David Stockman’s new book is a brilliant, penetrating analysis of the present state of the US economy and the US political system, and a detailed account of how the nation got into this mess. The book will upset Democrats and Republicans alike, and quite a few other constituencies as well, which can, in this case, be safely accepted as proof that Stockman’s narrative is spot on.
Stockman is an angry man and he admits so himself early in his 719-page tome. That anger adds bite and verve to his writing and keeps what is in fact a detailed historical account and economic analysis always highly entertaining. The book is long but never boring. Furthermore, Stockman does not let his anger cloud his judgement, which remains, in my view, relentlessly accurate throughout.
When dissecting Washington politics and Wall Street deal-making Stockman naturally draws on his experience as the director of the Office of Management and Budget under Ronald Reagan and his many years as an investment banker and private equity investor, and in so doing he reflects on much of his own professional life with commendable candor. But the book goes beyond these specific periods, and Stockman applies the analytical skills and insights acquired on these jobs to the critical examination of a wide spectrum of policy areas and historic periods. Stockman’s command of these topics and the masses of statistics and financial reports involved, and his powers of analytical dissection are impressive. But what is probably even more important for the success of his analysis is that it is based on an accurate understanding of essential economic relationships, in particular the importance of sound money. This is why the narrative that he develops captures America’s present challenges so truthfully and comprehensively. I very much shared Stockman’s anger when I started reading, but even more so when I had finished.
Public service
Stockman does a great service to his fellow Americans for he is providing a much-needed dose of realism that stands in stark contrast to the contrived optimism emanating from much of the political ‘debate’, from stock-pushing Wall Street experts on financial TV, and from the various Keynesian snake-oil merchants from both parties, all of whom want the public to believe that America is fundamentally healthy and just another round of ‘quantitative easing’, another deficit-funded tax break, or another ‘stimulus’ spending measure away from a bright future of self-sustained recovery. Instead, Stockman says it like it is. The US economy in 2013 is fundamentally weakened and structurally deformed by decades of artificially cheap money and a pathological debt addiction. Not the occasional artificial booms of the past twenty years, driven by Fed-induced bubbles in stocks, high-yield bonds and housing, give a correct picture of America’s long-term economic potential but the intermittent periods of slack when the fire-works on Wall Street inevitably end (and end in tears), and the persistent Main Street reality of declining employment prospects, stagnant real income and impaired competitiveness can no longer be covered up.
The Fed’s policy of cheap and then ever-cheaper credit has not only destroyed the free market by constantly distorting price signals, encouraging reckless debt accumulation and rewarding financial speculation (and consequently widening income and wealth gaps, as Stockman illustrates aplenty), it has thoroughly corrupted the political process as well. Stockman portrays a political system that, courtesy of the Fed’s cheap credit policies and interest rate repression, is now chronically incapable of living within its means, and is thus easy prey for hordes of crony capitalists – from the healthcare industry and the military-industrial complex to the ‘labor aristocracy’ of the united autoworkers union to the ‘too-big-to-fail’ banks, private-equity shops and hedge funds that play the system for a quick profit.
Crucially, Stockman puts his unsentimental assessment of America’s present reality into a broader historical context. Stockman identifies correctly the act of original sin that led America astray from the path of broadly free market economics and limited and fiscally responsible government, namely the abandonment of sound money. As America moved away from hard money, epitomized originally by the gold standard and a Federal Reserve with a strictly limited role as a bankers’ bank, and later, in already watered-down form, by the Bretton Woods gold-exchange-standard, and embraced an unconstrained fiat money system and ‘free-floating’ global paper monies it robbed the free market of its essential inner compass and ‘true north’ of market-based interest rates and market-enforced financial prudence.
The Fed, the central-banking branch of the federal government, was unleashed from its golden shackles in two historic steps in 1933 (by a Democrat president) and in 1971 (by a Republican president) but it was only over the past twenty years under the leaderships of Greenspan and Bernanke that the full destructive potential of unconstrained central banking has come to be felt. As Stockman shows with great clarity, both central bankers turned the Fed into a machine for macro-economic fine-tuning and prosperity management. Greenspan promised to watch the speculating classes’ backs by allowing them to blow bubbles and then shield them from the consequences. Bernanke took the mission one step further as he began (and still continues) to use his vast powers of fixing interest rates and printing limitless amounts of new money to steer the markets to the ‘correct’ yields on government bonds, the ‘correct’ spreads on mortgage-backed-securities, and the ‘appropriate’ shape of the yield curve, and by so doing to centrally manage the overall economy. Needless to say, such socialism for speculators, courtesy of the printing press, is happily explained by Wall Street economists as being in the public interest.
It is this deformation of money that is the root cause of the numerous deformations in the broader economy and the deformations in the political system. I am grateful that Stockman has fulfilled the important task of documenting in detail the many ways in which unsound money undermines the market economy and corrupts society.
Myth buster
Stockman is a myth buster par excellence. He busts myths that are cherished by Democrats and myths that are cherished by Republicans, and some cherished by both. Never pulling any punches and always happy to name names, he exposes as complicit in the deformation of American capitalism politicians, central bankers, and self-important economists of the Keynesian, monetarist and supply-side persuasion. He also identifies the many crony-capitalists, who shamelessly exploit the system’s many deformations for their own gain. But Stockman not only identifies the villains – the advocates and profiteers of unsound money – he also gives us the heroes, the defenders of sound money, people like Dwight Eisenhower, William McChesney Martin, and Paul Volcker, even if their efforts ultimately did not avert the corruption of American capitalism.
Here are the main myths that Stockman exposes:
Myth one: The 2008 financial crisis was the result of unregulated markets. TARP and the Fed saved the country from Great Depression 2.0
Nonsense, says Stockman. The financial crisis was the consequence of the Fed’s serial bubble blowing, and it should have been allowed to burn itself out in the corridors of Wall Street. Instead, Paulson and Bernanke panicked, declared economic martial law, namely that all rules of fiscal prudence and free market capitalism be tossed aside, and demanded that, via the bail-out of ‘insurance’ giant AIG, firms like Goldman Sachs, Morgan Stanley and others be saved from choking on their own outsized speculations.
Myth two: There was such a thing as the ‘Reagan Revolution’ and it revitalized American capitalism.
This is obviously a favourite whenever Republicans sit around the campfire. The reality looks different. Despite all the charisma and the eloquent free market rhetoric, the true legacy of the Reagan presidency is a Republican party that is now largely desensitized to fiscal profligacy and reconciled with endless deficits (Cheney’s famous dictum that “deficits don’t matter.”), as the party has happily joined the Democrats in the ‘aggregate demand’ management business. No longer to be outdone by ‘pro-active’ Democrats advocating Keynesian ‘spending’ to ‘stimulate’ growth, the Republicans came to embrace their own version of top-down GDP management: the Art-Laffer-inspired slashing of taxes at all cost. Fiscal prudence – and a true “hands-off” approach to the economy – was finally expunged from Republican DNA.
Myth three: The Great Depression was caused by the gold standard and was ended by Roosevelt’s Keynesian policies.
Ridiculous. The correction of the early 1930s was the combination of delayed effects of the First World War (a US agricultural boom that had led to overinvestment and distorted prices and had already ended in a bust in the 1920s) and the bursting of various bubbles blown during the Jazz-Age-version of bubble finance, such as the foreign bond market that provided funding for the purchase of then-sizable US exports, and the hot-money driven domestic equity boom. These distortions did not come about becauseof the gold standard but despite the gold standard, which had been severely weakened as a disciplinary force not least due to the growing role of the Fed since 1914, and in particular since the central bank funded the war effort through money-printing in 1917-1918. By 1929 liquidation and correction were unavoidable. But what should have been a quick and decisive cleansing was turned into a drawn-out economic catastrophe by bad policy. First, there was economic nationalism – tariffs and other forms of protectionism – and then Roosevelt’s disastrous interventionism and relentless tinkering with the economy. As Stockman illustrates, Roosevelt did not enact a Keynesian textbook program at all. In fact, the clueless president had no coherent program whatsoever but instead implemented the type of potpourri of populist anti-market measures so fashionable at the time among Europe’s fascist leaders: odd infrastructure programs, price and wage fixing, state-directed resource use.
“Having triggered the demise of the old international order, the Roosevelt program of necessity was a purely domestic grab bag of experiments, gimmicks, and nonstarters. These ad-hoc Washington interventions – the Tennessee Valley Authority (TVA), National Recovery Act (NRA), Agricultural Adjustment Act (AAA) – did little to revive the dormant machinery of market capitalism and economic wealth creation and, instead, mainly shuffled income and resources randomly among regions, industries, and even individual business firms.”
(Stockman, page 159)
Intermezzo
The New Deal had meant curtains for the ‘Old Republic’ and any commitment to sound money and sound public finances. However, and luckily for America, the newly expanded tool kit for interventionist politicians and central bankers remained largely unused for two decades after the end of World War II. A happy interregnum of monetary and fiscal discipline commenced, largely due to the good fortune of having people with strong traditional beliefs in positions of power, such as Dwight D. Eisenhower in the White House and William McChesney Martin at the Fed, two of Stockman’s heroes. Eisenhower slashed military spending after the Korean War and established the ‘Eisenhower minimum’ of strictly contained military outlays. Eisenhower was a soldier who hated war. A highly decorated general himself he famously warned his fellow Americans of the growing powers of the military-industrial complex and stared down a few generals himself when letting them resign in protest of his spending cuts. (By comparison, today’s Commander-in-Chief, former community organizer Barack Obama, oversees a military budget that is twice the size of even Bill Clinton’s.)
Over at the Fed, Martin not only coined the phrase “taking the punch bowl away when the party gets started”, he actually meant it and implemented it. Martin was deeply committed to the monetary discipline of the Bretton Woods system.
Needless to say, such discipline did not last long. America’s military adventures in Far East Asia and LBJ’s great society project put new demands on state spending and, by extension, on the printing press. The last link to gold – and the last remaining constraint on paper dollar creation- was severed in August 1971.
Myth four: Free floating paper monies are a sign of free market capitalism
The importance of what happened at Camp David in August 1971 can hardly be overestimated, and Stockman conveys the magnitude of these events vividly:
“Nixon’s estimable free market advisors who gathered at the Camp David weekend were to an astonishing degree clueless as to the consequences of their recommendation to close the gold window and float the dollar. In their wildest imaginations they did not foresee that this would unhinge the monetary and financial nervous system of capitalism. They had no premonition at all that it would pave the way for a forty-year storm of financialization and a debt-besotted symbiosis between central bankers possessed by delusions of grandeur and private gamblers intoxicated with visions of delirious wealth.”
(Stockman, page 281)
Stockman is particularly scathing of Milton Friedman’s influence on these events.
“The great irony, then, is that the nation’s most famous modern conservative economist became the father of Big Government, chronic deficits, and national fiscal bankruptcy. It was Friedman who first urged the removal of the Bretton Woods gold standard restraints on central bank money printing, and then added insult to injury by giving conservative sanction to perpetual open market purchases of government debt by the Fed. Friedman’s monetarism thereby institutionalized a regime which allowed politicians to chronically spend without taxing.”
(Stockman, page 272)
Famous academic economists who willingly throw themselves into the machinery of policy-making or policy-advice are among the most tragic-comic figures in Stockman’s narrative.
Thus we meet, on the political Left, John Maynard Keynes’s vicar on earth, the pompous Larry Summers pulling really big numbers out of the air, such as $800 billion, and demanding that this be spent instantly by Washington to stimulate the economy. There is, of course, Paul Krugman, who has never met a deficit-spending program that he thought was big enough. On the political Right, there is Art Laffer, who taught the Republicans not to worry about deficits if they result from tax-cutting as tax cuts are always stimulative and thus inherently self-financing. There is Milton Friedman who could explain the evils of rent-control better than anybody else but got free market money horribly wrong and provided intellectual cover for Tricky Dick’s dollar debasement. And then, naturally, there is Ben Bernanke, the veritable Dr. Strangelove of central banking, who believes this is 1930 all over again and who uses the present crisis to re-enact the policy program he believes, based on his own subjective and highly flawed interpretation of the Great Depression, the Fed should have enacted back then. One can only hope that this litany of abject failure serves as a warning to those economists waiting in the wings for their moment in the limelight, such as John Taylor who believes his eponymous rule is the answer to all central banking problems, or those economists who currently embrace the new Keynesian fad of ‘nominal GDP targeting’ (God help us!).
The deserving heroes of Stockman’s account are instead those statesmen and bankers who stuck by the old (and indeed ancient) rules of hard money and ‘balancing the books’.
Myth five: Modern financial markets represent free market capitalism.
Of course, in a proper free market, speculation, trading and the use of leverage would not only be permissible but would have an important role to play in the process of allocating savings and channeling scarce capital to productive uses. These activities would, however, be tightly controlled and strictly limited by the free market’s most effective regulators: profit and loss. Those regulators are now largely weakened or even removed entirely by the present system of costless fiat money, unlimited central bank backstops (Greenspan/Bernanke put) and artificially low interest rates. Without proper capitalist money, hard and apolitical, at the core of the monetary system, a free market in the rest of finance is impossible. Stockman does an excellent job illustrating the extent to which manipulated money and artificially cheap credit are corrupting the entire financial infrastructure by encouraging excessive risk-taking and the misuse of capital with severely adverse long-term consequences.
“…capital markets eventually lose their capacity to honestly price securities under a regime of unsound money; they end up dancing to the tune of the central bank; that is, pricing the trading value of financial assets based on expected central bank interventions, not the intrinsic value of their cash flows, rights, and risks.”
