keep the market liquid, nor with their buying a bank CD or time deposit knowing that they will not have a claim on the funds they have entrusted to the bank until maturity. In all of these cases, intermediaries are borrowing from savers in order to lend those savings out (this is not exactly a loan in the case of stocks). What Austrians object to is banks telling depositors they still have an instantaneous claim on the funds deposited when they have given someone else a claim on the same funds.
Under the elimination of fractional reserve banking, investment spending would be reduced, not to zero, but to a more sustainable level. This would not eliminate entrepreneurial errors, which are part and parcel of having to act in the face of uncertainty, but it would eliminate the cluster of errors generated by the inconsistent plans that would be made on the basis of falsified market signals of interest rates below their natural rate, thus moderating, or in the best-case scenario, eliminating the business cycle.
[Editor’s note: the following piece was originally published by World Dollar at zerohedge.com]
In 2003, Jörg Guido Hülsmann, a senior fellow of the Mises Institute, published the essay “Has Fractional-Reserve Banking Really Passed the Market Test?” in a Winter edition of The Independent Review. The key conclusion drawn was that it is the obfuscation of the difference between fractional-reserve IOUs and genuine money titles which preserves the the practice of fractional-reserve banking.
It is the belief of this author that this essay has not received the acclaim that it so richly deserves. Indeed, its implications for the future of money and banking are monumentous. If those who advance the Austrian School of economics, the Mises Institute and Zero Hedge most prominently among them, were to grant its ideas a great renaissance, the worldwide return to sound money may happen far sooner than most could have believed possible.
J.G. Hülsmann explains why “in a free market with proper product differentiation, fractional-reserve banking would play virtually no monetary role” (p.403). The incisive reason given is that genuine money titles are valued at par with money proper, while fractional-reserve IOUs + RP (Redemption Promise) would be valued below par, due to default risk.
Here is the deductive argument being made:
1. Debt (IOUs + RP) is promised money.
2. A promise has the risk of not being kept (default risk).
3. Therefore, promised money, debt (IOUs + RP), is less valuable than genuine money titles (/money proper).
J.G. Hülsmann goes on to explain why the mispricing of fractional-reserve debt (IOUs + RP) persists. The reasons given include the outlawing of genuine money titles and deceptive language (“deposits”). This author would like to add one more reason, namely the myth that the government could actually “guarantee” deposits in the event of a systemic run. Systemic runs mean, by definition, most if not all money proper exiting the fractional reserve banking system, meaning the money proper with which the “guarantees” could be fulfilled doesn’t exist, short of unprecedented levels of new money printing and financial repression. This point is acknowledged on p.22 of the otherwise unexceptional “The Chicago Plan Revisited” by Jaromir Benes and Michael Kumhof.
The history of fractional reserve banking is, then, defined by informational inefficiency. Market participants have failed to reflect the price differential between fractional reserve debt (IOUs + RP) and genuine money titles.
Let us now extend the deductive argument:
4. Therefore, an arbitrage opportunity exists. All holders of Debt (IOUs + RP) have an economic incentive to make the redemption request for genuine money titles (/money proper).
Mervyn King, ex-governor of the Bank of England, once claimed that it is irrational to start a bank run, but rational to participate in one once it has started. While the second part of the claim is correct, the first is not. It is irrational not to start a bank run, due to the arbitrage opportunity that exists.
This, of course, holds the assumption that the market will become informationally efficient, and will therefore capitalise on the mispricing. But the holding of this assumption is only credible if this idea is spread. We live in a time with an unprecedented level of competing voices wanting to be heard, the unfortunate consequence of which is that we drown out the voices that are truly exceptional. It is no exaggeration to say that “Has Fractional-Reserve Banking Really Passed the Market Test?” may prove to be the most revolutionary essay in the history of monetary economics and banking, if only it receives the level of appraisal and promotion it deserves.
On this matter, the reasons given for the persistence of the mispricing of fractional-reserve debt (IOUs + RP) are unsustainable in the long run. The lack of legal protection for genuine money titles is no more than a technicality, for there is nothing in practice that can sustainably prevent the existence of full reserve banks. Awareness that “deposits” are not actually money being held for safekeeping is a matter of educating the public, as is awareness that government’s deposit “guarantees” are not actually credible in the event of a systemic run.
If we assume, then, that fractional-reserve banking will come to its logical ending, there is good reason to believe that the shock will herald the endgame for fiat money. It is in fact the case that all fiat money is the liability of the central bank, which also carries the risk of non-repayment (default risk). This, again, means an arbitrage opportunity for market participants to withdraw the fiat money from the fiat money banking system. This confirms that the original basis for fiat money is destroyed, for its repayment to the central bank is not credible.
Finally, at long last, we have a worldwide return to sound money. Will there be a new 21st century Gold Standard? Will we recourse to cryptocurrencies such as Bitcoin? Will we see the rise of the Equal Opportunity Standard, with everyone in the world being issued once with an equal amount of World dollars? Or will there be another innovation to come? What we must defend, as proud advocates of freedom, is that the free market will decide. That governments finally learn to stop their oppressive, damaging interference with the monetary system.
