Recent statistics are confirming “economic recovery” in the UK and even some of the weaker eurozone states. I put this in quotes, because what we are seeing is expanding nominal GDP, which is not the same thing. GDP reflects money and credit going into the economy, which everyone believes is the same thing.
Instead of economic recovery, GDP is reflecting money leaving financial markets, particularly bonds, for less interest-rate sensitive havens. Globally, bonds represent invested capital of over $150 trillion, or more than twice global GDP, so even marginal amounts unleashed by rising bond yields can be financially destabilising and the effect on GDP growth could be electric. The mistake of confusing economic progress (a better description of what we all desire) with GDP is about to bite the economic establishment big-time and pressure for interest rates to rise early and substantially will intensify as a result, dragged up by those rising bond yields.
The problem facing central planners is that this GDP chimera is driven by a predominantly financial community that has money to invest in capital assets such as housing and even motor cars. The vast majority of economic actors, comprised of pensioners, low-wage workers living from payday to payday and the unemployed are simply disadvantaged as prices, already often beyond their reach, become even more unaffordable. It is a misfortune encapsulated in the concept of the Pareto Principle, otherwise known as the 80/20 rule, the law of the vital few, where the substantial majority will be badly squeezed by rising prices generated by the spending of that few.
The central planners are understandably focused on the misfortunes of the majority. For many of them, as prices start to rise so too do costs for their employers, many of which will be squeezed out of business. How can interest rates possibly be permitted to rise in the face of these dangers?
Central banks have drawn their line in the sand over interest rates and they will eventually be forced to reconsider their position. They are almost certain to be too slow in raising interest rates and so the markets will continually expect higher bond yields and higher interest rates to come. For those of us with long memories it is a repeat of the late-seventies stagflation era. Except this time, aggressively raising interest rates to stabilise the purchasing power of the currency is not an option: it will simply break the banking system lumbered with its share of the $150 trillion invested in bonds.
Markets are blithely assuming that central banks are in control of events. They are not even in control of their own governments’ profligacy, and they are losing their control over markets as well, as the tapering episode showed. The fatal error of rescuing both the banking system and government finances by reckless currency inflation is in the process of becoming apparent to all. Unless this policy is somehow reversed we risk a global rerun of the collapse of the German mark in 1923.
This article was previously published at GoldMoney.com.
It was not too surprising that there is going to be no tapering for some very good reasons. The commencement of tapering would have led deliberately to bond yields rising, triggered by an increase in sales of government bonds to the public and at the same time escalating sales by foreign governments as they attempt to retain control over their own currencies and interest rates. This was the important lesson from floating the rumour of tapering in recent months.
The reason tapering was not going to happen is summarised as follows:
1. Monetarists and therefore central bankers believe that rising bond yields and interest rates will strangle economic recovery. They want to see more robust evidence of recovery before permitting that to happen.
2. Rising bond yields would have required the Fed to raise interest rates sooner rather than later to stem the flight of bank deposits from the Fed’s own balance sheet held as excess reserves, which only earn 0.25%.
3. Importantly, the global banking system has too much of its collective balance sheet invested in fixed-interest bonds, and is also exposed to rising interest rates through interest rate swap derivatives. Tapering would almost certainly have precipitated a second bank crisis starting at the system’s weakest point.
4. The cost of funding the US Government’s deficit would have risen, difficult when the debt ceiling has to be renegotiated yet again.
5. Rising US interest rates will most probably destabilise emerging market currencies, risking a new Asian crisis.
6. It is a bad time to shift the burden of government funding back into the markets, because foreign holders have shown they will sell into rising yields.
The Fed has reaffirmed that zero interest rates will be with us for some time to come. It simply has no choice: it has to play down the risk of inflation. The result will be more price inflation, which is bad for the dollar and good for gold. This was reflected in the US Treasury yield curve, where prices of long maturities fell yesterday relative to the short end.
The markets had wrongly talked themselves into believing that tapering was going to happen, when the rumour was no more than an experiment. In the process precious metals were sold, driven by increasingly bearish technical talk every time a support level was breached. It is hardly surprising therefore that the recovery in gold and silver prices last night was dramatic, with gold moving up $70 and silver by $2 from intra-day lows. It looks like a significant second bottom is now in place above the June lows and the bear position, coupled with the shortage of physical metal will drive prices in the coming weeks.
The implications of the Fed not going ahead with tapering are bad for the dollar and won’t stop bond yields at the long end from rising. It shows that the whole US economy is in a massive debt trap that cannot be addressed for powerful reasons. The reality is the expansion of cash and deposits in the US banking system is tending towards hyperinflation and is proving impossible to stop. That is the message from this week’s FOMC meeting, and I expect it to gradually dawn on investors world-wide in the coming weeks.
I was grateful to the BBC World at One programme for giving me the opportunity today to comment on Mark Carney’s first Inflation Report. You can listen to what I said here.
The essence of what the Bank has announced is well known: they have begun using forward guidance to anchor both inflation and interest rate expectations as a cover for more active monetary policy.
This will usher in a new age of monetary Kremlinology.
The policy is all about the Committee’s intentions and judgments. It’s hedged about with provisos and escape routes. Journalists were quick to ask who thought what on the Committee, spotting that which thresholds are used and which judgments are made is dependent on the opinions of a few wise men.