(Stockman, page 383)
Stockman analyses a range of leveraged buy-out deals (LBOs) to show how, in our deformed financial system, these can often lead to huge pay-outs for highly leveraged investors while at the same time leaving the firms financially weakened and sometimes even bankrupt. This chapter may appear long and technically challenging for some readers but it is important as it gives the lie to frequent claims by those who operate in this arena that these activities are simply the free market at work, and that they lead to more efficient allocation of corporate control, to investment in productive capital and to jobs. Stockman exposes the full irony of the Republican Party putting forward Mitt Romney as their 2012 presidential candidate and trying to sell him as an experienced business man and ‘job creator’ when, as the former head of private-equity firm Bain Capital, he would be much more suitable as a poster boy for the lucky few who disproportionally benefitted from three decades of bubble finance and all the deformations it created, a system that stands in sharp contrast to the traditional capitalism the Republicans claim to advocate.
Stockman certainly does not make many friends on the political Left with his – brilliant and entirely justified – annihilation of the Roosevelt myth and the childish ‘Keynes 101’–programs of ‘spending ourselves to prosperity’, but his account supports to a considerable degree the allegation that the ‘1 percent’ live high on the hog at the expense of the rest of the population. However, as Stockman demonstrates at length, this is not the result of free market capitalism, and the answer to it is not regulation and confiscatory taxation. The root cause is unsound money and the possibilities that unsound money provides for the flourishing of ‘crony capitalism’.
Stockman’s outlook is not a happy one. As the nation runs out of balance sheets to leverage up and as, inevitably, ‘austerity’ sets in, he foresees ongoing political strife, further financial market manipulations, on-and-off print-operations by the Fed, and new financial crises. He closes the book with a few pages of policy recommendations, all of them sensible, I guess, and naturally following from the preceding extensive analysis. But Stockman is under no illusion – he knows that his policy ideas do not stand a snowball’s chance in hell of being implemented. In any case, the book is not really, first and foremost, about a new policy program but about shifting the parameters of the debate by providing a thorough and accurate description of America’s economic and political problems. And here the book succeeds with flying colors.
This is an important book. I wish it a wide readership.
The crypto-currency Bitcoin is still merely a speck on the global monetary landscape. It is young, experimental, and for all we know, it may ultimately fail to break into the monetary mainstream. However, on a conceptual level I am willing to call it a work of genius and arguably the most exciting development in the field of money for more than 130 years. Let’s say since the start of the Classical Gold Standard in 1879. Does this sound like hyperbole? Well, let me explain.
The Decline and Fall of Capitalist Money
The 20th century was, broadly speaking, a period of almost constant monetary decay. At around 1900 most economists, politicians and bankers would have correctly stated that global capitalism – an international market economy facilitating the free exchange of goods and services across political borders and thus allowing extensive human cooperation through trade – required an international, apolitical, and hard form of money. Such money was gold. It was the basis of the capitalist economy and it imposed strict discipline on all market participants. Crucially, that included governments and banks. Governments had to operate pretty much like private businesses. They had to balance their books, i.e. live within the means provided by taxation, and if they borrowed money in the marketplace their lenders were at full risk of default as no government could print money (gold) to repay loans or even meet interest payments on loans. Banks, of course, issued banknotes or bank-deposits that were not backed by gold but still used by the public as if they were money proper – these were and still are ‘money-derivatives’ – but again they did so at full risk of default as nobody could ‘print’ bank-reserves (gold again) to bail out the banks in case the public tired of the ‘derivatives’ and wanted to hold gold instead.
Over the course of the 20th century – or to be precise, from 1914 to 1971 – the monetary system was completely changed as a consequence of a number of entirely political maneuvers, all of them undermining the quality of money. Today, hard, international and apolitical money has everywhere been replaced with entirely elastic, national and politicized money, with money that central banks issue under a territorial monopoly at no cost and with no meaningful constraints on issuance, and that the central bankers use to ‘manage’ the ‘national’ economy (itself increasingly an out-of-date-concept), and to fund the state and grow the domestic banks (which, under the protection of a lender-of-last-and-first-resort, now issue unprecedented amounts of money derivatives).
Today the global monetary map resembles a patchwork of local, “nationalistic” paper monies, each of which is a political tool, often openly manipulated in an attempt to benefit the local export industry at the expense of foreign competitors or to ‘stimulate’ the ethereal concept of ‘aggregate demand’. Not surprisingly, the global economy is drowning in debt (increasingly public sector debt), suffers from a bloated financial sector and international trade tensions, and stumbles from one crisis to another, each one worse than its predecessor.
Bizarrely – but not entirely surprisingly – politicians, bankers and modern ‘enlightened’ economists now tell us that this unhinged financial system is to our benefit, really, just trust us.
Truth be told, the present monetary system is a hindrance to free trade, properly functioning markets and human cooperation across borders, and it might already be on its last leg. Yet a powerful but entirely misguided, consensus seems to have taken hold of public opinion, namely that ‘elastic’ money could be beneficial if money’s supply was only managed astutely by some clever monetary central planners.
I wrote Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown to challenge that consensus, to show that ‘elasticity’ of supply is always a negative for money. Elastic money is not needed. It is entirely superfluous. Moreover, elastic money is always disruptive. A monetary system based on an inherently elastic and constantly expanding supply of money is unstable and ultimately unsustainable. The reason why gold made such good money for thousands of years is precisely its essentially inelastic supply.
The word ‘Bitcoin’ does not even appear in my book. The reason is simply that I had not heard of Bitcoin by the time I handed in my final manuscript in early 2011. But when I learnt about Bitcoin soon afterwards I was immediately fascinated. Like many others, I could conceive of ‘internet money’ or ‘virtual money’. As I had explained in the book, money does not have to exist in physical form and the fact that most money today is electronic money poses no problem for the monetary theoretician. The problem with this type of money is not that it is immaterial but that its supply is completely elastic, and I simply could not see how money that was not based on a nature-given and strictly limited commodity could have an entirely inelastic supply. It was Bitcoin’s inelasticity by design that I saw immediately as one of its greatest strengths and its true genius.
My work rehabilitates the gold standard. It shows that it was a mistake to abandon gold as the basis of our financial system and replace it with entirely elastic state fiat money. When (not if) the present fiat money system finally ends we could and should return to gold. The only alternative I now see, at least on a purely conceptual level, is Bitcoin, or something like Bitcoin: hard, apolitical, immaterial, virtual money.
Bitcoin is cryptographic gold
By now most readers will probably have heard of Bitcoin and have some notion of what it is. But in any case, let me give you a quick run-down. The economist Nikolay Gertchev, in a blog on the Mises Institute website (republished here), explains it quite well, although Gertchev, like many other members of the “Austro-Libertarian” movement, is somewhat reserved when it comes to embracing Bitcoin. I am surprised by the extent of scepticism in that community and believe that in general it is unfounded. But first the description:
“A bitcoin is a unit of a nonmaterial virtual currency, also called crypto-currency, by the same name. (Bitcoin is a medium of exchange that only exists in the virtual world. DS) They are stored in anonymous “electronic wallets,” described by a series of about 33 letters and numbers. Bitcoins can travel from a wallet to a wallet, by means of an online peer-to-peer network transaction. Any inter-wallet transfer is registered in the code of the bitcoin, so that the record of its entire transaction history clearly identifies its owner at any single moment, thereby preventing potential ownership conflicts. Bitcoins can be further divided into increments as small as one 100 millionth of a bitcoin. The current outstanding volume of bitcoins is above 10 million and is projected to reach 21 million in the year 2140.”
“This brings us to the truly fascinating production process of the bitcoins. They are “mined” based on a pre-defined mathematical algorithm, and come in a bundle, currently of 25 units, as a reward for carrying out a large number of computational operations that aim at discovering the solution to what could be described as a randomized mathematical puzzle. The role of the algorithm is to ensure a declining progression of the overall stock of bitcoins, by halving the reward every four years. Thus, somewhere in the beginning of 2017, the reward bundle will consist of 12.5 units only. Also, the more bitcoins are produced, the harder are the randomized mathematical puzzles to be solved.”
Bitcoin is immaterial money yet strictly limited in its supply. Once 21 million units are in existence, probably in 2140, that’s it. No more Bitcoin can be issued. In fact, the supply of Bitcoin is more inelastic than the supply of gold. Also, the available supply of Bitcoin at any moment in time is substantially more transparent than that of gold.
If Bitcoin ever became money in its own right (how it could do so, I will discuss below), then it would be international, hard and entirely inelastic money. Like gold it also does not decay, is homogenous and (almost) perfectly divisible. Bitcoin fulfils all the requirements of good money. In the long run, gold does not have to fear fiat money, which is always suboptimal as it always is national, politicized, manipulated, unstable and inflationary money. For one thousand years, state paper monies have come and gone. Gold (and silver) stayed. Gold just has to sit still and wait for this, the latest and most audacious and arrogant, experiment with global free-floating paper money to fail, and it will come back. But now it faces, potentially, its first meaningful challenger: inelastic crypto-currency, Bitcoin.
Money of no authority
There is no central authority that issues Bitcoin and can manipulate its supply for its own gain or for any alleged ‘greater good’ of society. Positively cringe-inducing, although sometimes unintentionally funny, are the embarrassing attempts by establishment spokespeople to discredit Bitcoin on account that, unlike all that astutely managed state fiat money, Bitcoin would not constantly be losing purchasing power. In fact, just as in the case of gold, Bitcoin’s purchasing power can reasonably be expected to constantly appreciate over time.
But, so we hear the assorted ‘enlightened’ economists of the Keynesian persuasion exclaim in horror, that would mean we would all suffer from dreadful deflation, from which only an elite of highly-qualified government-appointed central bank bureaucrats and a well-oiled printing press can save us. Apart from the fact that these self-appointed money masters have neither proper economic theory nor the experience of a thousand years of financial history on the side of their destructive agenda, they obviously do not even comprehend how far their system of manipulated funny money has already discredited itself.
Inelastic money can satisfy ANY demand
As I have explained in Paper Money Collapse no society (not even a healthily growing one) needs a constantly expanding supply of money. Money is a unique economic good. Because it is the medium of exchange, money is the only good that is demanded exclusively for its exchange value, not for any use-value its substance (if it has a substance at all) may also have.
Nobody who has demand for money has demand for a certain quantity of paper notes, or a certain weight of gold, or a certain number of digits on a computer hard-drive. Money-users have demand for the exchange value that these items contain in exchange for other goods and service, i.e. qua being accepted by others as money. Demand for money is always demand for readily exercisable purchasing power.
Once a good is widely accepted as a medium of exchange (whether that good is gold, paper tickets, or sequences of digital ones and noughts), the public can, at any moment in time, hold precisely the amount of money – readily exercisable purchasing power – it wants to hold. If the demand for money goes up, the public will sell non-money goods for money or reduce money-outlays for non-money goods. As a result, the money-prices of non-money goods fall and the purchasing power of each monetary unit (whether gold, paper tickets, or digital code) will rise. This process satisfies – automatically, instantly and naturally – the higher demand for money. The public now holds more readily exercisable purchasing power in the form of money, not because a clever, über-prescient money producer has created new money units, but simply and much more straightforwardly, because the exchange-value of the existing money stock has increased.
Once a good is widely accepted as money, no further production of that good is required. In fact, as I also demonstrated in Paper Money Collapse, any attempt to flexibly inject money into the economy in order to ‘stabilize’ money’s purchasing power, or, as is declared policy today, to constantly debase it at an officially sanctioned rate, must not only fail in its primary objective (‘price level stability’) but must cause grave distortions in the wider economy. Furthermore, the steady secular deflation that is to be expected under inelastic money, such as gold or Bitcoin, is not only not economically disruptive, it is even beneficial. Just consider one aspect: as money will then have a moderate positive real return, people who have no knowledge of financial markets and investing, and who do not have the resources to hire professional advisors, can save by simply holding money. This is impossible in our fiat money economy of constant inflation and increasing monetary instability.
Truly international
As Bitcoin has no issuing authority it has no country of residence or origin. It is truly global money. It can be used for payment anywhere in the world without going through banking systems or foreign-exchange markets. It is undeniable that the multitude of local paper monies poses a considerable hindrance to free trade and thus the rise of living standards in large parts of the world as this system necessarily introduces an element of partial barter into international trade relations. Today’s massive foreign-exchange markets are nothing but a make-shift, a crutch to deal with the suboptimal and politically motivated arrangement of various local currencies. This market ties up capital (both financial and human) without adding any real wealth to society.
If Bitcoin were to get widely accepted – and that is still a big if – it could become a great platform for connecting potentially any two counterparties in the world in direct financial transactions. It is the ultimate disintermediator: no banks needed.
At this point it might be objected that it only connects people who have access to the internet or smartphones but this is obviously a rapidly shrinking barrier. On my travels in Africa last year, I found that internet access was usually more ubiquitous than bank branches. And by the way, Kenya and Tanzania already have M-Pesa, the world’s most developed mobile payment system that uses the mobile phone network to facilitate money transfers. These countries could easily make the transition to smartphone-based payment systems without ever making the detour through clunky bank branch networks.
On the issue of tying down capital, Bitcoin wins hands-down against any other financial system, including a gold standard. Bitcoin does not require any physical storage, which naturally is always expensive. Bitcoin is monetary raw material and payment system in one. (Although, fascinatingly, the free market has already created physical Bitcoins.)