[Editor’s note: This article also appears on Detlev Schlichter’s blog here. It is reproduced with kind permission and should NOT be taken to be investment advice.]
Investors and speculators face some profound challenges today: How to deal with politicized markets, continuously “guided” by central bankers and regulators? To what extent do prices reflect support from policy, in particular super-easy monetary policy, and to what extent other, ‘fundamental’ factors? And how is all this market manipulation going to play out in the long run?
New York Stock Exchange 1963 (Photo: Wikimedia; US News and World Report; Library of Congress)
It is obvious that most markets would not be trading where they are trading today were it not for the longstanding combination of ultra-low policy rates and various programs of ‘quantitative easing’ around the world, some presently diminishing (US), others potentially increasing (Japan, eurozone). As major US equity indices closed last week at another record high and overall market volatility remains low, some observers may say that the central banks have won. Their interventions have now established a nirvana in which asset markets seem to rise almost continuously but calmly, with carefully contained volatility and with their downside apparently fully insured by central bankers who are ready to ease again at any moment. Those who believe in Schumpeter’s model of “bureaucratic socialism”, a system that he expected ultimately to replace capitalism altogether, may rejoice: Increasingly the capitalist “jungle” gets replaced with a well-ordered, centrally managed system guided by the enlightened bureaucracy. Reading the minds of Yellen, Kuroda, Draghi and Carney is now the number one game in town. Investors, traders and economists seem to care about little else.
“The problem is that we’re not there [in a low volatility environment] because markets have decided this, but because central banks have told us…” Sir Michael Hintze, founder of hedge fund CQS, observed in conversation with the Financial Times (FT, June 14/15 2014). “The beauty of capital markets is that they are voting systems, people vote every day with their wallets. Now voting is finished. We’re being told what to do by central bankers – and you lose money if you don’t follow their lead.”
That has certainly been the winning strategy in recent years. Just go with whatever the manipulators ordain and enjoy rising asset values and growing investment profits. Draghi wants lower yields on Spanish and Italian bonds? – He surely gets them. The US Fed wants higher equity prices and lower yields on corporate debt? – Just a moment, ladies and gentlemen, if you say so, I am sure we can arrange it. Who would ever dare to bet against the folks who are entrusted with the legal monopoly of unlimited money creation? “Never fight the Fed” has, of course, been an old adage in the investment community. But it gets a whole new meaning when central banks busy themselves with managing all sorts of financial variables directly, from the shape of the yield curve, the spreads on mortgages, to the proceedings in the reverse repo market.
Is this the “new normal”/”new neutral”? The End of History and the arrival of the Last Man, all over again?
The same FT article quoted Salman Ahmed, global bond strategist at Lombard Odier Investment Managers as follows: “Low volatility is the most important topic in markets right now. On the one side you have those who think this is the ‘new normal’, on the other are people like me who think it cannot last. This is a very divisive subject.”
PIMCO’s Bill Gross seems to be in the “new normal” camp. At the Barron’s mid-year roundtable 2014 (Barron’s, June 16, 2014) he said: “We don’t expect the party to end with a bang – the popping of a bubble. […] We have been talking about what we call the New Neutral – sluggish but stable global growth and continued low rates.”
In this debate I come down on the side of Mr. Ahmed (and I assume Sir Michael). This cannot last, in my view. It will end and end badly. Policy has greatly distorted markets, and financial risk seems to be mis-priced in many places. Market interventions by central banks, governments and various regulators will not lead to a stable economy but to renewed crises. Prepare for volatility!
Bill Gross’ expectation of a new neutral seems to be partly based on the notion that persistently high indebtedness contains both growth and inflation and makes a return to historic levels of policy rates near impossible. Gross: “…a highly levered economy can’t withstand historic rates of interest. […] We see rates rising to 2% in 2017, but the market expects 3% or 4%. […] If it is close to 2%, the markets will be supported, which means today’s prices and price/earnings are OK.”
Of course I can see the logic in this argument but I also believe that high debt levels and slow growth are tantamount to high degrees of risk and should be accompanied with considerable risk premiums. Additionally, slow growth and substantial leverage mean political pressure for ongoing central bank activism. This is incompatible with low volatility and tight risk premiums. Accidents are not only bound to happen, they are inevitable in a system of monetary central planning and artificial asset pricing.
Low inflation, low rates, and contained market volatility are what we should expect in a system of hard and apolitical money, such as a gold standard. But they are not to be expected – at least not systematically and consistently but only intermittently – in elastic money systems. I explain this in detail in my book Paper Money Collapse – The Folly of Elastic Money. Elastic money systems like our present global fiat money system with central banks that strive for constant (if purportedly moderate) inflation must lead to persistent distortions in market prices (in particular interest rates) and therefore capital misallocations. This leads to chronic instability and recurring crises. The notion that we might now have backed into a gold-standard-like system of monetary tranquility by chance and without really trying seems unrealistic to me, and the idea is even more of a stretch for the assumption that it should be excessive debt – one of elastic money’s most damaging consequences – that could, inadvertently and perversely, help ensure such stability. I suspect that this view is laden with wishful thinking. In the same Barron’s interview, Mr. Gross makes the statement that “stocks and bonds are artificially priced,” (of course they are, hardly anyone could deny it) but also that “today’s prices and price/earnings are OK.” This seems a contradiction to me. Here is why I believe the expectation of the new neutral is probably wrong, and why so many “mainstream” observers still sympathize with it.