If you read Mark Carney’s speech to the U.S. Monetary Policy Forum in New York last year, it is clear what he intends. Mark Carney apparently understands the critique of the Austrian School, but he believes it is “a counsel of despair for current problems” so he proposes to prevent the disruption easy money creates using “broader macroprudential management”.
Today’s announcement includes,
The guidance will remain in place only if, in the MPC’s view, CPI inflation 18 to 24 months ahead is more likely than not to be below 2.5%, medium-term inflation expectations remain sufficiently well anchored, and the FPC has not judged that the stance of monetary policy poses a significant threat to financial stability that cannot otherwise be contained through the considerable supervisory and regulatory policy tools of the various authorities.
In so far as we did not already, we now live in a world of extensive explicit discretionary power over both money and the financial system which ought to allocate real capital to the most productive uses. To believe this will end well is hubris.
Manipulating the expectations of millions of individuals, households, businesses and financial market participants will create herding on a mass scale. Like a loose load in a ship, that will result in severe instability.
Employment created through an “exceptionally stimulative monetary stance” will come to an end when that stimulation is withdrawn. In chasing its employment threshold, the Bank will paint the economy and society into a corner.
Inflation will take the Bank by surprise. The “slack in the economy”, on which the Bank is relying to avoid price inflation, will turn out to be wasted capital, not idle capital waiting to come back into use. Prices will rise.
I’m reminded of something I heard economist Steve Horwitz say, and I feel sure he will forgive and correct me if my notes are not faithful,
Central banks cannot solve the problems they created any more than an arsonist makes a good firefighter.
Unfortunately, Mark Carney is nevertheless about to conduct a grand experiment which will prove that this is so.
There is some evidence in the UK of a pick-up in consumer spending, probably echoed elsewhere. There are two likely factors behind this, the first perhaps being seasonal, aided by the fine weather. The second is less obvious, but combines with the first to encourage purchases of big ticket items; and this is cheap consumer finance coupled with growing expectations of higher interest rates in the future.
Interest rate expectations are therefore fuelling demand for big-ticket items, such as autos and electronic goods, where the cost of credit has been cut to maintain sales. There also appears to be growing demand for fixed-rate mortgages, and thanks to banks willing to borrow short and lend long there are some very tempting refinancing deals available. In summary, low financing costs plus a decent summer is the basis for kick-starting economic optimism.
Economists are already revising their GDP growth expectations upwards. However, there is likely to be a growing tendency for prices to rise due to capacity constraints in companies that have bolstered their profits by withholding investment for the last three or four years. Consequently price rises will be greater than generally expected.
The situation in the US is similar, with an added factor. US consumers are more responsive to confidence in stock markets and property prices than in the UK, and here the news has been bullish. Interest rates are low, and they will rise, so buy those big-ticket items now. The cost of buying and financing the average house purchase has already risen an estimated 40%.
Governments and economists will think they have the recovery they have wished for. Unfortunately it will almost certainly be marred by price inflation greater than the increase in demand suggests. So while nominal GDP growth rates will turn out to be somewhat better than currently expected, the talk will be of temporary capacity constraints.
The end result is that while central banks will realise that price inflation is a growing problem they will be reluctant to use higher interest rates to choke off inflation. And if consumers see central banks are behind this curve, further consumer borrowing will be encouraged.
This leads into the second phase of inflation. The first was expansion of cash and deposit money and the second is its mobilisation. The price effect is likely to be dramatic as money shifts from Wall Street to Main Street (or in British terms, from the City of London to the high street). However, there is an additional currency effect which few economists factor in: markets begin to discount the future purchasing power of paper currencies, bringing anticipated and higher prices forward in time, while central banks appear to be reluctant to raise interest rates. The Volcker remedy of raising interest rates to choke off inflation is simply not a policy-maker’s option.
The central banks are bound to be more focused on the damage from rising bond yields to government deficits and bank balance sheets. They will also be acutely aware of the effect higher borrowing costs has on today’s high levels of consumer debt.
The conclusion is that the central banks’ inflationary response to the banking crisis five years ago is going to get considerably more difficult in the coming months as monetary inflation morphs into price inflation.
This article was previously published at GoldMoney.com
From 2006 the Bank of England’s Annual Report has declared the quantity of gold in its custody, including the UK’s own 310 tonnes. Prior to that date a diminishing quantity of on-balance sheet gold (sight accounts) was recorded in the audited accounts, which then disappeared. This tells us that sight accounts (where the BoE acts as banker and not custodian) were dropped. This is sensible, because the BoE is no longer directly liable to other central banks while gold prices are rising.
Of course, the BoE doesn’t hold just central banks’ gold; it also holds gold on behalf of LBMA members. However, LBMA storage at the BoE is probably a fairly small part of the total, because the bulk of settled transactions are in unallocated accounts where the underlying owner does not own physical metal, and the majority of transactions are closed even before settlement is due. Furthermore LBMA members have their own storage facilities or use independent vaults. So to all intents we can regard the BoE’s custody gold as owned by central banks.
It should be borne in mind London is the most important market for physical delivery, particularly for central banks. For this reason most central banks buy, sell, swap or lease their monetary gold in London. The exceptions are Russia, China and the central Asian states who have been the main buyers of gold – always from their own mine output – and do not ship this gold to London; and having substantial foreign reserves from trade surpluses, they have no requirement to do so.