Money requires trust. We presently do not live under a gold standard but, as Jim Grant has observed so astutely, a PhD-standard, a system of flexible, state-sponsored money, managed by people like Ben Bernanke and his team at the Fed, who enjoy the privilege of implementing policies based on their own faulty monetary theories and hair-raising interpretations of economic history, while a cheap-money-addicted class of speculators plays them like a fiddle and laughs all the way to the bank. The appeal of gold has always been that it does not require the public to put trust in a ‘money elite’ but that it only has to trust gold’s creator: mother nature. With Bitcoin you only have to trust the algorithm, and as this is open software, there cannot even be a hidden agenda. Bitcoin, just like a proper gold standard, is hard, capitalist money with no politics, no Federal Open Market Committee meetings, no monetary policy, no central banking bureaucracy. It is free market money.
Common objections to Bitcoin
Given its free market and ultra-hard-currency credentials, the scepticism towards Bitcoin in parts of the Austro-Libertarian community is somewhat surprising. I think some of the objections are easily refuted. There is, first of all, the idea that Bitcoin could have many imitators, which would undermine its uniqueness and reduce its attractiveness. If Bitcoin itself cannot be inflated, what about the concept of crypto-currencies, could it be inflated by too many different currencies on offer?
This argument strikes me as weak. By all accounts Bitcoin’s design and cryptographic robustness are an exceptional accomplishment. It is not as if any hacker of medium talent could pull off something similar tomorrow. But even if he could, the argument completely underestimates first-mover advantage in the area of goods and services with substantial network effects. How many people have launched a second Facebook or a second Twitter since these inventions kicked-off the social media craze, although technologically, these inventions are much simpler than crypto-currency? – Nobody. The network effects of these goods are immense. Once they have a certain acceptance it is hard, if not impossible, for late-comers to break in. These goods and services have value for their users predominantly because others use them too, and the more people use them, the more valuable they get. There is no good for which this is truer than money – the general medium of exchange. Customized money is an oxymoron. Consequently, once a form of money is accepted, it is very difficult to take business away from it.
This feature of money is obviously a problem for Bitcoin in its fight against established state paper monies but is equally a big plus when it comes to keeping potential new entrants into the crypto-currency arena at bay. Bitcoin now dominates the market for crypto-currencies (it pretty much IS the market for crypto-currencies, in my view) and I believe that only the discovery of major flaws in Bitcoin – none seem to have surfaced in its four-year life up to now, and every day they are less likely to appear – or if some vastly superior crypto-currency came along but I am hard-pressed to see in which aspect it could outperform Bitcoin. But just launching another crypto-currency – a Bitcoin clone – is certainly not going to put a dent into Bitcoin.
Menger and Mises would love Bitcoin
Many ‘Austrians’ get thrown off by Menger’s theory of the origin of money and Mises’ so-called ‘regression theorem’, and somewhat rashly conclude that Bitcoin can never achieve money-status because it did not originate from a non-money commodity. Mises was correct when he stated that something could only become money if it had previously, that is, before it was used by somebody as a medium of exchange in its own right for the first time, established some value in trade. For if that had not been the case, how could the first person to employ the commodity as money have any point of reference by which to assess its value and determined its exchange value for the first monetary transaction? However, this theorem, which remains unrefuted in my view, does not apply to Bitcoin. Bitcoin can simply piggyback on established forms of money that already have exchange-value and derive its original value from them before it does, over time, establish its own value.
The same has, in fact, happened in the case of paper money. The paper notes that are used as money today did not start their ascent to widely used and generally accepted monetary assets from humble beginnings as commodities – that is, as mere paper – but started out as paper-claims on physical gold. Gold was money and the paper tickets simply a technology to transfer ownership of gold. When the first banknote was used it did not derive its exchange value from its paper content but from the fact that it could be exchanged for a fixed amount of gold. That was the necessary reference point – in accordance with Mises’ regression theorem. Paper money started as payment technology and as the public got used to paying with paper rather than with gold coins and gold bars, the underlying gold content could be reduced over time and ultimately the link to gold completely severed. What gives value to these paper tickets today? – The fact that the public still accepts these paper tickets in exchange for goods and services. That is all. And in fact, it is all that is needed. Any form of money – even gold, which still retains some functionality as industrial commodity or consumption good (jewellery), although that functionality is now irrelevant for its role as monetary asset – any form of money derives its money-value from the trading public and the public’s willingness to exchange the monetary asset for goods and services.
And herein lies in fact Bitcoin’s biggest challenge. However, this challenge is not of a conceptual nature. The concept of Bitcoin as money is, as I have tried to show above, extremely compelling. But Bitcoin has to offer something to the average money-user that state paper money cannot offer. Just as the banknote bestowed an instant and discernible benefit to each money-user relative to heavy gold coins, that allowed it to become a widely used medium of exchange in its own right and ultimately even operate without any link to gold, so Bitcoin has to set itself apart from fiat money and overcome fiat money’s powerful network advantage. The fact that fiat money is suboptimal in terms of its inflation characteristics and its disruptive effects on the broader economy is not something that bothers the average money user at the moment he desires to engage in monetary transactions, and do so as conveniently, securely and easily as possible. The state paper money system today offers easily useable ‘computer money’ and the broader public is still happy to use it. Why switch to Bitcoin?
Will Bitcoin get accepted by the wider public?
It is my impression that the community of Bitcoin users, although apparently growing strongly, is still largely composed of those who are fascinated by the technology as such and who want to be part of something new, and those who like it for ‘ideological’ reasons, i.e. those who detest state paper money or dislike the banking system. Thus, there is apparently still a big contingent of computer ‘nerds’, hackers, crypto-anarchists, anti-government libertarians and Occupy-Wall-Street-types among its user base (which is not to say that there are not many who do not fall into any of these categories). How could Bitcoin attract a broader base of money-consumers beyond these groups?
One powerful aspect is cost. Bitcoin transactions are free, so Bitcoin could become – or maybe it is already – the Skype of payment systems. Another attraction could simply be the usually reasonable, and with some effort potentially considerable, anonymity and untraceability that Bitcoin offers. This seems to be a hotly debated topic. On the one hand, Bitcoin is incredibly transparent. All transactions are literally in the open domain. However, each ‘user’ is only identified by his ‘address’ and the number of addresses is practically unlimited. One could use a new address for each transaction. This may not mean instant untraceability from ‘the authorities’ but then again, certain techniques and add-ons, some of which are still being developed, have the potential to increase anonymity and untraceability even further. Additionally, it is possible to acquire Bitcoin for cash – rather than via the established and already regulated exchanges – and thus anonymously.
This means Bitcoin could be used, as is a frequent charge against it already, for illegal transactions involving drugs and guns. But people do not have to be drug or arms dealers, or even ordinary tax cheats, to appreciate a certain degree of financial privacy. As bank secrecy laws disappear everywhere and as almost all governments are waging a ‘war on cash’, by which any transaction that involves more than just petty cash is to be moved to electronic systems within the state’s fiat money network, so that ‘the authorities’ achieve full ‘transparency’ as to what the citizenry is up to at any moment, there could well be a widespread demand for ‘outside’ electronic payment systems offering privacy. For example, a range of ‘activities’ exist engaging in which may not be, or not yet be, illegal but considered a major potential embarrassment to the parties involved if made public (gambling, pornography, escort services), so that many people would not want to have payment for them on their permanent records. This potential development is not lacking in irony: our modern information society with its trends towards the ‘transparent citizen’ and unlimited data storage holds many threats to a free society, privacy and individual liberty. It would be fitting if countermoves to these trends emanated from the same technology.
An additional boost to Bitcoin may come straight from the crumbling state paper money infrastructure itself. The cases of Iceland and in particular Cyprus have driven home the point that ‘money in the bank’ is far from safe, and even if your deposits have survived the bank collapse and the ‘bail-in’, you may not get them out of the country any time soon as capital controls are likely be imposed. As the overstretched paper money economy staggers towards its inevitable demise, more of these instances will occur providing an additional opening for Bitcoin. To the best of my knowledge, Bitcoins cannot be confiscated and Bitcoin accounts cannot be frozen Additionally, you store Bitcoin yourself rather than put them into a fractional-reserve bank that would conveniently use them as ‘reserves’ for its own ‘money derivative’ production.
What are Bitcoins worth?
I agree with Jon Matonis that nobody can give a reasonable answer but that the outcome is probably binary: Either Bitcoin ultimately fails and the individual Bitcoins end up worthless. Or Bitcoin takes off and Bitcoins are worth hundreds of thousands of paper dollars, paper yen, paper euros, or paper pounds. Maybe more. Those who buy Bitcoin as a speculative investment should consider it an option on the future success of the crypto-currency. At time of writing, Bitcoins are trading at $127 and £83 at Bitcoin-exchange Mt. Gox.
On a personal note, my biggest ‘liquid’ asset continues to be physical gold. As I explained on numerous occasions, I consider gold to be the essential self-defense asset in the ongoing paper money crisis. Gold is not being used presently by the wider public as a medium of exchange either but its two-thousand-plus year history as global money means that it retains monetary asset status and that its historic function as a liquid and lasting store of value – a function that fiat money cannot fulfil – remains unrivalled. By comparison, the brand-new crypto-currency Bitcoin has to first earn its stripes as a monetary asset by proving itself as a ‘common’ medium of exchange. That is why I view Bitcoin very differently from gold, although the attraction of both has its origin in the demise of entirely elastic, politicized state fiat money. I will certainly continue to follow the Bitcoin revolution with interest and sympathy.
In the meantime, the debasement of paper money continues.
In a previous life as a London-based ‘global strategist’ (I was never sure what that was) I was known as someone who was worried by QE and more generally, about the willingness of our central bankers to play games with something which I didn’t think they fully understand: money. This may be a strange, even presumptuous thing to say. Surely of all people, one thing central bankers understand is money?
They certainly should understand money. They print it, lend it, borrow it, conjure it. They control the price of it… But so what? What should be true is not necessarily what is true, and in the topsy-turvy world of finance and economics, it rarely is. So file the following under “strange but true”: our best and brightest economists have very little understanding of economics. Take the current malaise as prima facie evidence.
Let me illustrate. Of the many elemental flaws in macroeconomic practice is the true observation that the economic variables in which we might be most interested happen to be those which lend themselves least to measurement. Thus, the statistics which we take for granted and band around freely with each other measuring such ostensibly simple concepts as inflation, wealth, capital and debt, in fact involve all sorts of hidden assumptions, short-cuts and qualifications. So many, indeed, as to render reliance on them without respect for their limitations a very dangerous thing to do. As an example, consider the damage caused by banks to themselves and others by mistaking price volatility (measurable) with risk (unmeasurable). Yet faith in false precision seems to us to be one of the many imperfections our species is cursed with.
One such ‘unmeasurable’ increasingly occupying us here at Edelweiss is that upon which all economic activity is based: trust. Trust between individuals, between strangers, between organisations… trust in what people read, and even people’s trust in themselves. Let’s spend a few moments elaborating on this.
First, we must understand the profound importance of exchange. To do this, simply look around you. You might see a computer monitor, a coffee mug, a telephone, a radio, an iPad, a magazine, whatever it is. Now ask yourself how much of that stuff you’d be able to make for yourself. The answer is almost certainly none. So where did it all come from? Strangers, basically. You don’t know them and they don’t know you. In fact virtually none of us know each other. Nevertheless, strangers somehow pooled their skills, their experience and their expertise so as to conceive, design, manufacture and distribute whatever you are looking at right now so that it could be right there right now. And what makes it possible for you to have it? Exchange. To be able to consume the skills of these strangers, you must sell yours. Everyone enters into the same bargain on some level and in fact, the whole economy is nothing more than an anonymous labor exchange. Beholding the rich tapestry this exchange weaves and its bounty of accumulated capital, prosperity and civilization is a marvelous thing.
But we must also understand that exchange is only possible to the extent that people trust each other: when eating in a restaurant we trust the chef not to put things in our food; when hiring a builder we trust him to build a wall which won’t fall down; when we book a flight we entrust our lives and the lives of our families to complete strangers. Trust is social bonding and societies without it are stalked by social unrest, upheaval or even war. Distrust is a brake on prosperity, because distrust is a brake on exchange.
But now let’s get back to thinking about money, and let’s note also that distrust isn’t the only possible brake on exchange. Money is required for exchange too. Without money we’d be restricted to barter one way or another. So money and trust are intimately connected. Indeed, the English word credit derives from the Latin word credere, which means to trust. Since money facilitates exchange, it facilitates trust and cooperation. So when central banks play the games with money of which they are so fond, we wonder if they realize that they are also playing games with social bonding. Do they realize that by devaluing money they are devaluing society?
To see the how, first understand how monetary policy works. Think about what happens in the very simple example of a central bank’s expanding the monetary base by printing money to buy government bonds.
That by this transaction the government has raised revenue for the government is obvious. The government now has a greater command over the nation’s resources. But it is equally obvious that no one can raise revenue without someone else bearing the cost. To deny it would imply revenues could be raised for free, which would imply that wealth could be created by printing more money. True, some economists, it seems, would have the world believe there to be some validity to such thinking. But for those of us more concerned with correct logical practice, it begs a serious question. Who pays? We know that this monetary policy has redistributed money into the government’s coffers. But from whom has the redistribution been?
The simple answer is that we don’t and can’t know, at least not on an amount per person basis. This is unfortunate and unsatisfactory, but it also happens to be true. Had the extra money come from taxation, everyone would at least know where the burden had fallen and who had decreed it to fall there. True, the upper-rate tax payers might not like having a portion of their wealth redirected towards poorer members of society and they might not agree with it. Some might even feel robbed. But at least they know who the robber is.
