In its latest edition, in a piece entitled ‘Monetary policy: Tight, loose, irrelevant’, the ineffably dire Ekonomista considers the work of three members of the Sloan School of Management who conducted a study of the factors which – according to their rendering of the testimony of the 60-odd years of data which they analysed in their paper, “The behaviour of aggregate corporate investment” – have historically exerted the most influence on the propensity for American businesses to ‘invest’.
The article itself starts by deploying that unfailingly patronising, ‘it’s economics 101′ cliché by which we should really have long ago learned to expect some weary truism will soon be rehashed as fresh journalistic wisdom.
It may be only partly an exaggeration to say that the weekly then adopts a breathless, teen-hysterical approach to a set of results which, with all due respect to the worthies who compiled them, should have been instantly apparent to anyone devoting a moment’s thought to the issue (and if that’s too big a task for the average Ekonomista writer, perhaps they could pause to ask one of those grubby-sleeved artisans who actually RUNS a business what it is exactly that they get up to, down there at the coalface of international capitalism). Far from being a Statement of the Bleedin’ Obvious, our fearless expositors of the Fourth Estate instead seem to regard what appears to be a tediously positivist exercise in data mining as some combination of the elucidation of the nature of the genetic code and the first exposition of the uncertainty principle. This in itself is a telling indictment of the mindset at work.
For can you even imagine what it was that our trio of geniuses ‘discovered’? Only that firms tend to invest more eagerly if they are profitable and if those profits (or their prospect) are being suitably rewarded with a rising share price – i.e. if their actions are contributing to capital formation, realised or expected, and hence to the credible promise of a maintained, increased, lengthened or accelerated schedule of income flows – that latter condition being one which also means the firms concerned can issue equity on advantageous terms, where necessary, in the furtherance of their aims.
[As an aside, do you remember when we used to ISSUE equity for purposes other than as a panic measure to keep the business afloat after some megalomaniac CEO disaster of over-leverage or as part of a soak-the-patsies cash-out for the latest batch of serial shell-gamers and their start-up sponsors?]
Shock, horror! Our pioneering profs then go on to share the revelation that firms have even been known to invest WHEN INTEREST RATES ARE RISING; i.e., when the specific real rate facing each firm (rather than the fairly meaningless, economy-wide aggregate rate observable in the capital market with which it is here being conflated) is therefore NOT estimated to constitute any impediment to the future attainment (or preservation) of profit. Whatever happened to the central bank mantra of the ‘wealth effect’ and its dogma about ‘channels’ of monetary transmission? How could those boorish mechanicals in industry not know they are only to invest when their pecuniary paramounts signal they should, by lowering official interest rates or hoovering up oodles of government securities?
At this point we might stop to insist that the supercilious, wielders of the ‘Eco 101’ trope at the Ekonomista note that these firms’ own heightened appetite for a presumably finite pool of loanable funds should firmly be expected to nudge interest rates higher precisely in order to bring forth the necessary extra supply thereof, just as a similar shift in demand would do in any other well-functioning market (DOH!), so please could they take the time in future to ponder the workings of cause and effect before they dare to condescend to us.
They might also reflect upon the fact that when the banking system functions to supplement such hard-won funds with its own, purely ethereal emissions of unsaved credit – thereby keeping them too cheap for too long and so removing the intrinsically self-regulating and helpfully selective effect which their increasing scarcity would otherwise have had on proposedschemes of investment – they pervert, if not utterly vitiate, a most fundamental market process. Having a pronounced tendency to bring about a profound disco-ordination in the system to the point of precluding a holistic ordering of ends and means as well as of disrupting the timetable on which the one may be transformed into the other, we Austrians recognize this as theprimary cause of that needless and wasteful phenomenon which is the business cycle. It is therefore decidedly not a cause for perplexity that investment, quote: ‘…expands and contracts far more dramatically than the economy as a whole’ as the Ekonomista wonderingly remarks
Nigh on unbelievable as it may appear to the policy-obsessed, mainstream journos who reviewed the academics’ work, all of this further implies that the past two centuries-odd of absolutely unprecedented and near-universal material progress did NOT take place simply because the central banks and their precursors courageously and unswervingly spent the whole interval doing ‘whatever it took’ to progressively lower interest rates to (and in some cases, through) zero! Somewhere along the line, one supposes that the marvels of entrepreneurship must have intruded, as well as what Deidre McCloskey famously refers to as an upsurge in ‘bourgeois dignity’ – i.e., the ever greater social estimation which came to be accorded to such agents of wholesale advance. This truly must shake the pillars of the temple of the cult of top-down, macro-economic command of which the Ekonomista is the house journal.