To add to our analytical difficulties, the custody figures presented are net of gold being leased, because leased gold is delivered out of custody. We know that the BoE encourages its central bank customers to pay for its expensive storage charges by earning leasing income, thanks to an unguarded admission from the Austrian central bank last year that it had defrayed its storage costs this way, and a Bundesbank statement that it withdrew gold from London rather than pay high storage fees. The BoE’s custody total is therefore a net figure, with significant quantities of gold out on lease and not actually in custody. However, we can derive some interesting information given the headline custody numbers and some reasonable assumptions.
We can therefore draw up a tentative table as follows:
The approach is to start with the declared gold in custody and subtract what we reasonably know exists to see what’s left. On reasonable assumptions (described in the notes to the table) we can account for all but 467 tonnes of the gold in the BoE’s custody in March 2006. However, remember this is a composite figure, because the BoE leases custodial gold by agreement with its customers – the majority of which will have been delivered out of custody to the market. We have no way of knowing whose gold is actually leased, but at least we more or less know what should be there.
We also know that the gold owned by the central banks represented in the table above plus that of Russia, China, the central Asian states and the US, totalled 12,361 tonnes in March 2006 according to the IMF/WGC statistics. The remaining central banks which are certain to keep gold in London between them owned 18,377 tonnes. To suggest that they had only 467 tonnes of this at the BoE is only true in the sense that some of their gold is out on lease. We can only speculate how much on the basis of what portion of 18,377 tonnes we would expect to be stored in London, but a figure in excess of 5,000 tonnes seems highly likely.
By March this year, the quantity of gold in custody had mysteriously risen from 3,532 tonnes to 6,284 tonnes, leaving a balance not-accounted-for in our table of 2,888 tonnes. Over the intervening years, western central banks officially sold 1,184 tonnes, most of which will have probably passed through the BoE’s vaults. This gold flow is not reflected in custody figures in the table.
The custody ledger is therefore more complicated than its face value. Gold is being leased and has gone out of the door. Gold is being held and not leased, and yet more gold has been shipped in from other centres to be sold, leased or swapped. The amount disclosed by the BoE is effectively a “float”: a net figure comprised of larger amounts. We can therefore assume that despite the rise in custodial gold, gold from the BoE vault has also been supplied to the market.
It is extraordinary that the BoE on behalf of other central banks has been arranging leasing contracts for gold that seems unlikely to return. The lessees may from time to time have been able to buy back the bullion to deliver to the lessor and re-deposited it back with the BoE; but most of bullion goes to India, China or South East Asia from whence it never returns. This may have been less of a problem before Chinese demand took off, people began buying ETFs, and there was a growing supply of scrap. But this has not been the case for several years now, and the remaining leasing agreements must have to be rolled forward, leaving central bank customers of the BoE semi-permanent creditors of bullion banks.
One can only surmise that the central banking community of North America and Europe see gold as an increasing embarrassment. Nevertheless it is hard to understand why central banks continue to lease gold, particularly after the banking crisis when central banks must have become more aware of systemic risks and the possibility their lessees might go bankrupt. More recently, leasing will have almost certainly been a source of finance for cash-strapped eurozone states, and might help explain how they have survived in recent months. However, this cannot go on for ever.
Since the Cyprus debacle
We now turn to the last column dated June this year. The figure for custodial gold of 4,977 tonnes is “at least 400,000 400-ounce bars” taken from tour-note 2 of the new virtual tour of the gold vaults on the BoE’s website. Tour-note 3 gives us the date the information was collated as June this year. This compares with the figure at February 28 from the BoE’s Annual Report of the equivalent of 505,117 bars. So it appears that at least 100,000 bars have disappeared in about four months.
Is the difference of 100,000 bars a mistake? The wording suggests not. The Bank appears to have thought that if it said in the virtual tour, “over 400,000 bars in custody” it would be sufficiently vague to be without meaning; but it is so much less than the figure in the Annual Report dated only four months earlier that it is unlikely to be a mistake. We must therefore conclude that they meant what they said, and that some 1,300 tonnes has left the vault since 1 March.
We now consider where this gold has gone. Gold demand in Europe began to accelerate after the Cyprus debacle at a time when Chinese and Indian demand was also growing rapidly. Meanwhile mine production was steady and scrap sales in the West were diminishing. This was leading to a crisis in the markets, with the bullion banks caught badly short. Hence the need for the price knock-down in early April.
The price knock-down appears to have been engineered on the US futures market, triggering stop-loss orders and turning a significant portion of ETF holders bearish. However, the lower price of gold spurred unprecedented demand for physical gold from everywhere, considerably in excess of ETF sales. The fact the gold price did not stage a lasting recovery tells us that someone very big must have been supplying the market from mid-April onwards, and therefore keeping the price suppressed.
So now we have the answer. The BoE sold about 1,300 tonnes into the London market, which given the explosion in demand for physical at lower prices looks about right.
This leaves us with two further imponderables. It seems reasonable given the acceleration in global demand that the bulk of the gold supplied by the BoE has gone to the non-bank sector around the world. In which case, the bullion banks in London still have substantial uncovered liabilities on their customers’ unallocated accounts, on top of the leases being rolled. The second is a question: how much of the remaining 1,580 tonnes not-accounted-for last month been sold since June?