When the government raises revenue by selling bonds to the central bank, which has financed its purchases with printed money, no one knows who ultimately pays. In the abstract, we know that current holders of money pay since their cash holdings have been diluted. But the effects are more subtle. To see just how subtle, consider Cantillon’s 18th century analysis of the effects of a sudden increase in gold production:
If the increase of actual money comes from mines of gold or silver… the owner of these mines, the adventurers, the smelters, refiners, and all the other workers will increase their expenditures in proportion to their gains. … All this increase of expenditures in meat, wine, wool, etc. diminishes of necessity the share of the other inhabitants of the state who do not participate at first in the wealth of the mines in question. The altercations of the market, or the demand for meat, wine, wool, etc. being more intense than usual, will not fail to raise their prices. … Those then who will suffer from this dearness… will be first of all the landowners, during the term of their leases, then their domestic servants and all the workmen or fixed wage-earners … All these must diminish their expenditure in proportion to the new consumption.
In Cantillon’s example, the gold mine owners, mine employees, manufacturers of the stuff miners buy and the merchants who trade in it all benefit handsomely. They are closest to the new money and they get to see their real purchasing powers rise.
But as they go out and spend, they bid up the prices of the stuff they purchase to a level which is higher than it would otherwise have been, making that stuff more expensive. For anyone not connected to the mining business (and especially those on fixed incomes: “the landowners, during the term of their leases”), real incomes haven’t risen to keep up with the higher prices. So the increase in the gold supply redistributes money towards those closest to the new money, and away from those furthest away.
Another way to think about this might be to think about Milton Friedman’s idea of dropping new money from a helicopter. He used this example to demonstrate how easy it would theoretically be for a government to create inflation. What he didn’t say was that such a drop would redistribute income in the same way more gold from Cantillon’s mines did, towards those standing underneath the helicopter and away from everyone else.
So now we know we have a slightly better understanding of who pays: whoever is furthest away from the newly created money. And we have a better understanding of how they pay: through a reduction in their own spending power. The problem is that while they will be acutely aware of the reduction in their own spending power, they will be less aware of why their spending power has declined. So if they find groceries becoming more expensive they blame the retailers for raising prices; if they find petrol unaffordable, they blame the oil companies; if they find rents too expensive they blame landlords, and so on. So now we see the mechanism by which debasing money debases trust. The unaware victims of this accidental redistribution don’t know who the enemy is, so they create an enemy.
Keynes was well aware of this insidious dynamic and articulated it beautifully in a 1919 essay:
By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. … Those to whom the system brings windfalls… become “profiteers” who are the object of the hatred…. the process of wealth-getting degenerates into a gamble and a lottery.
Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.
Deliberately impoverishing one group in society is a bad thing to do. But impoverishing a group in such an opaque, clandestine and underhanded way is worse. It is not only unjust but dangerous and potentially destructive. A clear and transparent fiscal policy which openly redistributes from the rich to the poor can at least be argued on some level to be consistent with ‘social justice.’ Governments can at least claim to be playing Robin Hood. There is no such defense for a monetary driven redistribution towards recipients of the new money and away from everyone else because if the well-off are closest to the money, well, it will have the perverse effect of benefitting them at the expense of the poor.
Take the past few decades. Prior to the 2008 crash, central banks set interest rates according to what their crystal ball told them the future would be like. They were supposed to raise them when they thought the economy was growing too fast and cut them when they thought it was growing too slow. They were supposed to be clever enough to banish the boom-bust cycle, and this was a nice idea. The problem was that it didn’t work. One reason was because central bankers weren’t as clever as they thought. Another was because they had a bias to lower rates during the bad times but not raise them adequately during the good times. On average therefore, credit tended to be too cheap and so the demand for debt was artificially high. Since that new debt was used to buy assets, the prices of assets rose in a series of asset bubbles around the world. And this unprecedented, secular and largely global credit inflation created an illusion of prosperity which was fun for most people while it lasted.
But beneath the surface, the redistributive mechanism upon which monetary policy relies was at work. Like Cantillon’s gold miners, those closest to the new credit (financial institutions and anyone working in finance industry) were the prime beneficiaries. In 2012 the top 50 names on the Forbes list of richest Americans included the fortunes of eleven investors, financiers or hedge fund managers. In 1982 the list had none.
Besides this redistribution of wealth towards the financial sector was a redistribution to those who were already asset-rich. Asset prices were inflated by cheap credit and the assets themselves could be used as collateral for it. The following chart suggests the size of this transfer from poor to rich might have been quite meaningful, with the top 1% of earners taking the biggest a share of the pie since the last great credit inflation, that of the 1920s.
Who paid? Those with no access to credit, those with no assets, or those who bought assets late in the asset inflations and which now nurse the problem balance sheets. They all paid. Worse still, future generations were victims too, since one way or another they’re on the hook for it.
So with their crackpot monetary ideas, central banks have been robbing Peter to pay Paul without knowing which one was which. And a problem here is this thing behavioural psychologists call self-attribution bias. It describes how when good things happen to people they think it’s because of something they did, but when bad things happen to them they think it’s because of something someone else did. So although Peter doesn’t know why he’s suddenly poor, he knows it must be someone else’s fault. He also sees that Paul seems to be doing OK. So being human, he makes the obvious connection: it’s all Paul and people like Paul’s fault.
But Paul has a different way of looking at it. Also being human, he assumes he’s doing OK because he’s doing something right. He doesn’t know what the problem is other than Peter’s bad attitude. Needless to say, he resents Peter for his bad attitude. So now Peter and Paul don’t trust each other. And this what happens when you play games with society’s bonding.
When we look around we can’t help feeling something similar is happening. The 99% blame the 1%; the 1% blame the 47%. In the aftermath of the Eurozone’s own credit bubbles, the Germans blame the Greeks. The Greeks round on the foreigners. The Catalans blame the Castilians. And as 25% of the Italian electorate vote for a professional comedian whose party slogan “vaffa” means roughly “f**k off” (to everything it seems, including the common currency), the Germans are repatriating their gold from New York and Paris. Meanwhile in China, that centrally planned mother of all credit inflations, popular anger is being directed at Japan, and this is before its own credit bubble chapter has fully played out. (The rising risk of war is something we are increasingly worried about…). Of course, everyone blames the bankers (“those to whom the system brings windfalls… become ‘profiteers’ who are the object of the hatred”).
But what does it mean for the owner of capital? If our thinking is correct, the solution would be less monetary experimentation. Yet we are likely to see more. Bernanke has monetized about a half of the federally guaranteed debt issued since 2009 (see chart below). The incoming Bank of England governor thinks the UK’s problem hasn’t been too much monetary experimentation but too little, and likes the idea of actively targeting nominal GDP. The PM in Tokyo thinks his country’s every ill is a lack of inflation, and his new guy at the Bank of Japan is revving up its printing presses to buy government bonds, corporate bonds and ETFs. China’s shadow banking credit bubble meanwhile continues to inflate…
For all we know there might be another round of illusory prosperity before our worst fears are realised. With any luck, our worst fears never will be. But if the overdose of monetary medicine made us ill, we don’t understand how more of the same medicine will make us better.
We do know that the financial market analogue to trust is yield. The less trustful lenders are of borrowers, the higher the yield they demand to compensate. But interest rates, or what’s left of them, are at historic lows. In other words, there is a glaring disconnect between the distrust central banks are fostering in the real world and the unprecedented trust lenders are signaling to borrowers in the financial world.
Of course, there is no such thing as “risk-free” in the real world. Holders of UK cash have seen a cumulative real loss of around 10% since the crash of 2008. Holders of US cash haven’t done much better. If we were to hope to find safety by lending to what many consider to be an excellent credit, Microsoft, by buying its bonds, we’d have to lend to them until 2021 to earn a gross return roughly the same as the current rate of US inflation. But then we’d have to pay taxes on the coupons. And we’d have to worry about whether or not the rate of inflation was going to rise meaningfully from here, because the 2021 maturity date is eight years away and eight years is a long time. And then we’d have to worry about where our bonds were held, and whether or not they were being lent out by our custodian. And of course, this would all be before we’d worried about whether Microsoft’s business was likely to remain safe over an eight year horizon.
We are happy to watch others play that game. There are some outstanding businesses and individuals with whom we are happy to invest. In an ideal world we would have neither Peters nor Pauls. In the imperfect one in which we live, we have to settle for trying hard to avoid the Pauls, who we fear mistake entrepreneurial competence for proximity to the money well. But when we find the real thing, the timeless ingenuity of the honest entrepreneurs, the modest craftsmen and craftswomen who humbly seek to improve the lot of their customers through their own enterprise, we find inspiration too, for as investors we try to model our own practice on theirs. It is no secret that our quest is to find scarcity. But the scarce substance we prize above all else is trustworthiness. Aware that we worry too much in a world growing more wary and distrustful, it is here we place an increasing premium, here that we seek refuge from financial folly and here that we expect the next bull market.
This article was previously published in Edelweiss Journal, Issue 12 (11 March 2013)
It’s official: global economic policy is now firmly in the hands of money cranks.
The lesson from the events of 2007-2008 should have been clear: boosting GDP with loose money – as the Greenspan Fed did repeatedly between 1987 and 2005 and most damagingly between 2001 and 2005 when in order to shorten a minor recession it inflated a massive housing bubble – can only lead to short term booms followed by severe busts. A policy of artificially cheapened credit cannot but cause mispricing of risk, misallocation of capital and a deeply dislocated financial infrastructure, all of which will ultimately conspire to bring the fake boom to a screeching halt. The ‘good times’ of the cheap money expansion, largely characterized by windfall profits for the financial industry and the faux prosperity of propped-up financial assets and real estate (largely to be enjoyed by the ‘1 percent’), necessarily end in an almighty hangover.
The crisis that commenced in 2007 was therefore a massive opportunity: an opportunity to allow the market to liquidate the accumulated dislocations and to bring the economy back into balance; an opportunity to reflect on the inherent instability that central bank activism and manipulation of interest rates must generate; an opportunity to cut off a bloated financial industry from the subsidy of cheap money; and an opportunity to return to sound money and, well, to capitalism. Because for all the thoughtless talk of this being a ‘crisis of capitalism’, a nonsense concocted on the facile assumption that anything that is noisily supported by bankers must be representative of free market ideology, the modern system of ‘bubble finance’, cheap fiat money and excessive debt has precious little to do with true free-market capitalism.
That opportunity was not taken and is now lost – maybe until the next crisis comes along, which won’t be long. It has become clear in recent years – and even more so in recent months and weeks – that we are moving with increasing speed in the opposite direction: ever more money, cheaper credit, and manipulated markets (there is one notable exception to which I come later). Policy makers have learned nothing. The same mistakes are being repeated and the consequences are going to make 2007/8 look like a picnic.
From ‘saving the world’ to blowing new bubbles
Of course, I was never very optimistic that the route back to the free market and sound money would be taken. At the time I left my job in finance in 2009 and began to write Paper Money Collapse, the authorities had already decided that to deal with the consequences of easy-money-induced bubbles we needed more easy money. ‘Quantitative easing’, massive bank bailouts, deficit spending and ultra-low policy rates had become the policy of choice globally. But at least the pretence was upheld for a while that these were temporary measures – ugly and unprincipled but required under the dreadful conditions of 2008 to save ‘the system’. The first round of debt monetization after the Lehman collapse – the exchange of $1 trillion of mortgage-backed securities on bloated bank balance sheets for freshly minted bank reserves from Bernanke’s printing press under ‘quantitative easing 1.0’ (QE1) – was presented as an emergency measure to avoid bank collapses and a systemic crisis.
I never thought that this was a convincing rationale as it was clear to me that whatever the accumulated dislocations were, there was ultimately no alternative to allowing the market to identify and liquidate them. Aborting, delaying and sabotaging this essential process of economic cleansing and rebalancing would only cause new problems. Even on the assumption that these were measures to deal with extreme ‘tail events’, I could not then and cannot now support them. But it is becoming abundantly clear that these measures are neither temporary nor restricted to avoiding bank runs or systemic chaos but that now, after the public has become sufficiently accustomed to them and a cheap-money-addicted financial industry has begun to incorporate them into their business models, they constitute the ‘new normal’, that they are now the accepted ‘modern’ tool kit of central bankers. Zero interest rates, trillion-dollar open-market operations to manipulate asset prices and to ‘manage’ the yield curve are now just another day in the modern fiat money economy. Nobody talks of restraining central bank activism. Rather, the temptation is growing to use these tools to kick-start another artificial boom.
In his excellent new book The Great Deformation – The Corruption of Capitalism in America, David Stockman provides a fascinating account of how the principles of sound money, balanced budgets and small government have progressively been weakened, betrayed, undermined and ultimately completely abandoned in American politics (often by Republican politicians and even some of the alleged ‘free market heroes’ of Republican folklore), and how today’s cocktail of bubble finance and trillion-dollar deficits represents the delayed but inevitable blossoming of destructive seeds that were sown with Roosevelt’s New Deal and Nixon’s default on the Bretton Woods gold exchange standard. In a chapter on the recent crisis, Stockman argues convincingly that the shameful bailout of Wall Street in 2008, in particular of Goldman Sachs, Morgan Stanley, and a few other highly leveraged entities via the bailout of ‘insurance’ giant AIG, were sold to Congress and the wider public with exaggerated claims that the nation’s real economy was at imminent risk of collapse. From my position as an economist and a market participant at the time of these events, Stockman’s analysis and interpretation strike me as entirely consistent and correct. But even if we were willing to give more credit to the claims of the ‘bailsters’ and interventionists that the fallout for Main Street would have been substantial, that would only further underline how far the Fed’s preceding easy money policies had destabilized the economy, and the question would still remain whether it could ever be a reasonable objective of policy to sustain these large-scale dislocations against market forces.