- Imbalances have accumulated over time. Not all were eradicated in the recent crisis. We are not starting from a clean base. Central banks are now all powerful and their massive interventions are tolerated and even welcome by many because they get “credited” with having averted an even worse crisis. But to the extent that that this is indeed the case and that their rate cuts, liquidity injections and ‘quantitative easing’ did indeed come just in time to arrest the market’s liquidation process, chances are these interventions have sustained many imbalances that should also have been unwound. These imbalances are probably as unsustainable in the long run as the ones that did get unwound, and even those were often unwound only partially. We simply do not know what these dislocations are or how big they might be. However, I suspect that a dangerous pattern has been established: Since the 1980s, money and credit expansion have mainly fed asset rallies, and central banks have increasingly adopted the role of an essential backstop for financial markets. Recently observers have called this phenomenon cynically the “Greenspan put” or the “Bernanke put” after whoever happens to lead the US central bank at the time but the pattern has a long tradition by now: the 1987 stock market crash, the 1994 peso crisis, the 1998 LTCM-crisis, the 2002 Worldcom and Enron crisis, and the 2007/2008 subprime and subsequent banking crisis. I think it is not unfair to suggest that almost each of these crises was bigger and seemed more dangerous than the preceding one, and each required more forceful and extended policy intervention. One of the reasons for this is that while some dislocations get liquidated in each crisis (otherwise we would not speak of a crisis), policy interventions – not least those of the monetary kind – always saved some of the then accumulated imbalances from a similar fate. Thus, imbalances accumulate over time, the system gets more leveraged, more debt is accumulated, and bad habits are being further entrenched. I have no reason to believe that this has changed after 2008.
- Six years of super-low rates and ‘quantitative easing’ have planted new imbalances and the seeds of another crisis. Where are these imbalances? How big are they? – I don’t know. But I do know one thing: You do not manipulate capital markets for years on end with impunity. It is simply a fact that capital allocation has been distorted for political reasons for years. Many assets look mispriced to me, from European peripheral bond markets to US corporate and “high yield” debt, to many stocks. There is tremendous scope for a painful shake-out, and my prime candidate would again be credit markets, although it may still be too early.
- “Macro-prudential” policies create an illusion of safety but will destabilize the system further. – Macro-prudential policies are the new craze, and the fact that nobody laughs out loud at the suggestion of such nonsense is a further indication of the rise in statist convictions. These policies are meant to work like this: One arm of the state (the central bank) pumps lots of new money into the system to “stimulate” the economy, and another arm of the state (although often the same arm, namely the central bank in its role as regulator and overseer) makes sure that the public does not do anything stupid with it. The money will thus be “directed” to where it can do no harm. Simple. Example: The Swiss National Bank floods the market with money but stops the banks from giving too many mortgage loans, and this avoids a real estate bubble. “Macro-prudential” is of course a euphemism for state-controlled capital markets, and you have to be a thorough statist with an iron belief in central planning and the boundless wisdom of officers of the state to think that this will make for a safer economy. (But then again, a general belief in all-round state-planning is certainly on the rise.) The whole concept is, of course, quite ridiculous. We just had a crisis courtesy of state-directed capital flows. For decades almost every arm of the US state was involved in directing capital into the US housing market, whether via preferential tax treatment, government-sponsored mortgage insurers, or endless easy money from the Fed. We know how that turned out. And now we are to believe that the state will direct capital more sensibly? — New macro-“prudential” policies will not mean the end of bubbles but only different bubbles. For example, eurozone banks shy away from giving loans to businesses, partly because those are costly under new bank capital requirements. But under those same regulations sovereign bonds are deemed risk-free and thus impose no cost on capital. Zero-cost liquidity from the ECB and Draghi’s promise to “do whatever it takes” to keep the eurozone together, do the rest. The resulting rally in Spanish and Italian bonds to new record low yields may be seen by some as an indication of a healing Europe and a decline in systemic risk but it may equally be another bubble, another policy-induced distortion and another ticking time bomb on the balance sheets of Europe’s banks.