Conflating these two imponderables, unless the BoE can ship in some more gold sharpish, there is unlikely to be enough available to supply the market at current prices and bail out the bullion banks in London, so they must still be in trouble. The supply of gold for lease seems to have diminished, because the Gold Forward Rate has gone persistently negative indicating a shortage.
It appears the leasing scheme, whereby central bank gold is supplied into the market, has finally backfired. Prices have risen over the period being considered and leased gold has disappeared into Asia at an accelerating rate never to return. While the bullion banks operating in the US futures market have got themselves broadly covered, the bullion banks in London appear to have passed up on the opportunity to gain protection from rising bullion prices.
The final and fatal mistake was to misjudge the massive demand unleashed as the result of price suppression. This was a schoolboy-error with far-reaching consequences we have yet to fully understand.
This article was previously published at GoldMoney.com.
On Tuesday July 2, US central bank policy makers voted in favour of the US version of the global bank rules known as the Basel 3 accord. The cornerstone of the new rules is a requirement that banks maintain high quality capital, such as stock or retained earnings, equal to 7% of their loans and assets.
The bigger banks may be required to hold more than 9%. The Fed was also drafting new rules to limit how much banks can borrow to fund their business known as the leverage ratio.
We suggest that the introduction of new regulations by the Fed cannot make the current monetary system stable and prevent financial upheavals.
The main factor of instability in the modern banking system is the present paper standard which is supported by the existence of the central bank and fractional reserve lending.
Now in a true free market economy without the existence of the central bank, banks will have difficulties practicing fractional reserve banking.
Any attempt to do so will lead to bankruptcies, which will restrain any bank from attempting to lend out of “thin air”.
Fractional reserve banking can, however, be supported by the central bank. Note that through ongoing monetary management, i.e., monetary pumping, the central bank makes sure that all the banks can engage jointly in the expansion of credit out of “thin air” via the practice of fractional reserve banking.
The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out, because the redemption of each will cancel the other redemption out.
By means of monetary injections, the central bank makes sure that the banking system is “liquid enough” so that banks will not bankrupt each other.
The consequences of the monetary management of the Fed as a rule are manifested in terms of boom-bust cycles.
As times goes by this type of management runs the risk of severely weakening the wealth generation process and runs the risk of severely curtailing so called real economic growth.
We maintain that as long as the present monetary system stays intact it is not possible to prevent a financial crisis similar to the one we had in 2007-9. The introduction of new tighter capital requirements by banks cannot make them more solvent in the present monetary system.
Meanwhile, banks have decided to restrain their activity irrespective of the Fed’s new rules. Note that they are sitting on close to $2cg trillion in excess cash reserves. The yearly rate of growth of banks inflationary lending has fallen to 4.1% in June from 4.2% in May and 22.4% in June last year.
Once the economy enters a new economic bust banks are likely to run the risk of experiencing a new financial crisis, the reason being that so called current good quality loans could turn out to be bad assets once the bust unfolds.
A visible decline in the yearly rate of growth of banks inflationary lending is exerting a further downward pressure on the growth momentum of our monetary measure AMS.
Year-on-year the rate of growth in AMS stood at 7.7% in June against 8.3% in May and 11.8% in June last year.
We suggest that a visible decline in the growth momentum of AMS is expected to bust various bubble activities, which sprang up on the back of the previous increase in the growth momentum of money supply.
Remember that economic bust is about busting bubble activities. Beforehand it is not always clear which activity is a bubble and which is not.
Note that once a bust emerges seemingly good companies go belly up. Given that since 2008 the Fed has been pursuing extremely loose monetary policy this raises the likelihood that we have had a large increase in bubble activities as a percentage of overall activity.
Once the bust emerges this will affect a large percentage of bubble activities and hence banks that provided loans to these activities will discover that they hold a large amount of non-performing assets.
A likely further decline in lending is going to curtail lending out of “thin air” further and this will put a further pressure on the growth momentum of money supply.
In fractional reserve banking, when money is repaid and the bank doesn’t renew the loan, money evaporates. Because the loan was originated out of nothing, it obviously couldn’t have had an owner.
In a free market, in contrast, when money i.e. gold is repaid, it is passed back to the original lender; the money stock stays intact.
Since the present monetary system is fundamentally unstable it is not possible to fix it. The central bank can keep the present paper standard going as long as the pool of real wealth is still expanding.
Once the pool begins to stagnate – or worse, shrinks – then no monetary pumping will be able to prevent the plunge of the system.
A better solution is of course to have a true free market and allow the gold to assert its monetary role. As opposed to the present monetary system in the framework of a gold standard money cannot disappear and set in motion the menace of the boom-bust cycles.
Summary and conclusion
Last week US central bank policy makers voted in favour of tighter rules on banks’ activities. The essence of the new rules is that banks maintain high quality capital equal to 7% of their assets. The new rules are aimed at making banks more solvent and to prevent repetitions of the 2008-2009 financial upheavals. We suggest that in the present monetary system which involves the existence of the central bank and fractional reserve banking it is not possible to make the monetary system more stable and immune to financial upheavals. As long as the Fed continues to tamper with interest rates and money supply we are going to have boom-bust cycles and financial upheavals.