Be that as it may, the dislocations were largely sustained and plenty of new ones added. Talk of ‘exit strategies’ – that is, of a ‘normalization’ of interest rates and shrinking of central bank balance sheets – has now pretty much died down. Super-low interest rates are now a permanent tonic for the financial industry. In fact, the nature of the debate has shifted markedly over the past 15 months as the idea is progressively gaining adherents that the new hyper-interventionist tool-kit of the central bankers that was slipped in under the cloak of avoiding financial Armageddon in 2008 should now be used pro-actively to start a new easy-money-induced credit boom, that aggressive money printing and debt monetization should be employed to generate a new growth cycle. Many economists are de facto demanding a new bubble.
In America, QE2 was already targeted at boosting the prices of government debt and thereby lowering interest rates and encouraging more lending – which naturally means more borrowing and more debt, the opposite of deleveraging and rebalancing. And QE3 – which is an open-ended $85-billion-a-month price-fixing exercise for selected mortgage- and government- securities – is even targeted officially at lowering the unemployment rate, meaning Fed officials seriously claim that they can create (profitable and lasting?) jobs by cleverly manipulating asset prices.
The resurgence of the money cranks
Rising real wealth is always and everywhere the result of the accumulation of productive capital, which means real resources saved through the non-consumption of real income, and its employment by entrepreneurs in competitive markets under the guidance of uninhibited price formation. This process requires apolitical, hard and international money. Monetary debasement always hinders real wealth creation; it does not aid it. Easy money leads to boom and bust, never to lasting prosperity. Easy money is not a positive-sum game and not even a zero-sum game. It is always and everywhere a negative-sum game.
To claim, instead, that an economy’s performance and society’s wealth is lastingly enhanced by pumping more fiat money through its financial system requires a considerable degree of economic illiteracy and, in the wake of the recent crisis, selective amnesia. Not too long ago, such assertions as to the benefit of inflation and money printing would have clearly marked its proponent as a money crank. But the cranks are now manning the monetary policy ships everywhere, and the international commentariat is either willingly complicit in spreading economic nonsense or intellectually challenged when it comes to exposing the naivete and recklessness of these policies.
Nothing confirms the renewed dominance of money crankism more than the present sad spectacle of Japan, a country that became a post-WWII economic powerhouse in no small measure thanks to the old capitalist virtues of hard work, high savings rates, strong capital accumulation, and innovative and international-minded entrepreneurship, now taking a leaf out of the policy book of Argentina and embarking on a mission of aggressive money printing, currency debasement, asset price manipulation and inflationism. Japanese savers are already losing international purchasing power by the bucket load as the Yen keeps plummeting in international markets.
The idea that currency debasement will result in lasting, self-sustained growth and rising prosperity is positively laughable. I do not doubt that Japan’s new initiative of aggressive monetization has the potential to improve the headline numbers on a number of corporate earning reports and to even give a near-term boost to GDP. Like most drugs, easy money tempts its users with the promise of an immediate but short-lived high. What is, however, absolutely certain is that whatever ‘stimulus’ is generated in the short term is bought at the price of more imbalances (most certainly higher indebtedness) that will weigh down severely on the Japanese population in the future. What is even more worrying is that Japan’s gigantic pool of government debt – held to a large extent by an aging population as a ‘pension nest egg’ and by domestic banks on highly levered balance sheets – is a veritable powder keg, and the Bank of Japan’s new inflation strategy is tantamount to playing with fire.
The deflation myth
It has become commonplace to justify Japan’s monetary ‘experimentation’ with reference to the country’s long suffering under supposedly ‘crippling’ deflation. Even otherwise respectable financial newspapers and journals lazily repeat this standard refrain. It is complete and utter nonsense. Whatever Japan’s problems are, and I am sure they are numerous and sizable, deflation is not one of them.
Firstly, there is no economic rationale for assuming that the type of moderate and ongoing deflation (secular deflation) that analysts suspect in Japan and that is the result of stable money and marginal improvements in productivity could constitute a problem for the economy’s performance. Why such deflation is harmless (and even preferable to moderate inflation) I explain in detail in chapter 5 ofPaper Money Collapse. I make no claim to originality here, as this insight was widely accepted among most serious mainstream economists up to and including the first third of the twentieth century when it became sadly ‘forgotten’ rather than refuted. But if you don’t want to take my word for it or go through the argument in my book, or if you want to have ‘empirical evidence’, then you might want to listen to Milton Friedman, hardly an advocate of the gold standard, who (together with Anna Schwartz) analyzed the late 19th century economy of the United States which had both stronger growth and much more deflation (in particular after the fiat money episode of the Civil War had ended) than Japan had over the past 20-odd years, and who concluded that U.S. data “casts serious doubts on the validity of the now (1963) widely held view that secular price deflation and rapid economic growth are incompatible.”
Secondly, there is not even any deflation in Japan that deserves the name. The data (which is here) does not support it. I am sure the economists at the Bank of Japan employ massive magnifying glasses to detect deflation in their data series. What Japan has is, by any rational standard, price stability.
In February 2013, the consumer price index (CPI) stood at 99.3. Ten years earlier, in February 2003, it stood at 100.3, and ten years before that, in February 1993, at 99.6. Apart from the fact that, as with any price-index data, the methodology, accuracy and relevance of these statistics is always highly debatable, it is clear that if we do take the data at face value we see an economy that has roughly enjoyed stable prices for two decades. In fact, prices rose marginally in the late 1990s, remained stable for a few years, and have recently declined marginally.
In February of this year, the inflation rate was -0.6 percent year over year. Would any of the commentators who lament Japan’s ‘crippling deflation’ claim that an inflation rate of +0.6 percent year over year would constitute worrying inflation, or even deserve the label ‘inflation’ at all? Would it not simply be called a rounding error? – By comparison, official UK inflation stood at +2.8 percent year over year in February 2013 and has fluctuated between +1.1 percent and +5 percent over the past 4 years alone. What monetary system is more conducive to rational economic calculation and planning – Japan’s or Britain’s? (It should be worth noting that over those 4 years the British economy has NOT outperformed Japan, despite its ‘wonderful’ inflation.)
Those commentators who tell us that this ‘crippling deflation’ is hurting the economy because people postpone spending decisions in anticipation of lower prices, want us to believe that Mr. and Mrs. Watanabe don’t buy a new popup toaster for ¥3,930 this year because – at a 0.6 percent p.a. deflation rate – they can reasonably assume that it will only cost ¥3,906 to buy the same toaster next year. And they won’t even buy it next year at ¥3,906 because the year after that it will only cost ¥3,883. The Watanabes would thus be able to save ¥47 over two years by not eating any toast (and it goes without saying that they may save considerably more by never eating toast!). This is a saving of – wait for it! – $0.47 or £0.31 (at present exchange rates) for postponing the purchase of a standard consumption item for two years – 730 mornings without toast! The notion that this ‘crippling’ deflation is holding back Japanese growth is simply beyond ridiculous, yet you can hardly open a newspaper these days without seeing such nonsense presented as economic analysis. (I would recommend that these experts on consumer psychology call the people at Apple, Samsung and other providers of tablets, smartphones and various consumer technology items and tell them that they are missing a trick: it is evidently rising prices that get people buying, not falling prices!)
Funding the state
The deflation argument is so flimsy that one can only assume it is a convenient scapegoat for a different agenda: securing printing-press funding for the state. Under Japan’s new monetary debasement plan, the Bank of Japan will practically buy the entire annual issuance of new government debt and thus fund excessive public sector spending directly via the printing press. Japan is famously the world’s most highly indebted state at 230% of GDP and runs an annual budget deficit of around 10% of GDP. Even the most troubled members of EMU enjoy better funding stats.
The often-heard argument that such profligacy has evidently not been punished by markets for years and decades, so why should the day of reckoning be any nearer now, is unconvincing. For years, the Japanese public has in fact saved and has faithfully handed its private savings over to the state, which immediately wasted them on Keynesian ‘stimulus’ projects that will never bring a meaningful return (bridges and roads to nowhere, public pools, agricultural subsidies). For a long time it was to a considerable degree private frugality that funded public excess. But now the savings rate has collapsed to 2 percent and given the shrinking workforce and aging population is unlikely to ever recover. Private savings are thus no longer sufficient to fund the state’s recklessness, so now it is up to the Bank of Japan to keep the state in business and maintain a mirage of solvency. The inflationary implications of funding massive government waste through money-printing rather than voluntary savings are, of course, considerable.
The risk here is not that the policy of monetary debasement will again amount to ‘pushing on a string’ and fail to raise inflation and inflation expectations. The much riskier and likelier outcome is that this policy will ultimately ‘succeed’. The aging Japanese population sits on a massive pile of government debt that is not backed by productive capital but that the population still considers its ‘pension assets’. Debasing the purchasing power of fixed income streams that Japanese pensioners draw from this pool will ultimately dampen domestic consumption – the very component of GDP that the inflationists claim to boost with their monetary debasement. If inflation only rises from -0.6 percent to +1 percent, the entire Japanese yield curve is ‘under water’. Only very long maturity bonds will still provide a positive real yield. This will also hurt the banks which are massive (leveraged) owners of government debt. And of course, a meaningful sell-off in the bond market would quickly wipe out bank capital.
Such a sell-off may still not occur anytime soon. At the present UK inflation-rate of +2.8 percent, most of the UK’s government bonds are also trading at negative real yields. In fact, in recent months many bond investors around the world have exhibited a remarkable willingness to hold bonds at negative real returns. It appears as if many of these securities have become, in the eyes of their holders, ‘cash equivalents’, i.e. instruments that are held for reasons of safety and liquidity, not for reasons of income generation. How far the central banks can exploit this phenomenon is uncertain. Central banks cannot turn water into wine but almost any asset into (fiat) money by ‘monetizing’ them. The only limit to this operation is the willingness of the public to hold these new ‘monetized’ assets, and frankly I doubt that there is money demand in Japan to the tune of 230 percent of GDP. – We shall find out.
Money crankism will spread
‘Abenomics’ will not solve Japan’s problems; it will make the Japanese worse off and it has the potential to trigger a mighty financial crisis. Yet, what is surely inevitable might not be imminent. During the early honeymoon between ‘Abenomics’ and financial reality, the idea of printing yourself to prosperity is likely to have imitators, with the UK being a prime candidate. In terms of total indebtedness, the UK is the one industrialized country that can compete with Japan, meaning it is in the same supersized debt-pickle. Even the timid attempts by Chancellor Osborne to lower the speed at which Her Majesty’s government goes further into debt are being attacked as savage ‘austerity’ by the opposition and large parts of the media. In his latest budget he put the remaining taxpayer-chips on another housing bubble and gave the Bank of England more room to ignore inflation. Over at Thredneedle Street, the Deputy Governor of the Bank of England, Paul Tucker, openly fantasized about negative interest rates recently, outgoing Governor Mervyn King voted for more QE (overruled), and Governor-elect Mark Carney promises to be, well, – flexible. Bottom line: desperation is spreading. Watch this place! Chances are the Old Lady is the next to throw any remaining caution and remaining vestiges of monetary sanity to the wind and – go ‘all in’.
This will end badly.
P.S.: As to ‘the exception’, the only place where money crankism is not the order of the day yet is – the Euro Zone!– Yes, I am serious. – I know, I know. This is an amalgamation of semi-socialist, semi-bankrupt welfare states that share the same politicized paper currency issued by a central bank that has already bailed out too many banks, has manipulated various government bond markets and whose balance sheet as a percent of GDP is larger than the Fed’s. However: in a global sea of monetary madness there are at least a few remaining signs of sanity and orthodox monetary discipline on display in the much derided EMU. Greece was allowed or encouraged to default on part of its debt, which meant that bond-holders had to eat losses. Cyprus’ biggest bank is being wound down, which means depositors are going to eat losses, too. There is a persistent push towards ‘austerity’. On the fiscal front, the Euro Zone easily outperforms the US, the UK and, of course, Japan. While the Fed has increased its balance sheet girth by almost $300 billion in the first three months of 2013 alone, the ECB has reduced its own by almost €400 billion over the same time. My rule is this: the more Professor Krugman is foaming at the mouth and the more apoplectic the commentary from the strategists, analysts and economists in the bailout-addicted financial industry get, the more it seems that Mrs Merkel & Co are getting a few things right.
On Thursday April 4 the Federal Reserve Vice Chairman Janet Yellen said in Washington the Federal Open Market Committee (FOMC) should be prepared to alter its $85 billion monthly pace of bond buying based on changes in the economic outlook.
Yellen’s comments support a proposal by St. Louis Fed President James Bullard to reduce the pace of purchases as the economy improves, or expand it if the economy weakens.
Also, the Fed Chairman Ben Bernanke said last month the FOMC is considering this strategy to “appropriately calibrate” its policy.
The view that the Fed should calibrate its monetary policy in line with the likely state of the economy stems from the popular way of thinking that the role of the central bank is to make sure that the economy stays on a path of balanced economic growth.
According to this way of thinking the economy is seen as some kind of space ship that has deviated from its trajectory.
To bring it back onto the correct path, policy makers must give it an external push. So if the push in terms of loose monetary policy doesn’t produce the required results then policy makers must become more aggressive until the space ship is brought onto the desired path.