- Inflation is not dead. Many market participants seem to believe that inflation will never come back. Regardless of how easy monetary policy gets and regardless for how long, the only inflation we will ever see is asset price inflation. Land prices may rise to the moon but the goods that are produced on the land never get more expensive. – I do not believe that is possible. We will see spill-over effects, and to the extent that monetary policy gets traction, i.e. leads to the expansion of broader monetary aggregates, we will see prices rise more broadly. Also, please remember that central bankers now want inflation. I find it somewhat strange to see markets obediently play to the tune of the central bankers when it comes to risk premiums and equity prices but at the same time see economists and strategists cynically disregard central bankers’ wish for higher inflation. Does that mean the power of money printing applies to asset markets but will stop at consumer goods markets? I don’t think so. – Once prices rise more broadly, this will change the dynamic in markets. Many investors will discount points 1 to 3 above with the assertion that any trouble in the new investment paradise will simply be stomped out quickly by renewed policy easing. However, higher and rising inflation (and potentially rising inflation expectations) makes that a less straightforward bet. Inflation that is tolerated by the central banks must also lead to a re-pricing of bonds and once that gets under way, many other assets will be affected. I believe that markets now grossly underestimate the risk of inflation.
Some potential dislocations
Money and credit expansion are usually an excellent source of trouble. Just give it some time and imbalances will have formed. Since March 2011, the year-over-year growth in commercial and industrial loans in the US has been not only positive but on average clocked in at an impressive 9.2 percent. Monetary aggregate M1 has been growing at double digit or close to double-digit rates for some time. It presently stands at slightly above 10 percent year over year. M2 is growing at around 6 percent.
U.S. Commercial & Industrial Loans (St. Louis Fed – Research)
None of this must mean trouble right away but none of these numbers indicate economic correction or even deflation but point instead to re-leveraging in parts of the US economy. Yields on below-investment grade securities are at record lows and so are default rates. The latter is maybe no surprise. With rates super-low and liquidity ample, nobody goes bust. But not everybody considers this to be the ‘new normal’: “We are surprised at how ebullient credit markets have been in 2014,” said William Conway, co-founder and co-chief executive of Carlyle Group LP, the US alternative asset manager (as quoted in the Wall Street Journal Europe, May 2-4 2014, page 20). “The world continues to be awash in liquidity, and investors are chasing yield seemingly regardless of credit quality and risk.”
“We continually ask ourselves if the fundamentals of the global credit business are healthy and sustainable. Frankly, we don’t think so.”
1 trillion is a nice round number
Since 2009 investors appear to have allocated an additional $1trn to bond funds. In 2013, the Fed created a bit more than $1trn in new base money, and issuance in the investment grade corporate bond market was also around $1trn in 2013, give and take a few billion. A considerable chunk of new corporate borrowing seems to find its way into share buybacks and thus pumps up the equity market. Andrew Smithers in the Financial Times of June 13 2014 estimates that buybacks in the US continue at about $400bn per year. He also observes that non-financial corporate debt (i.e. debt of companies outside the finance sector) “expanded by 9.2 per cent over the past 12 months. US non-financial companies’ leverage is now at a record high relative to output.”
Most investors try to buy cheap assets but the better strategy is often to sell expensive ones. Such a moment in time may be soon approaching. Timing is everything, and it may still be too early. “The trend is my friend” is another longstanding adage on Wall Street. The present bull market may be artificial and already getting long in the tooth but maybe the central planners will have their way a bit longer, and this new “long-only” investment nirvana will continue. I have often been surprised at how far and for how long policy makers can push markets out of kilter. But there will be opportunities for patient, clever and nimble speculators at some stage, when markets inevitably snap back. This is not a ‘new normal’ in my view. It is just a prelude to another crisis. In fact, all this talk of a “new normal” of low volatility and stable markets as far as the eye can see is probably already a bearish indicator and a precursor of pending doom. (Anyone remember the “death of business cycles” in the 1990s, or the “Great Moderation” of the 2000s?)
Investors are susceptible to the shenanigans of the manipulators. They constantly strive for income, and as the central banks suppress the returns on many mainstream asset classes ever further, they feel compelled to go out into riskier markets and buy ever more risk at lower yields. From government bonds they move to corporate debt, from corporate debt to “high yield bonds”, from “high yield” to emerging markets – until another credit disaster awaits them. Investors thus happily do the bidding for the interventionists for as long as the party lasts. That includes many professional asset managers who naturally charge their clients ongoing management fees and thus feel obliged to join the hunt for steady income, often apparently regardless of what the ultimate odds are. In this environment of systematically manipulated markets, the paramount risk is to get sucked into expensive and illiquid assets at precisely the wrong time.
In this environment it may ultimately pay to be a speculator rather than an investor. Speculators wait for opportunities to make money on price moves. They do not look for “income” or “yield” but for changes in prices, and some of the more interesting price swings may soon potentially come on the downside, I believe. As they are not beholden to the need for steady income, speculators should also find it easier to be patient. They should know that their capital cannot be employed profitably at all times. They are happy (or should be happy) to sit on cash for a long while, and maybe let even some of the suckers’ rally pass them by. But when the right opportunities come along they hope to be nimble and astute enough to capture them. This is what macro hedge funds, prop traders and commodity trading advisers traditionally try to do. Their moment may come again.
As Sir Michael at CQS said: “Maybe they [the central bankers] can keep control, but if people stop believing in them, all hell will break loose.”
I couldn’t agree more.