Remarkably, the Ekonomista’s piece is also daringly heterodox in inferring that, given this highly singular insensitivity to market interest rates, we might therefore return more assuredly to the long-forsaken path of growth if Mario Draghi and his ilk were to treat themselves to a long, contemplative sojourn, taking the waters at one of Europe’s idyllic (German) spa townsinstead of constantly hogging the limelight by dreaming up (and occasionally implementing) ever more involved, Cunning Plans directed towards driving people to act in ways in which they would otherwise not choose to do, but in which Mario and Co. conceitedly deem that they should.
Rather, the hacks have the temerity to assert – and here, Keynes be spared! – it might do much more for the investment climate if the Big Government to which they so routinely and so obsequiously defer were to pause awhile in its unrelenting programme to destroy all private capital, to suppress all economic initiative, and to restrict the disposition of income to thecentralized mandates of its minions and not to trust them to the delocalized vagaries of the market – all crimes which it more readily may perpetrate under the camouflage provided by the central banks’ mindless and increasingly counter-productive, asset-bubble inflationism.
Having reached this pass, might we dare to push the deduction one step closer to its logical conclusion and suggest that the only reason we continue today to suffer a malaise which the self-exculpatory elite (of whom none is more representative than the staff of the Ekonomista itself) loves to refer to as ‘secular stagnation’ is because its own toxic brew of patent nostrums is making the unfortunate patient upon whom it inflicts them even more sick? That, pace Obama the Great, The One True Indispensable Chief of the NWO, the three principal threats we currently face are not Ebola, but QE-bola – a largely ineradicable pandemic of destruction far more virulent than even that dreadful fever; not the locally disruptive Islamic State but the globally detrimental Interventionist State – the perpetrator of a similarly backward and repressive ideology which the IMF imamate seeks to impose on us all; and definitely not the Kremlin’s alleged (though highly disputable) revanchism being played out on Europe’s ‘fringe’ but the Kafkaesque reality of stifling and undeniable regulationism at work throughout its length and breadth?
We might end by reminding the would-be wearer of the One Ring, as He lurks warily, watching the opinion polls from His lair in the White House, that in being so active in propagating each one of these genuinely existential threats to our common well-being, He (capitalization ironically intended) will not so much ‘help light the world’ – as He nauseatingly claimed in His purple-drenched, sophomore’s set-piece at the UN recently – as help extinguish what little light there still remains to us poor, downtrodden masses.
The offending article:
Tight, loose, irrelevant
Interest rates do not seem to affect investment as economists assume
IT IS Economics 101. If central bankers want to spur economic activity, they cut interest rates. If they want to dampen it, they raise them. The assumption is that, as it becomes cheaper or more expensive for businesses and households to borrow, they will adjust their spending accordingly. But for businesses in America, at least, a new study* suggests that the accepted wisdom on monetary policy is broadly (but not entirely) wrong.
Using data stretching back to 1952, the paper concludes that market interest rates, which central banks aim to influence when they set their policy rates, play some role in how much firms invest, but not much. Other factors—most notably how profitable a firm is and how well its shares do—are far more important (see chart). A government that wants to pep up the economy, says S.P. Kothari of the Sloan School of Management, one of the authors, would have more luck with other measures, such as lower taxes or less onerous regulation.
Establishing what drives business investment is difficult, not. These shifts were particularly manic in the late 1950s (both up and down), mid-1960s (up), and 2000s (down, up, then down again). Overall, investment has been in slight decline since the early 1980s.
Having sifted through decades of data, however, the authors conclude that neither volatility in the financial markets nor credit-default swaps, a measure of corporate credit risk that tends to influence the rates firms pay, has much impact. In fact, investment often rises when interest rates go up and volatility increases.
Investment grows most quickly, though, in response to a surge in profits and drops with bad news. These ups and downs suggest shifts in investment go too far and are often ill-timed. At any rate, they do little good: big cuts can substantially boost profits, but only briefly; big increases in investment slightly decrease profits.