Conversely, if the economy, for whatever reason, is pushed onto the path of high inflation, then the central bank by means of a tighter monetary stance must bring the space ship onto the “correct” path.
Within this way of thinking, given that the economy is currently way below its right growth path there are plentiful of unemployed resources. Consequently, this permits policy makers to adopt a very aggressive loose stance without igniting inflation.
We suggest that this way of thinking is erroneous. An economy is about human beings and not about a space ship that follows along a growth path.
A policy that attempts to bring the economy onto the “correct” trajectory leads to a diversion of wealth from wealth generators to non–wealth-generating activities, thereby weakening the process of the wealth generation, i.e. it leads to an economic impoverishment.
In the meantime, the latest economic data seems to support the view that the Fed is unlikely to reverse its loose monetary stance soon.
The ISM manufacturing activity index fell to 51.3 in March from 54.2 in the previous month – whilst the ISM services index eased to 54.4 last month from 56 in the month before.
Non farm employment increased in March by 88,000 against the median forecast of economists for an increase of 190,000. Year-on-year employment increased by 1.91 million after rising by 2.027 million in February and an increase by 2.03 million in January. Additionally the diffusion index of employment in the private sector fell to 54.3 last month from 59.6 in February and 65.2 in December last year.
Elsewhere we have suggested that fluctuations in economic data are set in motion by fluctuations in the growth momentum of money supply as depicted by our monetary measure AMS.
After closing at 2.2% in June 2010 the yearly rate of growth of AMS climbed to 14.8% by October 2011.
Afterwards the yearly rate of growth has been following a declining path closing at 7.3% in March this year. (A change in the money supply rate of growth doesn’t affect all activities instantly – there is a time lag. For some activities the time lag is short while for others it is much longer).
We suggest that the fact that the growth momentum of AMS has been declining since October 2011 implies that downward pressure on economic activity has already been set in motion.
As time goes by the supporting effect on economic activity from the rising growth momentum of AMS during June 2010 to October 2011 is likely to weaken whilst the fall in growth momentum since October 2011 onward is likely to start to dominate the economic scene.
Based on the lagged growth momentum of real AMS (AMS adjusted for CPI) we suggest that the growth momentum of industrial production could come under strong pressure from the second half of this year. This is likely to undermine the growth momentum of employment (see chart).
We hold that massive monetary pumping by the Fed not only didn’t provide support to the economy but on the contrary has severely damaged the process of wealth generation. Elsewhere we have shown that it is the formation of real wealth that funds and thereby supports underlying economic growth.
This runs contrary to the popular way of thinking that loose monetary policy can somehow fund and grow an economy. All that loose monetary policy can do is to give rise to various non-productive bubble activities and thereby undermine underlying economic growth.
As long as the pool of real wealth is expanding loose monetary policies can give the impression that they grow the economy. Once however the pool becomes stagnant, or starts to decline, the economy follows suit.
In this case if central bank policy makers try to enforce aggressive monetary pumping this weakens the wealth generation process and weakens the pool of funding further. There are signs that this might be already happening. As a rule when the central bank pushes money into the banking system banks lend this money out thus boosting the money supply rate of growth and after a time lag this boosts the economic activity.
At present this mechanism is not working. Despite a massive increase in the Fed’s pumping as depicted by its balance sheet, banks so far have chosen to sit on the pumped cash rather than lend it out. In early April the Fed’s balance sheet stood at $3.2 trillion against $0.9 trillion in January 2008. Banks surplus cash jumped to $1.726 trillion in early April from $1.578 trillion in January. In January 2008 surplus cash stood at around $2.4 billion.
As the pool of real wealth comes under pressure banks find it much harder to acquire good quality borrowers, hence the supply of lending is slowing down. Now if the Fed were to attempt to force banks to increase lending this is not going to help real economic growth if the pool of funding is under pressure. The best thing the Fed could do to help the economy is to do nothing as soon as possible. This will strengthen wealth generators and in turn the wealth generation process.
Summary and conclusion
Some Fed officials have suggested that once the US economy gains strength it will be appropriate to reduce monetary pumping. The latest economic data seems to support the view that the US central bank is unlikely to reverse its loose monetary stance soon. The ISM manufacturing and services indexes have weakened last month whilst employment increased in March well below economists’ expectations. We suggest that the fact that the growth momentum of AMS has been declining since October 2011 implies that downward pressure on economic activity has already been set in motion. We also hold that the process of wealth generation was badly damaged by loose monetary policies of the Fed. This runs the risk of a prolonged economic slump. The best thing the Fed could do to help the economy is to do as soon as possible nothing.
The Cyprus banking kerfuffle has ignited a blogosphere storm debating the likelihood that depositors elsewhere, perhaps even ‘guaranteed’ ones, may find themselves on the hook for recapitalising their domestic banks. Largely lost in this discussion however is the unpleasant reality that a substantial portion of the international financial sector has been undercapitalised or even insolvent since at least 2008, if not before. Policy responses to the financial crisis have not changed this fact. Indeed, as resource misallocations are the ultimate cause of bankruptcy or insolvency, the exponential increase in price-fixing distortions in the wake of the global financial crisis ensures that depositors in aggregate are now facing far greater losses than they were back in 2008. Someone has to pay for past resource misallocations even when central banks succeed in sweeping these under the rug of monetary inflation. Will it be you?
THE BANKS ARE (STILL) INSOLVENT
You don’t need to live in Cyprus to be aware that banks in numerous countries are woefully undercapitalised, in some cases to the point of insolvency. Sure, regulatory financial accounting conventions allow for a huge amount of smoke-and-mirrors obfuscation, delaying the day of reckoning, but an insolvent bank is insolvent regardless of the regulators’ choices of accounting conventions to apply from one day to the next.
Although the specific distinctions vary from country to country, large banks have multiple sources of capital in their liability structure with varying degrees of seniority. As losses are incurred they are absorbed by this structure, tranche by tranche. First goes the shareholder equity, then the subordinated debt (which includes a great number of interbank derivative positions, about which more later), then the senior debt, then uninsured deposits.
Back in 2008, however, government and central bank officials chose not to follow existing law and apportion losses to banks’ liability structures through appropriate insolvency proceedings. Rather, they chose to go straight to the taxpayers to bail out their respective financial systems, in some cases by outright nationalising institutions. This was done because the institutions in question were deemed ‘too big to fail’ (TBTF) and their insolvency would have threatened to derail the entire financial system.
THE BANKER BAILOUT BACKLASH
This policy (mis)judgement, that socialising bank losses served the interests of society, has been the subject of much dispute, including in previous Amphora Reports[1] and, more recently, in David Stockman’s outstanding new book, The Great Deformation (available on Amazon here). Indeed, as one banker scandal after another has come to light since 2008 there has now been a huge banker bailout backlash. Politicians understand that, in the event another crisis hits and the TBTF banks are at risk of failure yet again, taxpayers may refuse to support another systemic rescue. What to do?
Well, behind the scenes, economic officials the world over have been busy putting together working frameworks for how to deal with future bank failures. One recent, prominent example is a joint paper by the US Federal Deposit Insurance Corporation and the Bank of England, in cooperation with the US Federal Reserve and the Financial Stability Board of the Bank for International Settlements, the international bank supervisory body based in Basle, Switzerland [2]. Given its international character and the prominence of the institutions involved, this paper should be understood as a working template for how large international bank failures will be addressed in future. The paper begins with an explanation of the problem (emphasis added):
The financial crisis that began in late 2007 highlighted the shortcomings of the arrangements for handling the failure of large financial institutions that were in place on either side of the Atlantic. Large banking organizations in both the U.S. and the U.K. had become highly leveraged and complex, with numerous and dispersed financial operations, extensive off-balance-sheet activities, and opaque financial statements. These institutions were managed as single entities, despite their subsidiaries being structured as separate and distinct legal entities. They were highly interconnected through their capital markets activities, interbank lending, payments, and off-balance-sheet arrangements.
The paper then proposes what appears, at first glance, to be an entirely reasonable way to deal with a possible future failure of such an institution:
[R]esolution strategies should maintain systemically important operations and contain threats to financial stability. They should also assign losses to shareholders and unsecured creditors in the group, thereby avoiding the need for a bailout by taxpayers. These strategies should be sufficiently robust to manage the challenges of cross-border implementation and to the operational challenges of execution.
Fair enough. How reasonable to actually have a framework in place that allows banks to fail without placing taxpayers on the hook. But as with many apparently reasonable policy initiatives, the devil lurks in the details, specifically in paragraph 13 (an appropriate number perhaps?):
An efficient path for returning the sound operations of the [bank] to the private sector would be provided by exchanging or converting a sufficient amount of the unsecured debt from the original creditors of the failed company into equity. In the U.S., the new equity would become capital in one or more newly formed operating entities. In the U.K., the same approach could be used, or the equity could be used to recapitalize the failing financial company itself—thus, the highest layer of surviving bailed-in creditors would become the owners of the resolved firm. In either country, the new equity holders would take on the corresponding risk of being shareholders in a financial institution. Throughout, subsidiaries (domestic and foreign) carrying out critical activities would be kept open and operating, thereby limiting contagion effects. Such a resolution strategy would ensure market discipline and maintain financial stability without cost to taxpayers.
What this amounts to is a debt-for-equity swap arrangement for the “highest layer of surviving bailed-in creditors.” While in some cases the ‘highest layer’ might be that of the bondholders, in others it would include depositors, as is the case in Cyprus for example. Yet this is to be done while “subsidiaries carrying out critical activities would be kept open and operating, thereby limiting contagion effects.” So what, exactly, are these ‘critical activities’? And what is meant by ‘contagion effects’?
What the authors are referring to here is the interbank market, not only for wholesale lending in the money markets but also for all manner of financial derivatives and the underlying collateral on which they are, in some way, secured. This is what caught regulators by surprise in 2008: following the collapse of Lehman Brothers a fire-sale slump in collateral values led to a cascade of interbank margin calls and the market seized up, threatening relatively well-capitalised firms that had appeared previously not to be at risk. The paper thus implies that the way to prevent contagion in future is to prevent a sudden contraction in the interbank lending+derivatives market.
Think about this for a moment: The interbank market, a leveraged, inverted pyramid of subordinated debt built on top of a comparatively limited amount of senior debt collateral, is to be held intact by regulatory fiat while depositors are ‘bailed-in’ via a debt-for-equity swap. Do you see the sleight-of-hand at work here? Under the guise of protecting taxpayers, depositors of failing institutions are to be arbitrarily, de-facto subordinated to interbank claims, when in fact they are legally senior to those claims!
In other words, regulators are laying the operational groundwork for a new type of banker bailout deemed politically acceptable. The last time around, they went straight to the taxpayers. The next time around, they are going straight to the depositors.
Now it so happens that depositors are never explicity mentioned in the paper. They are always referred to as ‘unsecured creditors’. But the effective meaning of this term is belied by the fact that the proposal assigns the FDIC the job of resolving US-based institutions via the debt-for-equity swap mechanism mentioned earlier. Were the bondholders rather than depositors in primary focus this would not be the case as the FDIC has no direct responsibility for the wholesale, non-depositor sources of credit to US financial institutions.
Finally, consider the brutal, unjust irony of the entire proposal. Remember, its stated purpose is to solve the problem revealed in 2008, namely the existence of insolvent TBTF institutions that were “highly leveraged and complex, with numerous and dispersed financial operations, extensive off-balance-sheet activities, and opaque financial statements.” Yet what is being proposed is a framework sacrificing depositors in order to maintain precisely this complex, opaque, leverage-laden financial edifice!
If you believe that what has happened recently in Cyprus is unlikely to happen elsewhere, think again. Economic policy officials in the US, UK and other countries are preparing for it. Remember, someone has to pay. Will it be you? If you are a depositor, the answer is yes.
WHAT ABOUT GUARANTEED DEPOSITS?
What if your deposits are ‘guaranteed’? Does this mean that you will be excluded from abribtrary subordination? Perhaps. Perhaps not. Once officials start changing the rules they have a naughty tendency to keep right on going. That said, perhaps ‘guaranteed’ deposits are indeed sacrosanct in certain countries, if not in Cyprus. (To clarify, ‘guaranteed’ depositors in Cyprus are not participating in the debt-for-equity swap arrangement being implemented there, but they are subject to strict and indefinite capital controls. At best this is a huge inconvenience; at worst, a holding pattern prior to a subsequent future bail-in in the event that the unguaranteed deposits are insufficient to recapitalise the banks. A distinct possibility in my opinion.)
But step back for a moment. What, exactly, is a deposit guarantee? Who provides it? Why, the taxpayer of course. So to the extent that guaranteed depositors do not directly recapitalise failing banks, they do so indirectly as taxpayers. Remember, someone has to pay.
Recall, however, that the entire shift in focus from taxpayer-funded bail-outs to depositor bail-ins originates in the political backlash against the banks. Taxpayers don’t like being on the hook for corrupt bankers’ past mistakes. That said, they don’t much like being on the hook for anything. Take a look around at those large and growing public sector deficits and debts. Guess how they came about. They exist because countries have been resorting to inflation to finance their bloated welfare states as well as banker bailouts.
Economic officials may not care to call this debt-financing inflation, but inflation it is. Those debts are being financed, directly and indirectly, by rapidly expanding central bank balance sheets and associated broad money and credit creation. At some point in future, this monetary inflation will show up in consumer prices. It is just a question of time [3].
So in the end, depositors, guaranteed or not, taxpayers, and anyone not benefiting from inflation is paying for the resource misallocations that caused the insolvency of much of the global financial system. Unless you work for a leveraged financial institution or a government that spends money it doesn’t have, that ‘someone’ who pays probably includes you.