Seth Lipsky, the editor of the storied New York Sun
(a brand distinguished by the long residency of Henry Hazlitt), recently, in the Wall Street Journal
, brought to wider attention certain remarkable recent comments by Paul Volcker. Volcker spoke before the May 21st annual meeting of the Bretton Woods Committee at the World Bank Headquarters in Washington, DC. Volcker’s remarks did not present a departure in substance from his long-standing pro-rule position. They nonetheless were striking, newly emphatic both by tone and context.
Volcker, asked by the conference organizer for his preferred topic, declared that he had said:
“What About a New Bretton Woods???” – with three question marks. The two words, “Bretton Woods”, still seem to invoke a certain nostalgia – memories of a more orderly, rule-based world of financial stability, and close cooperation among nations. Following the two disasters of the Great Depression and World War II that at least was the hope for the new International Monetary Fund, and the related World Bank, the GATT and the OECD.
No one here was actually present at Bretton Woods, but that was the world that I entered as a junior official in the U.S. Treasury more than 50 years ago. Intellectually and operationally, the Bretton Woods ideals absolutely dominated Treasury thinking and policies. The recovery of trade, the opening of financial markets, and the lifting of controls on current accounts led in the 1950’s and 60’s to sustained growth and stability.
The importance, especially from a speaker of Volcker’s stature presenting among the current heads of the two leading Bretton Woods institutions, the IMF’s Christine Lagarde, and the World Bank Group’s Jim Yong Kim, among other luminaries, potentially has radical implications. Volcker provided a quick and precise summary of the monetary and financial anarchy which succeeded his dutiful dismantling of Bretton Woods:
Efforts to reconstruct the Bretton Woods system, either partially at the Smithsonian or more completely in the subsequent negotiations of the Committee of 20, ultimately failed. The practical consequence, and to many the ideological victory, was a regime of floating exchange rates. Somehow, the intellectual and convenient political argument went, differences among national financial and economic policies, shifts in competitiveness and in inflation rates, all could be and would be smoothly accommodated by orderly movements in exchange rates.
How’s that working out for us? Volcker played an instrumental role in dutifully midwifing, as Treasury undersecretary for monetary affairs under the direction of Treasury Secretary John Connally the “temporary” closing of the gold window announced to the world on August 15, 1971 by President Nixon. Volcker now unequivocally indicts the monetary regime he played a key role in helping to foster.
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.
The United States, in particular, had in the 1970’s an unhappy decade of inflation ending in stagflation. The major Latin American debt crisis followed in the 1980’s. There was a serious banking crisis late in that decade, followed by a new Mexican crisis, and then the really big and damaging Asian crisis. Less than a decade later, it was capped by the financial crisis of the 2007-2009 period and the great Recession. Not a pretty picture.
Volcker fully recognizes the difficulties in restoring a rule-based well functioning system both in his speech and in this private comment to Lipsky made thereafter. Lipsky: “It’s easy to say what’s wrong,” Mr. Volcker told me over the weekend, “but sensible reforms are a pretty tough thing.”
The devil, of course, is in the details. What rule should prevail? There is an almost superstitious truculence on the part of world monetary elites to consider the restoration of the gold standard. And yet, the Bank of England published a rigorous and influential study in December 2011, Financial Stability Paper No. 13, Reform of the International Monetary and Financial System. This paper contrasts the empirical track record of the fiduciary dollar standard directed by Secretary Connally and brought into being (and then later administered by) Volcker. It determines that the fiduciary dollar standard has significantly underperformed both the Bretton Woods gold exchange standard and the classical gold standard in every major category.
As summarized by Forbes.com
contributor Charles Kadlec, the Bank of England found
When compared to the Bretton Woods system, in which countries defined their currencies by a fixed rate of exchange to the dollar, and the U.S. in turn defined the dollar as 1/35 th of an ounce of gold:
- Economic growth is a full percentage point slower, with an average annual increase in real per-capita GDP of only 1.8%
- World inflation of 4.8% a year is 1.5 percentage point higher;
- Downturns for the median countries have more than tripled to 13% of the total period;
- The number of banking crises per year has soared to 2.6 per year, compared to only one every ten years under Bretton Woods;
That said, the Bank of England paper resolves by calling for a rules-based system, without specifying which rule. Volcker himself presents as oddly reticent about considering the restoration of the “golden rule.” Yet, as recently referenced in this column, in his Foreword to Marjorie Deane and Robert Pringle’s The Central Banks (Hamish Hamilton, 1994) he wrote:
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.’ The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy.
There is an active dispute in Washington between Republicans, who predominantly favor a rule-based monetary policy, and Democrats, who predominantly favor a discretion-based monetary policy. The Republicans have not specified the rule they wish to be implemented. The specifics matter.
There is an abundance of purely empirical evidence for the gold standard’s effectiveness in creating a climate of equitable prosperity. The monetary elites still flinch at discussion the gold option. That said, the slow but sure rehabilitation of the legitimacy of the gold standard as a policy option was put into play by one of their own, no less than the then World Bank Group president Robert Zoellick, in an FT
op-ed, The G20 must look beyond Bretton Woods.