This article was published yesterday at stevebaker.info.
Today sees the return of the Financial Services (Banking Reform) Bill to Parliament. It does not do enough.
In the book Banking 2020: A vision for the future, my essay summarises the institutional problems with our monetary and banking orthodoxy:
The features of today’s banking system
As Governor of the Bank of England Sir Mervyn King told us in 2010: ‘Of all the many ways of organising banking, the worst is the one we have today.’
Notes and coins are irredeemable: the promise to pay the bearer on demand cannot be fulfilled, except with another note or coin with the same face value. Notes and coins are tokens worth less than their face value and are issued lawfully and exclusively by the state. This is fiat money.
When this money is deposited at the bank it becomes the bank’s property and a liability. The bank does not retain a full reserve on demand deposits. In the days of gold as money, fractional reserves on demand deposits explained how banks created credit. Today, credit expansion is not bounded by the redemption of notes, coins, and bank deposits in gold.
Because banks are funded by demand deposits but create credit on longer terms, they are risky investment vehicles subject to runs in a loss of confidence. States have come to provide taxpayer-funded deposit insurance. This subsidises commercial risk, producing more of it and creating moral hazard amongst depositors who need not concern themselves with the conduct of banks.
The state also provides a privileged lender of last resort: the central bank. It lends to illiquid but solvent banks getting them through moments of crisis. In a fiat money system, central banks have the power to create reserves and otherwise intervene openly in the money markets. Today this is most evident in the purchase of government bonds with new money, so-called quantitative easing.
The central banks also manipulate interest rates in the hope of maintaining a particular rate of price inflation through just the right rate of credit expansion to match economic growth. That otherwise free-market economists and commentators support such obvious economic central planning is one of the absurdities of contemporary life.
Compounding these flaws is the limited liability corporate form. Whereas limited liability was introduced to protect stockholders from rapacious directors, its consequence today is ensuring no one taking commercial risks within banks stands to share in the downside. This creates further moral hazard.
Regulatory decisions have been taken to encourage banks to make bad loans and dispose of them irresponsibly. Among these are the US Community Reinvestment Act and the present government’s various initiatives to promote the housing market and further credit expansion.
Having insisted banks make bad loans, the regulatory state imposed the counterproductive International Financial Reporting Standards (IFRS) which can over-value assets and over-state the capital position of banks. This drives the creation of financial products and deals which appear profitable but which are actually loss-making. Since these notoriously involve vast quantities of instruments tied to default, the system is booby-trapped.
Amongst the many practical consequences of these policies was the tripling of the money supply (M4) in the UK from £700 billion in 1997 to £2.2 trillion in 2010. Credit expansion at this rate has had predictable and profound consequences including asset bubbles, sectoral and geographic imbalances, unjust wealth inequality, erosion of physical capital, excess consumption over saving, and the redirection of scarce resources into unsustainable uses.
Moreover, credit cannot be expanded without limit. Eventually, the real world catches up with credit not backed by tangible assets: booms are followed by busts.
The essay provides some objectives for monetary reform and sets out proposals from Dowd et al and Huerta de Soto.
I was pleased that the Parliamentary Commission on Banking Standards highlighted problems with incentives and accounting – the conversation is going in the right direction. At some point, when it becomes apparent that Mervyn King was right and we do have the worst possible banking system, I hope decision makers will realise that banks and the product in which they deal, money, are inseparable and that meaningful banking reform demands monetary reform.
You can download the book here.
City A.M. reports today Dovish Carney stuns markets:
EQUITY markets jumped yesterday after the Bank of England shocked investors by indicating that rates would stay at historic lows in the near future, despite recent signs that the British economy is starting to strengthen.
That investors are shocked by the news that Mark Carney plans a further extended period of easy money is more surprising than the news itself. But it turns out markets are good at responding to superficial data over the clearly stated intent of big players in the market, like central bank officials.
Consider the evidence of Lord George, former Bank of England Governor, to the Treasury Select Committee in 2007, in which he confesses his role in seeding economic disruption in an attempt to avoid recession:
Tuesday 20 March 2007 – Treasury – Minutes of Evidence
Q117 Ms Keeble: What makes it worse is that the one tool that the MPC has is interest rates and that filters through to our constituents in the form of higher mortgages. That makes them complain even more; it becomes cyclical.
Lord George: Yes, if house prices are going up. But one has to step back and recognise—I referred to it earlier—that when we were in an environment of global economic weakness at the beginning of the decade it meant that external demand was declining. Related to that, business investment was declining. One had only two alternatives in sustaining demand and keeping the economy moving forward: one was public spending and the other was consumption. It is true that taxation and public spending can influence the demand climate and consumer spending, but confronted with what we saw we knew that we had to stimulate consumer spending. We knew that we had pushed it up to levels that could not possibly be sustained in the medium and longer term, but for the time being if we had not done that the UK economy would have gone into recession, just like the economies of the United States, Germany and other major industrial countries. That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out, but we really did not have much of a choice about what we did unless we accepted that we would yank it back or give up stability altogether. That is the point I am trying to make in answer to Mr Newmark. There are some people—maybe lots—who say that house prices is the biggest problem, that the mortgage rate is going up, housing is not affordable and so on.