DEPOSIT ‘INSURANCE’ IS JUST PART OF THE NEGATIVE-SUM GAME
Common sense informs us that real risks can only be insured with real savings. This is one explanation for why countries with low savings rates tend to inflate their way out of economic recessions, rather than to restructure and resume healthy growth through Schumpeterian creative destruction. History suggests that the inflationary process becomes a vicious cycle as inflation further disincentivises savings, resulting in an even lower savings rate, followed by even more counter-cyclical inflation down the road.
As it erodes wealth, however, inflation is not a form of insurance. It is merely a means of reducing the real burden of unserviceable debts by transferring economic resources from savers to borrowers. A nasty side effect of inflation is that it causes resource misallocations and subsequent crises. Neo-Keynesian economic models refuse to acknowledge this but economists of many stripes including Richard Cantillon, Hume, Marx, Lenin, von Mises, von Hayek, Alan Greenspan and even Keynes himself were aware of it. With the notable exceptions of Marx and Lenin they also warned of these hidden dangers. (Marx and Lenin actually encouraged inflation as a means to confiscate wealth from the capitalists and concentrate it in a central bank owned and run by the state. The establishment of a central bank was plank 5 of Marx’s Communist Manifesto.)
To expand on a previous point, to the extent that it is applied to an entire financial system, deposit ‘insurance’ is therefore a misnomer. The only way depositors system-wide can possibly be made whole is by the state issuing a sufficient amount of debt in order to raise the necessary funds from the central bank. But as this is inflation, the very depositors being bailed out are the depositors whose wealth is being confiscated through inflation! System-wide deposit insurance is robbing Peter to pay Peter, so to speak. But if Peter doesn’t notice, will he object?
Sadly, whether we notice or not, the result of this game of robbing ourselves is not zero-sum but rather negative-sum: a ‘dead-weight-loss’ in the economic jargon. This is because the financial system is a huge consumer of misallocated resources that could otherwise be directed toward fulfilling the actual needs and wants of consumers. That’s right: alongside bloated governments, the greatest resource misallocation in the world today is that of the financial system itself, which has grown like a cancer ever since central banks wrestled control of the money supply away from the ‘golden anchor’ that, prior to 1971, largely kept it in check.
In numerous countries there is now much evidence that depositors are re-evaluating their trust in their respective financial systems and voting with their wire transfers. This is entirely understandable. Indeed, although it may go against the conventional wisdom, I would argue that the threat of a bank run is a healthy thing. How else to keep bankers in check, when the present system gives them every incentive to leverage up as much as possible, thereby concentrating profits in their hands yet socialising losses on the depositors and taxpayers via bail-outs, bail-ins and inflation?
How refreshing it would be to see banks competing on claims of depositor security for a change, as opposed to which bank has the friendliest image, the most fashionable logo, is the ‘greenest’, or occupies the tallest building in London or New York? Indeed, such faux competition highlights that banking is an industry sorely lacking in real competition.
Notwithstanding all the evidence to the contrary, some still call the bankers ‘capitalists’. While they’re at it, they might as well call the Communist Manifesto a capitalist work.
[1] The Amphora Report has tackled this issue on multiple occasions. Probably the most extensive discussion was in A TALE OF TWO CRISES, Amphora Report vol. 2 (December 2011). The link is here.
[2] The entire proposal is worth reader can be found at the link here.
[3] For a more thorough discussion of this deflation-into-inflation tangent please see FROM DEFLATION PUSH TO INFLATION SHOVE, Amphora Report vol. 3 (June 2012). The link is here.
On rare occasions I make specific, near-term market predictions, most recently in Q3 last year, when I called for a modest equity market correction. As it happened, only a tiny correction occurred, followed by a large subsequent rally taking the S&P500 index to 1,550 this week. Now I am making a similar if bolder prediction: A larger correction, possibly a crash (20%+), appears imminent. There are various fundamental and market technical reasons for this view but these all follow from the same ultimate cause: policymaker activism. The Fed and other major central banks ‘own’ this rally. If a crash occurs, and takes the global economy down with it, let’s place blame where it belongs.
The road to record highs
The old adage, “Don’t fight the Fed,” is one that many investors learn first-hand by taking losses. The printing press can be a powerful thing. But like most if not all powerful things, it has its limits. Think of a chess player able to choose which piece goes where. That might seem quite a power until faced with checkmate, when no further moves are possible.
Having stimulated a large increase in money and credit growth through QE in the second half of last year, the Fed now faces checkmate. Why is this so? Because the surge has now reversed as velocity has plummeted. Year to date, both broad money and private sector credit growth are zero even through the monetary base is growing at nearly a 70% annualised rate [1]. The Fed is, therefore, pushing as hard as ever, but still pushing on a string. Moreover, following on by far the largest amount of artificial fiscal and monetary stimulus ever thrown at the US economy, including during the Great Depression, the string is far longer than that which existed back in 2008.
THE MONETARY BASE HAS SURGED OF LATE…
…BUT BROAD MONEY AND CREDIT GROWTH HAVE SUDDENLY SLOWED TO ZERO
Although they will not admit this, the Fed is now essentially out of options. Recent talk about negative interest rates is just that: talk. As the NY Fed research staff have already noted, they could not work in practice [2]. Some will argue that there remains an arrow in the quiver, namely the power to outright monetise debt, public and private, and pro-actively debase the dollar. But this would end the dollar’s reserve currency status, something that would greatly reduce the Fed’s power in any case, and it would most probably lead quickly back to some form of global gold standard [3]. (While I and many other sound money advocates would endorse such a policy, I am well aware that the current Fed leadership abhors the thought of wearing a monetary straightjacket.)
It would not be accurate to claim, however, that the previous surge in money and credit growth did not impact the economy. Most probably it prevented the H2 2012 global growth slowdown from being larger than it was. More obvious is that strong growth in money and credit balances changed investors’ risk preferences, such that they decided to hold proportionately more equities than bonds. This has pushed up valuations for the former. Rotation out of bonds has had relatively little impact on prices, however, as the Fed has been buying large amounts of Treasuries and, importantly, primarily in longer maturities, where their buying activities have a much greater price impact as this compresses term premia. (Short-maturity bond prices are primarily a function of short-term interest rates, which are set by the Fed and which have been essentially zero since 2008.)
Celebration on Liberty Street?
So notwithstanding the slowing economy, the Fed has engineered a large stock market rally. No doubt Fed officials are celebrating. Some investors might also be pleased, but it primarily benefits those who want to cash out at high valuations. Corporate insiders, for example, are selling at the fastest rate in years. Many companies are raising capital through either initial or secondary offerings. Such activity is a sign of a market top, however, and should concern the far larger ‘buy-and-hold’ crowd seeking to increase their wealth through a sustained rally.
There are several other reasons to be seriously concerned. First, consider valuations. Naturally a crash is more likely from elevated valuations than from depressed ones. Where are we now? Well, at 1,550, the S&P500 index is valued at around 14x forward earnings. That is not far above the post-1980 average, so may not appear lofty to some, but consider: This historical period includes many years of bubble-like valuations, including 1987, 1997-2000 and 2005-07. Depressed years, such as 1981-82 are less well represented in this sample.
Second, relying on forward earnings may be problematic as they are notoriously overstated relative to realised reality. In the present instance, forward earnings growth estimates are in the double-digits, even though profit margins are already at record highs. If history is a guide, profit margins are highly unlikely to remain this wide for long [4].
ELEVATED PROFIT MARGINS UNSUSTAINABLE
Third, the current rally has been characterised by steadily declining volumes. In other words, a relatively small number of transactions have been responsible for pushing up prices. This is in sharp contrast to some research suggesting that a ‘wall of cash’ has been pushing the market higher. (In any case, cash cannot directly push prices higher as for every cash buyer there is also a seller.)
Finally, let’s return to our starting point: Money and credit growth were strong in H2 2012 but this got little traction in actual economic activity. So what has this money and credit been used for? There is much evidence that it has been used as leverage to purchase shares. For example, margin interest on the NYSE is unusually high, at a level associated with previous market crashes.
What credit giveth, it can take away
Applying a little logic, if it is true that, courtesy of activist central bankers, the money and credit growth surge last year is behind the ongoing if increasingly low-volume rally in equities, then a sharp slowing or contraction of money and credit growth should trigger a sharp reversal. If accompanied by corporate profit warnings or other negative headlines, it could precipitate a crash.
As discussed, profit warnings are highly likely to continue in the current environment. Given that there has been nearly zero US household disposable income growth over the past year—in part due to the recent increase in payroll+Obamacare taxes—it is difficult to see how forward earnings expectations of 10%+ can possibly be met. Yes, the foreign sector might be doing better but recent dollar strength will depress those profits when accounted for in dollar terms. Slowing or contracting money and credit plus profit warnings could crash the market. Soon.
The bulls counter these arguments in various ways. Perhaps the most common bullish argument at present is that interest rates are low and will stay low as long as US unemployment remains elevated. After all, this is explicit Fed policy and I began this edition with “Don’t fight the Fed”. But if I’m right and the Fed and other central banks now face checkmate, it makes no difference. The Fed may try to stop a crash but short of trashing the dollar I doubt it can succeed. Of course, if the Fed does intervene and the dollar falls sharply, equity investors will still lose wealth in real if not nominal terms. Checkmate is checkmate.
At this point, the risk/reward for owning equities is tilted in favour of cash. Better still, if you believe that the Fed would at least try to arrest or reverse a crash with additional stimulus measures, would be to acquire safe haven real assets and liquid commodities that cannot be arbitrarily devalued by desperate central banks, including of course gold.
Speaking of gold, it has performed poorly of late. In my view the decline in the gold price is the mirror image of the decline in the equity risk premium. Once risk preferences shifted in favour of equities, yet money and credit growth slowed abruptly, it was absolutely necessary that certain other prices would decline. Not only gold, but copper, crude oil and most agricultural products have also fallen in price. By contrast, the Fed has directly prevented a material decline in bond prices through increased intervention.
Central banks probably have continued buying gold however, just as they were buying at a record pace last year. But as with all things, just because one sector of the market is buying doesn’t mean that prices can’t decline. For example, there are numerous recent reports of commodity hedge fund redemptions, implying forced liquidations of commodity positions. While some commodity hedge funds purport to be ‘market-neutral’, in my experience advising and working with such funds, I can assure you that most retain a long bias. Fund liquidations therefore imply net selling, not net buying.
I don’t disparage holding a commodity long bias, however. Regular readers of the Amphora Report know why: A long position in commodities is in effect a short position in currencies at risk of devaluation: Not just the dollar, but the euro, yen, sterling … you name it. Excessive debts and currency devaluation go hand in hand historically and I see no reason why this time should be different, other than devaluations will be more global than at any time since the 1930s. Indeed, there are reasons to believe they may be larger. Poor demographics and large public sectors in the developed economies imply unusually low productivity growth. This does not bode well for these economies’ abilities to service their vast accumulated debts without resort to large devaluations [5].
In closing, whether or not I am proven right by events, I would encourage my readers to ponder what, exactly, a rising stock market implies when it decouples from the real economy. In my view it is yet more evidence that resource misallocations are widespread; that investment decisions are being heavily distorted via manipulated interest rates and bond markets; that fundamental, value-driven investment is being ‘crowded out’ by raw, undisciplined speculation [6]. This is not the way to grow a healthy economy, although it can, and clearly has, provided short-term stimulus from time to time.
Investors think longer-term than speculators. They also think longer-term than politicians. What is happening now is that the short-termism for which politicians are frequently and rightly criticised has come to dominate the financial markets, the economy and, quite possibly, society generally. History is not kind to societies that operate in an arbitrary, risk-it-all and get-rich-quick way. Long-term investment, savings, thrift and the rule of law tend to result in better outcomes. Central banks are doing far, far greater damage than they realise.
[1] To see just how dramatic these money and credit developments are please see the relevant charts from the St Louis Fed’s weekly US financial data publication here.
[2] For a thorough discussion of the NY Fed paper on negative interest rates please see PAR FOR THE PATHOLOGICAL COURSE, Amphora Report vol. 3 (September 2012). The link is here.
[3] This is, in fact, the central thesis of my 2012 book, THE GOLDEN REVOLUTION, available on Amazon here.
[4] For an excellent discussion of the dangers of relying on forward earnings estimates please see this article by John Hussman here.
[5] The US devalued the dollar vs gold by some 60% in 1934.
[6] This topic was explored at length in a previous Amphora Report, THE ASSET PRICING IMPLICATIONS OF THE GREAT BAILOUT, linked here.
This article was previously published in The Amphora Report, Vol 4, 13 March 2013.
I attended a lecture recently given by Dr. John Thanassoulis from Oxford University. His objective in this lecture was to explore the question of whether there is a case for financial regulation which intervenes in bankers’ pay. To cut a long story short, Thanassoulis’s conclusion was that, yes, effectively the Government should intervene in bankers’ pay and cap it at an appropriate level to lower the overall risk of the banking industry. Leaving aside who decides what “an appropriate level” to pay bankers is, in my view there are a host of problems with Thanassoulis’s analysis and conclusions.
Before getting into the problems I will describe Thanassoulis’s argument. Fundamentally, he believes that the level of remuneration at banks is a legitimate source of concern because the higher the remuneration the greater the following:
a) Restriction of bank lending
b) Increased risk incentive for the banker
c) Increased risk taking by banks in general.