There he observed, in part, that “Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.”
There are many eminent and respectable elite proponents of the gold standard. Foremost among these Reagan Gold Commissioners Lewis E. Lehrman (with whose Institute this writer has a professional association) and Ron Paul, and Forbes Media CEO Steve Forbes, coauthor of a formidable new book, Money
, among them. There are many more, too many to list here.
In the penultimate paragraph of his remarks to the Bretton Woods Committee Volcker observes:
Walter Bagehot long ago set out succinctly a lesson from experience: “Money will not manage itself”. He then spoke from the platform of the Economist to the Bank of England. Today it is our mutual interdependence that requires a degree of cooperation and coordination that too often has been lacking on an international scale.
As the great Walter Layton, editor of the Economist, wrote in 1925, “the choice which presents itself is not one between a theoretical standard on the one hand and gold with all its imperfections on the other, but between the gold standard … and no control at all.” “No control at all” anticipates Volcker’s own critique.
If Chairman Volcker overcame his aversion to considering the gold standard as a respectable option for consideration he just might find that his his stated concern “We are long ways from (a new Bretton Woods conference)” may be exaggerated. A golden age of equitable prosperity and financial stability is closer than Mr. Volcker believes.
The corollary to Volcker’s dictum, “ultimately the power to create is the power to destroy” is that the power to destroy is the power to create. It is time, and past time, Mr. Volcker, to give full and respectful consideration to the gold standard which served the world very well indeed and would serve well again.
This article was previously published at Forbes.com
According to the French historian Fernand Braudel, to understand the present we should master the whole of world history. The same may be said for the rate of interest: to grasp its significance we should have a full understanding of the whole of economics. Interest is the most important price of economy, the most pervading, as pointed out by the American economist Irving Fisher. Interest plays a key role in affecting all economic activity: interest and the price level are strictly interconnected, subject to leads and lags, they move in the same direction. A falling interest rate induces falling prices and a rising interest induces rising prices. Capital values are derived from income value: if interest is 5%, a capital amount yielding $100 every year has a value of $2,000. The interest rate translates, as it were, the future into the present bridging capital to its income.
When interest drops from a high down to a low level it raises the capitalized value of equipments, bonds, annuities or any other assets providing a stream of future incomes. The rate of interest reveals the individual’s rate of time preference or their “impatience for money”: the inclination towards current consumption over future consumption and vice versa. For example if the individual is indifferent between €1.04 next year and €1.00 today, his rate of time per preference per annum is four percent.
Interest can therefore be considered the minimum future amount of money required to compensate the consumer for foregoing current consumption. It is as it were, the return on sacrificing consumption towards more future consumption. When time preference falls, savings rise and interest falls. And the lower the time preference the more the supply of income saved and transferred in the form of credit to satisfy investment demand. In the economy there cannot be any real net investment without an equal amount of real net saving. The price balancing the supply of income (from savings) and the demand for it (for spending and investment) was defined by the Scandinavian economist Kurt Wicksell, the “natural rate of interest”.
Its function is to ration out existing scarce savings into productive uses and to induce to sacrifice current consumption to add to the stock of capital. The 18th century French finance minister Anne-Robert-JacquesTurgot put it this way:
The current interest of money is the is the thermometer by which the abundance or scarcity of capitals may be judged; it is the scale on which the extent of a nation’s capacity for enterprises in agriculture, manufactures, and commerce, may be reckoned.. Interest may be looked upon as a kind of like a sea level …… under which all labor, culture, industry, commerce cease to exist». In the contemporary economy interest is a monetary tool by which central banks pretend to regulate the abundance of capital. Unfortunately in doing so they make the economy sink under the sea level. To understand this effect the rate of interest has to be investigated through its relation with money and capital.
Interest and Money
In ordinary language interest is defined either as the cost or the price for borrowing money, but these notions are partly true. If interest is a cost for the borrower is also an income for the lender. On the other hand by defining interest as a “price” we are lead into thinking that it varies inversely to the money quantity. This is what the monetary theory of the interest holds. Despite some appearance of truth it is a fallacious doctrine because being also the interest a quantity of money paid or collected against a loan it varies in direct proportion to the quantity of money. For example, if a loan was $100 earning $5, and the money supply doubled, it will rise to $200 earning $10. Interest must double to make loans equivalent (in fact: 5/100=10/200) although in percentage remains unchanged. If anything, other things being equal, an increase of money supply causes interest to rise, not to fall, for the “price of money” is not interest but money purchasing power. Furthermore the definition of interest as the price for money obscures the fact that what is exchanged in a loan is not money but present money against future money, namely credit. Credit is the temporary transfer of wealth or purchasing power from one person to another upon payment of interest. Since purchasing power is wealth and wealth producing income is capital, the rate of interest is the income paid for the use of capital. But what is used is not “abstract capital” because there is not a generic demand for capital, otherwise there would be no difference between the interest rate and the discount rate, but between the money market and the capital market. When a person asks for a loan for consumption he is not asking for capital but for money as means of payment. Who discounts bills or notes does not need capital he already has in some form or another, he wants to transform it in a more liquid form. Ultimately he needs “liquidity” not to expand his capital or business but to anticipate its monetary form. Because most businesses due to seasonal fluctuations cannot be conducted on a cash basis they need credit or liquidity just to compensate these fluctuations. The price for the temporary use of liquidity is the rate of discount. It doesn’t represent interest on capital but a rent, as it were, measuring the value of the money services namely for specific services: making the flow of the production smooth, keeping solvency or allowing specific profits in money transactions. The whole all transactions involving transfers of liquidity used to increase the marketability of all the forms of wealth as to render them more fluid, form the money market. Here money is invested without losing its form, without turning itself into capital which is the money income employed in production. However, liquidity emerging as cash surpluses to fund cash balances deficits, is always grounded on capital operations and being limited by the use of capital depends on the rate of interest.