And a few weeks ago, the Bank’s Andy Haldane confessed that they “have intentionally blown the biggest government bond bubble in history” (I abridge a little):
Wednesday 12 June 2013 – TRANSCRIPT OF ORAL EVIDENCE
Q41 Mark Garnier: … If you thought that QE was creating financial instability, would you try to warn the MPC and, if so, how would you do it?
Andrew Haldane: I absolutely see it as my one of jobs as an FPC member to alert not just the MPC but this Committee and the wider world if I thought that QE, or monetary policy actions more broadly, was posing significant risks to UK financial system stability. …
To the substance, this is a risk that I feel very acutely right now. If I were to single out what for me would be the biggest risk to global financial stability right now it would be a disorderly reversion in the yields of government bonds globally, for any one of a variety of reasons. We have seen shades of that over the last two or three weeks. Let’s be clear, we have intentionally blown the biggest government bond bubble in history. That is where we are, so we need to be vigilant to the consequences of that bubble deflating more quickly than we might otherwise have wanted. That is a risk. It is one we as FPC need to be very vigilant to.
So, by officials’ own admission, the Bank under Eddie George created levels of debt-fuelled consumption which they knew could not last in the hope of avoiding recession and, following that bubble bursting, they have now deliberately inflated the biggest bond market bubble in history. When I see markets herding in response to the pronouncements of these big players, I think “What could possibly go wrong?”
As I set out in my speech on the Budget (video), Mark Carney has clearly explained his intention to use the Bank of England to manipulate economic expectations to manufacture recovery. This will not work.
It is certainly true that the central banks can alter economic expectations but the idea that they can do so helpfully is fanciful. It is founded on the same errors as socialism and like socialism, it cannot work because the information necessary is not available and because it relies on aggregating away much that makes us human.
We’ve had two confessions from central bank officials. I feel I can predict confidently that Mark Carney will one day confess, more or less, “We thought we could manage the economy by steering the expectations of tens of millions of people using monetary policy to blow various bubbles while making pronouncements about policy. We were wrong.”
One of the great tragedies of our circumstances is that so many people will label this central planning “capitalism”. Eventually, the state will have to get out of money and banking. Mark Carney’s coming failure should accelerate the day.
Back in 2006, as the debate was raging whether or not the US had a mortgage credit and housing bubble, I had an ongoing, related exchange with the Chief US Economist of a large US investment bank. It had to do with what is now commonly referred to as the ‘shadow banking system’.
While the debate was somewhat arcane in its specifics, it boiled down to whether the additional financial market liquidity created through the use of securities repo and other forms of collateralised lending were destabilising the financial system.
The Chief US Economist had argued that, because US monetary aggregates were not growing at a historically elevated rate, the Fed was not adding liquidity fuel to the house price inflation fire and that monetary policy was, therefore, appropriate. (Indeed, he denied that the rapid house price inflation at the time was cause for serious concern in the first place.) I countered by arguing that these other forms of liquidity (eg. securities repo) should be included and that, if they were, then in fact the growth of broad liquidity was dangerously high and almost certainly was contributing to the credit+housing bubble.
We never resolved the debate. My parting shot was something along the lines of, “If the financial markets treat something as a money substitute—that is, if the incremental credit spread for the collateral providing the marginal liquidity approaches zero— then we should treat it as a form of de facto money.”
He dismissed this argument although I’m not sure he really understood it; at least not until there was a run on money-market funds in the wake of the Lehman Brothers bankruptcy in November 2008. It was at that point that economic officials at the Fed and elsewhere finally came to realise how the shadow banking system had grown so large that it was impossible to contain the incipient run on money-market funds and, by extension, the financial system generally without providing explicit government guarantees, which the authorities subsequently did.
This particular Chief US Economist had previously worked at the Fed. This was and remains true, in fact, of a majority of senior US bank economists. Indeed, in addition to a PhD from one of the premiere US economics departments, a tour of duty at the Fed, as it were, has traditionally been the most important qualification for this role.
Trained as most of them were, in the same economics departments and at the same institution, the Fed, it should perhaps be no surprise that neither the Fed, nor senior economists at the bulge-bracket banks, nor the US economic academic and policy mainstream generally predicted the global financial crisis. As the discussion above illuminates, this is because they failed to recognise the importance of the shadow banking system. But how could they? As neo-Keynesian economists, they didn’t—and still don’t—have a coherent theory of money and credit.
FROM BLISSFUL IGNORANCE TO PARANOIA
Time marches on and with lessons learned harshly comes a fresh resolve to somehow get ahead of whatever might cause the next financial crisis. For all the complacent talk about how the “recovery is on ￼track” and “there has been much economic deleveraging” and “the banks are again well-capitalised,” the truth behind the scenes is that central bankers and other economic officials the world over remain, in a word, terrified. Of what, you ask? Of the shadow banking system that, I believe, they still fail to properly understand.
Two examples are provided by a recent speech given by Fed Governor Jeremy Stein and a report produced by the Bank of International Settlements (BIS), the ‘central bank of central banks’ that plays an important role in determining and harmonising bank regulatory practices internationally.