Companies, Mr Kothari says, tend to dwell too much on recent experience when deciding how much to invest and too little on how changing circumstances may affect future returns. This is particularly true in difficult times. Appealing opportunities may exist, and they may be all the more attractive because of low interest rates. That should matter—but the data suggest it does not.
* “The behaviour of aggregate corporate investment”, S.P. Kothari, Jonathan Lewellen, Jerold Warner
Economists at the Federal Reserve have devised a new indicator, which they hold will enable US central bank policy makers to get better information regarding the state of the labour market. The metric is labelled as the Labour Market Conditions Index (LMCI).
Note that one of the key data Fed policy makers are paying attention to is the labour market. The state of this market dictates the type of monetary policy that is going to be implemented.
Fed policy makers are of the view that it is the task of the central bank to navigate the economy toward a path of stable self-sustaining economic growth.
One of the indicators that is believed could inform policy makers about how far the economy is from this path is the state of the labour market.
A strengthening of the labour market is seen as indicative that the economy may not be far from the desired growth path.
A weakening in the labour market is interpreted as indicating that the distance is widening and the economy’s ability to stand on its own feet is diminishing.
Once the labour market shows strengthening this also raises the likelihood that the Fed will reduce its support to the economy. After all, to provide support whilst the economy is on a path of stable self-sustained growth could push the economy away from this path towards a path of accelerating price inflation, so it is held.
Conversely, a weakening labour market conditions raises the likelihood that the Fed will either maintain or strengthen its loose monetary stance. Failing to do so, it is held, could push the economy onto a path of price deflation and economic crisis.
The uniqueness of the LMCI, it is held, is that it covers a broader range of labour market pieces of information thereby raising the likelihood of depicting a more correct state of labour market conditions than an individual piece of information could provide.
The LMCI is derived from 19 indicators such as the number of people employed full time and part time, the labour participation rate, the hiring rate, hiring plans etc.
When the index is rising above the zero line it is interpreted that labour market conditions are strengthening. A fall in the index below the zero line is taken as a deterioration in the labour market.
In September the index rose by 2.5 points after gaining 2 points in August. Note however that in April this year the index increased by 7.1 points. Following the logic of Fed policy makers and assuming that they will pay some attention to the LMCI, if the index were to continue strengthening then the Fed may start considering tightening its monetary stance.
We suggest that the Fed’s responses to the LMCI are not going to bring the economy onto a path of stability and self-sustaining economic growth, but on the contrary will lead to more instability and economic impoverishment.
The state of a particular indicator such as the LMCI cannot tell us the state of the pool of real wealth i.e. whether it is expanding or shrinking.
It is not important to have people employed as such but to have them employed in wealth generating activities. Employment such as digging ditches and building non-wealth generating projects are only depriving wealth generators from the expansion of the pool of real wealth. This undermines the ability to grow the economy and leads to economic misery.
The belief that the Fed can navigate and grow the economy is wishful thinking. All that Fed officials can do is to pump money and tamper with the interest rate structure. None of this however can lead to economic growth.
The key to economic growth is the expansion in capital goods per individual. This expansion however must be done in accordance with the dictates of the free market and not on account of an artificial lowering of interest rates and monetary pumping.
Loose monetary policy will only result in the expansion of capital goods for non-wealth generating projects i.e. capital consumption.
Only by means of the allocation of resources in accordance with the dictates of the market can a wealth generating infrastructure be established. Such infrastructure is going to lead to economic prosperity.
To conclude then, the Fed’s new indicator adds more means for US central bank officials to tamper with the economy, which will lead to greater economic instability and economic impoverishment.
Summary and conclusions
The Fed has introduced a new economic indicator labelled the Labour Market Conditions Index (LMCI). The LMCI is derived from 19 labour market related indicators; hence it is held it is likely to provide a more realistic state of the labour market.
This in turn will enable Fed policy makers to navigate more accurately the economy toward a path of stable non-inflationary economic growth.
We suggest that what is required is not information about the strength of the labour market as such but information on how changes in labour market conditions are related to the wealth generation process.