Interest and capital
While the rate of discount concerns money or short term credit to anticipate the monetary form of real capital, the rate of interest concern the money or long term credit to extend real capital. So it is a long rate not a discount rate because what is lent is not money but capital (which is wealth employed in view of more future production). Hence the purpose of capital or long credit market is to provide the nexus between savers and borrowers to finance productive investments and expand the economy. Thus interest is the price balancing the supply and demand for money capital. An increased supply competing for borrowers pushes down the interest. An increases demand competing for lenders pushes up interest. The interaction supply/demand establishes the rate of interest at the point where the lenders rate of time preference tends to equal the borrowers rate of profit. This is because the use of capital depends on its marginal utility: in the market it is convenient to borrow till the income earned from the use of capital will exceed the cost of its use coinciding with the rate of time preference. So interest is the price of money capital as determined by the interaction between the least productive use and the savers’ return on sacrificing consumption. In practice it oscillates between an upper limit and a lower limit. The former is the rate of profit, otherwise borrowing would not be convenient, and the latter the rate of time preference which represents for the economy as a whole the cost of capital accumulation. This lower limit cannot be zero otherwise lenders would use income directly giving up sacrificing current consumption.
However because the rate of interest reflects the productivity of capital and it’s convenient to borrow until capital yields a positive income, it is the rate of profit that commands the rate of interest. Hence interest may also be defined as the market price of money capital typified by the rate of profit.
To the extent people are provident and have a low time preference, the capital is abundant, the rate of interest is low and long term capital-intensive projects can be undertaken, the economy expands, technological progress advances and wages productivity rises. Conversely, if the time preference is high, capital is scarce, interest higher and more liquid projects prevail. However according to the monetary theory the market rate of interest is typified by the return or yield per year on riskless long term government bonds which are deemed to typify the benchmark for the rate of profit on capital assets. Yet because governments consume instead of producing the bond yield typifies the shifts of income supply towards consumption uses. In fact the lower the bond yield the higher the government consumption and the lesser the capital available for production. Therefore bond yields reflect propensity to consume, in contrast with interests on capital reflecting propensity to invest.
Because capital it is tied up for long time in production and regain its liquid form after the sale of products, the rate of interest has a different economic nature than the rate of discount: while the latter is subject to money fluctuations, the former is less sensitive to them for it gives up its monetary form for an extended period until the time of loan repayment. Moreover by borrowing liquidity one looks at prospects of immediate gain while by borrowing capital one looks at incomes over a longer period of time. In general, the interest rate is higher than the discount rate because being less liquid commands a premium for liquidity. However when production languishes, profits fall, capital withdraws from production, interest falls while discount rate rises as demand for short-term loans rises to preserve liquidity. Interest rises during periods of economic development when present income is sacrificed and invested in capital. Once capital starts to produce new income, interest falls setting the pace for the boom period when discount rises because the higher volume of spending increases demand for money. So in general they vary independently from one another. Although there is a constellation of rates of interest depending on the loan maturities, all tend to a same level. Money capital moves where it is most needed, runs from less profitable assets to more profitable ones and like water flows to find its level. So by continuous market oscillations any capital tends to provide the same income any difference due to the risk.
It’s worth noting that if the liquidity of capital invested is lost for many years it can be regained at any time in the stock exchange by selling shares. However because shares represent titles on already existing capital, their sale does not adds to capital stock and doesn’t affect the rate of interest, rather it adds to liquidity affecting the discount rate.
Other interest rate determinants
Interest as a market price arising from the interaction between the rate of profit and the time preferences governs the price of capital assets as well as their allocation other things being equal. In fact, because the rate of profit arises in the economic system as a difference between the prices of products and the prices of factors of production to manufacture them, it is affected by these price levels. Fluctuations in these prices cause fluctuations in the rate of profit and as consequence in the rate of interest which is typified by the rate of profit. And because capital assets are determined by discounting their expected returns by interest rates of the same maturities as the life of the capital assets,it follows that all capital allocation in the market is affected by the ratio of demand to supply of both products and factors of production.