Thanassoulis characterises these aspects as an externality (in other words a cost that others have to pay rather than the banks themselves) thus requiring intervention. Interestingly, he views competition in the banking industry as a problem, because in order to compete for the best banking employees banks must pay higher remuneration thus increasing risk. In his view, competition in a free market can sometimes be a problem.
Thanassoulis’s analysis results in him drawing other bizarre conclusions. Because he is concerned that that banking executives are overly concerned with the short-term (unlike say government regulators) and because bankers discount deferred pay, banks should be forced to defer pay to force bankers to focus on the long-term. Secondly, remuneration should be capped to a proportion of assets under management or profits, nominally to lower risk but also to refocus banking towards lending. Banks exist to lend money but apparently this is not sufficient motivation for them to actually lend money. It is also not clear who is qualified to actually decide what the cap should be or who can define the long-term versus the short-term. Is the long-term 20 years or three? Is the short-term three months or one year? How far into the future can one accurately divine? That is a question for mystics perhaps or maybe left for analysis after the fact.
Oftentimes, when you find yourself making conclusions that on their face are absurd it is wise to go back and revisit your premises. In this case, Thanassoulis’s basic premise is that for whatever reason bankers took excessive risks. Fundamentally, he believes that bankers took excessive risks because they were incentivised to do so by their compensation package. And furthermore, he seems to lump “bankers” into one homogeneous group when in fact, there are many types of bankers who perform various different functions. Essentially, when many people think of bankers, they often seem to have in mind equity traders, a group I could imagine would fit the public image of an aggressive, all caution to the wind, testosterone charged bankers. Indeed, Thanassoulis appears to refer interchangeably between traders and bankers without defining either. The reality of course is far more complex.
Certainly commercial bankers (such as RBS, HBOS, Lloyds, who needed varying amounts of bail-outs) tend to be a much more genteel group than might be suggested by their public image. The approach taken by such bankers to lending is consideration of the borrower’s ability to pay them back, whether this is over three years or twenty (long term?). Simply put, banks will not lend if they do not believe there is a reasonable chance of regaining their principal. It is true that during boom times a lot of loans were made that ex post have proven to be unwise, but the risks weren’t fully appreciated at the time. Bankers, like many individuals, conducted themselves as though the good times would continue to roll. The issue here, therefore, is not excessive risk-taking but a misspecification of risk. Commercial lenders base their specification of risk on actuarial models which unfortunately, can be biased based on recent events. Furthermore, these models cannot account accurately for the business cycle, thus risk estimates are biased downwards. As such, bankers are making loans based on a belief that the risk is lower than it really is.
Furthermore, the very nature of banks allows them to have more funds available for these improperly specified loans than they otherwise would. This is for two reasons. First, modern commercial banks hold fractional reserves. At the height of the boom period banks were holding perhaps 1% of deposits on reserve and lending the rest out. Secondly, where necessary, the central bank would provide additional liquidity (i.e. print money to support banks’ lending).
And so not only was the risk estimate of lending understated, the amount of money available to lend was too high. If banks have money to be lent it will be lent. This is the modern function of banks. The pressure on banks to lend will increase over time as profits that are made on earlier successful projects need to be reinvested. This results in the banks increasing in size (due to increased asset values, new employees required to manage the multiplying projects etc.) necessitating further lending in a crowded loan market. Furthermore the increasing esteem of banks provides further pressure to become involved in prestigious new projects. These developments will also cause banking pay to rise and increase competition in the market to hire bankers.
Additionally, with a lowered perception of risk the interest rate charged to borrowers will be lower than it otherwise would be. This in turn encourages companies and individuals to borrow money and invest in projects or spend on frivolities. Indeed, borrowers will also have a lowered perception of risk, essentially for the same reason as bankers. And so while the cross-hairs of blame are centred on bankers, the same mistakes were made by all market participants. HMV and Woolworths are two such casualties that borrowed money for investment in projects that ultimately proved to be wasteful.
Fiddling around with bankers pay, capping it, deferring it, re-portioning it is a complete waste of time, trying to solve a problem that does not exist. Bankers’ pay, its composition or amount, has nothing to do the causes of the recent economic bust, other than that it is merely another symptom of the business cycle. Bankers are well paid because the economy is set up to reward them in this manner. The majority of the financial resources in the economy are funnelled through the banking system and bankers take their cut. This is because of the legal and economic structure in which banks operate. That is, the central bank fractional reserve system. Thus, in good times and bad, banks disproportionately benefit.
In any event, the compensation of banking employees is not a major source of risk in banking. The major risk factors in banking include (but are not limited to) the risk of the project itself, market risk (i.e. movement in variables such as interest rates) and the gap between short-term borrowing and long-term lending. If well paid banking executives steer the bank towards high yield projects it is because they have the appearance of being relatively low risk, not because they are anxious to take on high risk, high yield projects. Unfortunately, they are unaware that the benefits from such projects are an illusion created by the very business cycle that banks perpetuate.
The obvious solution is to abolish every aspect of fractional reserve banking, including central banking and fiat currency. This will not happen any time soon as it benefits the government to have this system in place. The government has access to a hidden tax through inflation and a willing scapegoat when things go wrong. The villagers will go armed with pitchforks and torches trying to kill the wrong monster.
Indeed, while complaining that banks are not lending, (after criticising them for lending too much!) the government assures that banks will not lend in any great amount by making it impossible to do so. The low interest rate environment, created by that agency of the government, the Bank of England, has made it impossible for banks to exit many of their positions for many years. But we should recognise here that the primary objective of the government is to ensure the survival of their colleagues at banks around the country (and by extension the world) and not either a quick end to the depression or lending to businesses that may or may not need the funds.
As such, John Thanassoulis’s conclusions are quite invalid and will not solve any particular economic problem. Instead, he has fallen prey to the smoke screen promoted by the Government which has focused the causes of the depression on trivial issues like bankers’ pay. Indeed, in this manner the Government takes advantage of feelings of envy amongst the population at large to focus their rage away from government policy and the fundamental causes of the depression. This is slightly analogous to a similar method used with petrol prices. When prices are too high, it’s not because of the approximately 150% tax on petrol but because of greedy oil companies and price-gouging petrol station owners.
What the Bank of England is trying to do is restart the money creation process which dropped us into this mess while keeping expectations of inflation low. It’s an extremely dangerous game, one which Hayek explored in his Nobel lecture: it is a policy which cannot create sustainable prosperity but which may create massive inflation, with all its destructive effects.
Having mostly failed to see this crisis coming before failing to predict even the general pattern of events, senior economists now want more of the medicine which already nearly killed the patient. This may look like madness or stupidity to those of us without a high level of formal education in economics. It is neither. Contemporary economists are trapped in an intellectual prison founded on now-old errors of method and epistemology: the knowledge and simplifications necessary to make their mathematical models work are unavailable and invalid respectively.
As a result, economists and central bankers in particular think it is their task to intervene when the choices and actions of tens of millions of people produce aggregate statistics they, and politicians, don’t like. Massive economic disruption and misallocation of resources — ultimately, human suffering — is the result. Unfortunately, it looks like those few who hold the terrible power of monetary policy are determined to test their ideas to destruction.
Following the UK credit rating downgrade, I gave Newsnight an interview. They chose a couple of sentences in which I pointed out the reality that welfare, health, education and debt interest are about 3/4 of spending on 2012 figures and that they will have to be cut eventually if we are serious about the state living within its means. You can find it at 17:00. If I had been given longer, I would have said those things you can find in this interview with RT:
We have been on a merry-go-round of deficit spending, excruciating taxes, heavy borrowing and easy money for most of 40 years. That merry-go-round is now running down and will stop. Attempts to spin it up through monetary policy are extremely dangerous: they will store up worse trouble for later.
If the Government does not act to end expansionist policy in time by a return to balanced budgets, by ending government borrowing from the commercial banks, by stopping quantitative easing and by letting the market determine the height of interest rates, then it will have chosen the German way of 1923.
“The Checklist Manifesto – How to get things right”, is a masterful book for its narrative and practical application. Written by Atul Gawande, an acclaimed surgeon based in the US, he takes us on a journey of how the simple checklist helps individuals deal with immensely complex situations, where risks can be calculated and often lives protected – skyscraper construction, medicine and investment banking.
First introduced into the US Air Force to assist pilots, the humble checklist in all its simplicity has helped generations of pilots navigate the complexity of flying modern aeroplanes. Gawande himself has introduced the concept into operating theatres and hospitals around the world with astounding success.
At Hinde Capital we have embraced such a concept almost naturally in an attempt to codify both our objective and subjective observations of the market place. Our hope is to eliminate behavioural biases that can lead to a misdiagnosis of events before an investment decision.
It has long been our contention that central bankers have misdiagnosed the dynamics of the global economy, particularly in this last decade. Right up until the implosion of equity markets in 2007 and 2008 Bernanke said there was no housing bubble, that inflation was benign, even though almost every asset price from equities to gold was trending in a succession of levitating new highs. When considering how to guide a system as complex as the global economy with so many independent countries and decision makers, we often wonder what type of checklist a modern central bank was actually employing. The crucial ingredient, though, is not only a checklist but the correct checklist.
Central Bank Checklist Manifesto
In a hospital one of the most basic but effective checklists deployed since the 1960s as introduced by nurses was a vital signs chart – every few hours or so nurses would check the following:
Pulse
Blood pressure
Temperature
Respiration
Likewise a central bank observes certain vital signs to observe the state of the economy – their patient. To have an understanding of what the ‘vital signs’ checklist is for the Fed, let’s look at their duties as outlined in their manifesto ‘The Federal Reserve System – Purposes & Functions.’
The Federal Reserve’s duties fall into four general areas:
• conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates
• supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers
• maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
• providing financial services to depository institutions, the US government, and foreign official institutions, including playing a major role in operating the nation’s payments system
Let’s focus on the first point. The Fed’s objectives include economic growth in line with the economy’s potential to expand; a high level of employment; stable prices (that is, stability in the purchasing power of the dollar); and moderate long-term interest rates. So their vital signs checklist may go something like this:
Growth
Employment
Inflation
Interest rates
Alan Blinder, a former Fed governor and Vice Chairman (1994-96) wrote an insightful working paper called ‘Monetary Policy Today: Sixteen Questions and about Twelve Answers’. These questions in many ways are a checklist questioning parts of the Fed manifesto. Blinder himself resigned as Vice Chairman under Greenspan as he was in disagreement with his diagnosis of the US and global economy.
Central banks have tried to be omnipotent in guiding economic behaviour rather like a surgeon accustomed to holding centre stage in his ‘operatic’ theatre. The central banker can’t enforce his will on agents in the economy because it does not allow for human beings’ subjective preferences on how to spend and live. Using a policy of market expectations to direct human action, based on assumptions of some rational expectation, has been proven to be flawed. Besides which, who leads? The marketplace or the central bank? – the dog or the dog’s tail?
The great US humourist of the Depression era, Will Rogers once famously said, “There have been three great inventions since the beginning of time: fire, the wheel, and central banking”. His comment, laced with no small amount of irony, may have well been uttered today.
Central Bank CAnniBALism
Central banks are the devil. They are like drug dealers except they administer regular doses of supposedly legally prescribed barbiturates to their addicts. The ‘easy money’ or ‘credit’ they create is an opiate, and like all addictions there is a payback for the addicts, one exacted only in loss of health, misery, and death.
Our reliance on ‘easy money’ as facilitated by credit has become terminal. Like drug users we continue to attempt to find a heightened state of nirvana. We continue to hark for the utopian days prior to the eruption of the post-2008 crisis, even though our well-being was fallacious and based on an illusion of wealth paid for by credit – a creditopia. The abuse of credit is what defined the Great Financial crisis and one that still defines our economic system and one which will define a much worse crisis to come.
Central bankers have begun a concerted effort to fight the global debt problem which has been stifling growth as tax revenues merely serve to finance debt servicing rather than addressing the repayment of principal outstanding. Omnipotent governors, Bernanke, Carney, Draghi, Svensson and Iwata or Kuroda (either are likely to replace Shirakawa at the BoJ) are to take a far more aggressive and activist role in pursuing a new framework for growth and inflation by seeking an alternative way to conduct monetary policy. It’s called Nominal GDP Level targeting (NGDPLT) and it is in our opinion as significant a moment as Volcker’s appointment to the Federal Reserve governorship in 1978.
Many will recall Volcker’s moment was to engineer a swift monetary contraction and deceleration of the money velocity to try and reign in excessively high inflation and stabilise growth. It worked. Today we are witnessing an ‘Inverse Volcker’ moment, whereby the opposite is likely true.
The question remains: are they all still ‘inflation nutters’ as Mervyn King, the BoE Governor glibly referred to those central bankers who focussed solely on inflation targets to the potential detriment of stable growth, employment and exchange rates.
Are central bankers merely expanding the boundaries of monetary largesse by focusing on a broader mandate and merely evolving the singular variable approach of inflation targeting, or have they finally found a solution to eradicating boom-bust business cycles? This is a question we need to answer as we are currently witnessing a Central Bank Revolution which could portend severe consequences for prices in our economies, and all the attendant misery that comes with very high inflation.
Nominal GDP Level targeting advocates believe they have a plausible case for a change of mandate by central banks and one which is being gradually adopted, but we believe that like central banks they have misdiagnosed the cause of the crisis by failing to examine the impact of credit creation in our global economy. Money matters, but credit matters more.
In our latest HindeSight Investor Letter – The Central Bank Revolution I (Well ‘Nominally’ So) – we explore and counter this new wave of economics called Market Monetarism, which advocates NGDPLT and which appears to be revolutionising central bank monetary policy.