The BIS report, “Asset encumberance, financial reform and the demand for collateral assets,” was prepared by a “Working Group established by the Committee on the Global Financial System,” which happens to be chaired by none other than NYFed President William Dudley, former Chief US Economist for Goldman Sachs. (No, he is not the Chief US Economist referred to earlier in this report, although as explained above these guys are all substitutes for one another in any case.) 
In the preface, Mr Dudley presents the report’s key findings, in particular “evidence of increased reliance by banks on collaterised funding markets,” and that we should expect “[t]emporary supply-demand imbalances,” which is central banker code for liquidity crises requiring action by central banks.
He also makes specific reference to ‘collateral transformation’: when banks swap collateral with each other. This practice, he notes, “will mitigate collateral scarcity.” But it will also “likely come at the cost of increased interconnectedness, procyclicality and financial system opacity as well as higher operational, funding and rollover risks.”
Why should this be so? Well, if interbank lending is increasingly collateralised by banks’ highest quality assets, then unsecured creditors, including depositors, are being de facto subordinated in the capital structure and are highly likely to ‘run’ at the first signs of trouble. And if banks are holding similar types of collateral that suddenly fall in value, then they can all become subject to a run at the same time, for the same reason.
Collateral transformation is thus a potentially powerful FWMD. But don’t worry, the BIS and other regulators are on the case and doing the worrying. As a belated response to the financial crisis that they all failed to foresee, the latest, greatest trend in financial system oversight is ‘liquidity regulation’. Fed Governor Jeremy Stein explains the need for it thus:
[A]s the financial crisis made painfully clear, the business of liquidity provision inevitably exposes financial intermediaries to various forms of run risk. That is, in response to adverse events, their fragile funding structures, together with the binding liquidity commitments they have made, can result in rapid outflows that, absent central bank intervention, lead banks to fire-sell illiquid assets or, in a more severe case, to fail altogether. And fire sales and bank failures–and the accompanying contractions in credit availability–can have spillover effects to other financial institutions and to the economy as a whole. Thus, while banks will naturally hold buffer stocks of liquid assets to handle unanticipated outflows, they may not hold enough because, although they bear all the costs of this buffer stocking, they do not capture all of the social benefits, in terms of enhanced financial stability and lower costs to taxpayers in the event of failure. It is this externality that creates a role for policy. 
Ah yes, wouldn’t you know it, that ubiquitous, iniquitous enigma: market failure. Regulators have never found a market that doesn’t fail in some way, hence the crucial need for regulators to prevent the next failure or, at a minimum, to sort out the subsequent mess. In the present instance, so the thinking behind liquidity regulation goes, prior to 2008 the regulators were overly focused on capital adequacy rather than liquidity and, therefore, missed the vastly expanded role played by securitised collateral in the international shadow banking system. In other words, the regulators now realise, as I was arguing back in the mid-2000s, that the vast growth in shadow banking liquidity placed the stability of the financial system at risk in the event that there was a drop in securitised collateral values.
In 2007, house prices began to decline, taking collateral values with them and sucking much of the additional, collateral-based liquidity right back out of the financial system, unleashing a de facto wave of monetary+credit deflation, resulting in the subsequent financial crisis. But none of this was caused by ‘market failure’, as Governor Stein contends. Rather, there is another, simpler explanation for why banks were insufficiently provisioned against the risk of declining collateral values, yet it is not one that the regulators much like to hear, namely, that their own policies were at fault.
In one of my first Amphora Reports back in 2010 I discussed in detail the modern history of financial crises, beginning with the 1980s and concluding with 2008. A pattern rapidly becomes apparent:
[Newton’s] third law of universal motion was that for each and every action there is an equal and opposite reaction. While applicable to the natural world, it does not hold with respect to the actions of financial markets and the subsequent reactions of central banks and other regulators. Indeed, the reactions of regulators are consistently disproportionate to the actions of financial markets. In sinister dialectical fashion, the powers assumed and mistakes made by policymakers tend to grow with each crisis, ￼thereby ensuring that future crises become progressively more severe…
[W]as the Fed’s policy reaction to the 1987 crash proportionate or even appropriate? Was it “an equal but opposite reaction” which merely temporarily stabilised financial markets or did it, in fact, implicitly expand the Fed’s regulatory role to managing equity prices? Indeed, one could argue that this was merely the first of a series of progressively larger “Greenspan Puts” which the Fed would provide to the financial markets during the 18 years that the so-called “Maestro” was in charge of monetary policy and, let’s not forget, bank regulation…
By the late 1980s, a huge portion of the S&L industry was insolvent. The recession of 1990-91, made a bad situation worse. FSLIC funds were rapidly depleted. But a federal guarantee is supposed to be just that, a guarantee, so Congress put together a bailout package for the industry. A new federal agency, the Resolution Trust Corporation (RTC), issued bonds fully backed by the US Treasury and used the proceeds to make insolvent S&L depositors whole…
In retrospect, the entire S&L debacle, from its origins in regulatory changes and government guarantees, through the risky lending boom, bust, credit crunch and fiscal and monetary bailout can be seen as a precursor to the far larger global credit bubble and bust of 2003-2008: Just replace the S&Ls with Fannie/Freddie and the international shadow banking system. But there is no need to change the massive moral hazard perpetrated by incompetent government regulators, including of course the Fed, and the reckless financial firms who played essentially the same role in both episodes.