However, the value of money is also determined by supply and demand of money. If interest, in essence, depends on real factors such as time preferences, rate of profit and supply and demand, being itself a money sum must logically be dependent on the value of money although indirectly. To explain the emergence of interest the Austrian economist Eugene Bohm Bawerk argued that because present goods due to the time preference worth more than future goods of like kind and quantity, they command a premium over the future goods. In other terms, interest is the discount of future goods as against present goods or the demand price of present goods in term of future goods. However, once goods are priced in term of money, the interest rate becomes a ratio of exchange between present and future money sums and its value may not coincide with the ratio between their physical quantities because of changes occurring in the prices level. If, for example the money supply rises, the value of the expected monetary sum lent falls. Then savers expecting a rise in prices will ask for a higher interest to compensate for the loss in the value of loan capital (this confirms the mistake of monetary theory in claiming that a rise in the money supply lowers interest). Because money affects the value of real capital it’s wrong to assert (as Knut Wicksell did) that a loan might be likened to a temporary transfer of goods repayable in goods rewarded by an interest paid also in goods and determined by the supply and demand of physical goods. Interest cannot be appraised by abstracting from money because as the money value changes so does the value of real factors determining interest, all acting through money. Only if the value of money were constant would the “real” and “monetary” interest coincide.
As Ludwig von Mises pointed out, interest is a category of human action, a primordial phenomenon unlikely to disappear even in the most ideal world. In fact the forces determining interest prevents it from falling permanently to zero or even below. If it were zero saved income could not be exchanged for more future income or to say it differently, the valuation between present and future goods would be at par which may happen only in world where all goods would be free and no capital would be necessary to produce them. If the interest were negative future goods would command a premium on present goods, a reversal of human nature whereby present goods would be valued less than future goods and lenders would have to pay an interest instead of receiving it. The capital would shrink and the economy would regress. Such extreme values which are a little like to the absolute zero in physics, may be only inflicted to interest by exceptional circumstances such as revolutions, seizures, thefts, invasions all situations of great danger when people would prefer to pay a “penal rate” rather than lose their entire capital. Still, in the contemporary economy, similar abnormal situations are artificially created. This is because interest is not commanded by the self generating forces regulating the rate of interest, but by the central banks planned monetary policy closely related to the governments’ fiscal policy.
Central banks set an official or discount rate, a minimum and arbitrary lending rate, the “price for liquidity”, which varies through monetary policy consisting of buying and selling in the open market governments issued bonds against such liquidity. Thus monetary policy acts as a pressure and suction pump alternately decreasing and increasing the quantity of money to push the interest up and down either to keep bonds in the desired relationship with the official rate or to provide a money supply favorable to economic stability and growth. In so doing central banks mimic the natural tendency of interest. For example by expanding money supply during recessions they lower the official rate as this were the after effect of new income streams arising out of foregoing savings required to restore economic growth. The long term rate then changes through expectations towards the official rate: if the latter falls the former is expected to rise and vice versa. However because interests are used to determine the present value of capital assets by discounting their expected income, monetary policy misprices capital assets and misallocate them. This is because the entire interest market structure (the relationship among interest rates influencing prices of income producing assets of different maturity) depends solely on liquidity fluctuations commanded by monetary policy which is completely divorced from the real factors that determine the interest and lay the foundation of liquidity. So not in any sense can the market rate of interest be compared with the one determined by central banks. By ignoring the distinction between money and capital, monetary policy denies the natural function of time preferences and rate of profit confining them to an adaptive role vis-à-vis of their monetary manipulation.
On the other hand because government bonds provide the basis for the money expansion that grows as interest drops, the official rate may be looked upon as a tool of fiscal policy reflecting capital dissipation.This is because central banks pay for these bonds not with income released by foregoing capital operations, but with means of payment they themselves “coin” and lend as they were saved income. This manoeuvre – also known as credit easing – is tantamount to discounting and putting into circulation expected wealth as if it were current wealth, to consume or to use as capital. In other words, central banks by advancing means of payment act as the future were so prosperous as to pledge an ever increasing wealth allowing for their repayment. But the fact is that the most of these means of payment passed off as an existent wealth besides using up, without replacing, the wealth already produced, will never be repaid for they will be misallocated into unproductive uses by a rate of interest not reflecting the existence of money capital but the mere expansion of means of payment that, as already pointed out, should cause interest to rise, not to fall. The paradox is that subsequent rounds of this expansion entail equivalent rounds of waste making capital scarcer and scarcer. Thus economic downturns are just the result of the attempt to create capital on the foundation of monetary policy rather than on the foundation of the real factors determining the rate of interest. Unfortunately, they tend to become permanent to the extent central banks in trying to alleviate them expand money by buying bonds on a huge scale so as to push interest down to zero. But at this level lenders, having no incentive to turn income into capital, will turn capital into income which means they will be living out of their capital until is depleted. As interest vanishes “under the sea level” so does capital till “labour, culture, industry, or commerce will cease to exist” as Turgot predicted long ago.