Notwithstanding this prominent pattern of market-distorting interest-rate manipulation, guarantees, subsidies and occasional bailouts, fostering the growth of reckless lending and other forms of moral hazard, the regulators continue their self-serving search for the ‘silver bullet’ to defend against the next ‘market failure’ which, if diagnosed correctly as I do so above is, in fact, regulatory failure.
Were there no moral hazard of guarantees, explicit or implicit, in the system all these years, the shadow banking system could never have grown into the regulatory nightmare it has now become and liquidity regulation would be a non-issue. Poorly capitalised banks would have failed from time to time but, absent the massive systemic linkages that such guarantees have enabled—encouraged even—these failures would have been contained within a more dispersed and better capitalised system.
As it stands, however, the regulators’ modus operandi remains unchanged. They continue to deal with the unintended consequences of ‘misregulation’ with more misregulation, thereby ensuring that yet more unintended consequences lurk in the future.
MIGHT COLLATERAL TRANSFORMATION BE THE CRUX OF THE NEXT CRISIS?
In his speech, Governor Stein also briefly mentions collateral transformation, when poor quality collateral is asset-swapped for high quality collateral. Naturally this is not done 1:1 but rather the low quality collateral must be valued commersurately higher. In certain respects these transactions are similar to traditional asset swaps that trade fixed for floating coupons and allow financial and non-financial businesses alike to manage interest rate and credit risk with greater flexibility. But in the case of collateral transformation, what is being swapped is the principal and the credit rating it represents, and one purpose of these swaps is to meet financial regulatory requirements for capital and, in future, liquidity.
An obvious consequence of such collateral transformation is that it increases rather than decreases the linkages in the financial system and thus in effect replaces firm-specific, idiosyncratic risk with systemic risk, exactly the opposite of what the regulators claim they are trying to do by increasing bank regulatory capital ratios. Liquidity regulation is an attempt to address this accelerating trend and the growing systemic risks it implies.
Those financial institutions engaging in the practice probably don’t see things this way. From the perspective of any one instution swapping collateral in order to meet changing regulatory requirements, they see it as necessary and prudent risk management. But within a closed system, if most actors are behaving in the same way, then the net risk is not, in fact, reduced. The perception that it is, however, can be dangerous and can also contribute to banks unwittingly underprovisioning liquidity and undercapitalising against risk.
Viewed system-wide, therefore, collateral transformation really just represents a form of financial alchemy rather than financial engineering. It adds no value in aggregate. It might even detract from such value by rendering opaque risks that would otherwise be more immediately apparent. So I do understand the regulators’ concerns with the practice. I don’t, however, subscribe to their proposed self-serving remedies for what they perceive as just another form of market failure.
PLAGARISED COPIES OF AN OLD PLAYBOOK
Already plagued by the ‘Too Big to Fail’ (TBTF) problem back in 2008, the regulators have now succeeded in creating a new, even more dangerous situation I characterise as MAFID, or ‘Mutual Assured FInancial Destruction.’ Because all banks are swapping and therefore holding essentially the same collateral, there is now zero diversification or dispersion of financial system risk. It is as if there is one massive global bank with thousands of branches around the world, with one capital base, one liquidity ratio and one risk-management department. If any one branch of this bank fails, the resulting margin call will cascade via collateral transformation through the other branches and into the holding company at the centre, taking down the entire global financial system.
Am I exaggerating here? Well, if Governor Stein and his central banking colleagues in the US, at the BIS and around the world are to be believed, we shouldn’t really worry because, while capital regulation didn’t prevent 2008, liquidity regulation will prevent the scenario described above. All that needs to happen is for the regulators to set the liquidity requirements at the right level and, voila, financial crises will be a thing of the past: never mind that setting interest rates and setting capital requirements didn’t work out so well. Setting liquidity requirements is the silver bullet that will do the trick.
Sarcasm aside, it should be clear that all that is happening here is that the regulators are expanding their role yet again, thereby further shrinking the role that the markets can play in allocating savings, capital and liquidity from where they are relatively inefficiently utilised to where they are relatively more so. This concept of free market allocation of capital is a key characteristic of a theoretical economic system known as ‘capitalism’. But capitalism cannot function properly where capital flows are severely distorted by regulators. Resources will be chronically misallocated, resulting in a low or possibly even negative potential rate of economic growth.
The regulators don’t see it that way of course. Everywhere they look they see market failure. And because Governor Stein and his fellow regulators take this market failure as a given, rather than seeking to understand properly how past regulatory actions have severely distorted perceptions of risk and encouraged moral hazard, they are naturally drawn to regulatory ‘solutions’ that are really just plagiarised copies of an old playbook. What is that definition of insanity again, about doing the same thing over and over but expecting different results?
 Neo-Keynesians will deny this, claiming that their models take money and credit into account. But they do so only to a very limited extent, with financial crises relegated to mere aberrations in the data. The Austrian economic school of Menger, Mises, Hayek, etc, by contrast, has a comprehensive and consistent theory of money and credit that can explain and even predict financial crises.
 The entire paper can be found at the link here (PDF).
 This entire speech can be found at the link here.
 FINANCIAL CRISES AND NEWTON’S THIRD LAW, Amphora Report Vol. 1 (April 2010). The link is here.
This article was previously published in The Amphora Report, Vol 4, 10 June 2013.