This however, the LMCI doesn’t provide. Since Fed officials are likely to react to movements in the LMCI we hold this will only lead to a deepening in the misallocation of resources and to a further weakening of the wealth generation process.
“Sir, The next financial apocalypse is imminent. I know this to be true because the House & Home section in FT Weekend is now assuming the epic proportions last seen before the great crash. Twenty-four pages chock full of adverts for mansions and wicker tea-trays for $1,000. You’re all mad.
Sell everything and run for your lives.”
- Letter to the FT from Matt Long, Seilh, France, 3rd October 2014.
“Investors unfortunately face enormous pressure—both real pressure from their anxious clients and their consultants and imagined pressure emanating from their own adrenaline, ego and fear—to deliver strong near-term results. Even though this pressure greatly distracts investors from a long-term orientation and may, in fact, be anathema to good long-term performance, there is no easy way to reduce it. Human nature involves the extremes of investor emotion—both greed and fear—in the moment; it is hard for most people to overcome and act in opposition to their emotions. Also, most investors tend to project near-term trends—both favourable and adverse—indefinitely into the future. Ironically, it is this very short-term pressure to produce—this gun to the head of everyone—that encourages excessive risk taking which manifests itself in several ways: a fully invested posture at all times; for many, the use of significant and even extreme leverage; and a market-centric orientation that makes it difficult to stand apart from the crowd and take a long-term perspective.”
- Seth Klarman, Presentation to MIT, October 2007.
“At first, the pendulum was swinging towards infinite interest, threatening the dollar with hyperinflation. Right now the pendulum is swinging to the other extreme, to zero interest, spelling hyper-deflation. This is just as damaging to producers as the swing towards infinite interest was in the early 1980’s. It is impossible to predict whether one or the other extreme in the swinging of the wrecking ball will bring about the world economy’s collapse. Hyperinflation and hyper-deflation are just two different forms of the same phenomenon: credit collapse. Arguing which of the two forms will dominate is futile: it blurs the focus of inquiry and frustrates efforts to avoid disaster.”
- Professor Antal Fekete, ‘Monetary Economics 101: The real bills doctrine of Adam Smith. Lecture 10: The Revolt of Quality’.
“Low interest rate policy has the following grave consequences:
- Normally conservative investors are increasingly under duress and due to the outlook for interest rates remaining low for a long time, are taking on excessive risk. This leads to capital misallocation and the formation of bubbles.
- The sweet poison of low interest rates and easy money therefore leads to massive asset price inflation (stocks, art, real estate).
- Through carry trades, interest rates that are structurally too low in the industrialized nations lead to asset bubbles and contagion effects in emerging markets.
- A structural weakening of financial markets, as reckless behaviour of market participants is fostered (moral hazard).
- A change in human behaviour patterns, due to continually declining purchasing power. While thrift is slowly but surely transmogrified into a relic of the past, taking on debt becomes rational.
- The acquisition of personal wealth becomes gradually more difficult.
- The importance of money as a medium of exchange and a unit of account increases in importance relative to its role as a store of value.
- Incentives for fiscal probity decline. Central banks have bought time for governments. Large deficits appear less problematic, there is no incentive to implement reform, resp. consolidate public finances in a sustainable manner.
- The emergence of zombie-banks and zombie-companies. Very low interest rates prevent the healthy process of creative destruction. Zero interest rate policy makes it possible for companies with low profitability to survive, similar to Japan in the 1990s. Banks are enabled to nigh endlessly roll over potentially delinquent loans and consequently lower their write-offs.
- Unjust redistribution (Cantillon effect): the effect describes the fact that newly created money is neither uniformly nor simultaneously distributed in the population. Monetary expansion is therefore never neutral. There is a permanent transfer of wealth from later to earlier receivers of new money.”
- Ronald-Peter Stöferle, from ‘In Gold We Trust 2014 – Extended Version’, Incrementum AG.
The commentary will have its next outing on Monday 27th October.
“When sorrows come,” wrote Shakespeare, “they come not single spies, but in battalions.” Jeremy Warner for the Daily Telegraph identifies ten of them. His ‘ten biggest threats to the global economy’ comprise:
- Geopolitical risk;
- The threat of oil and gas price spikes;
- A hard landing in China;
- Normalisation of monetary policy in the Anglo-Saxon economies;
- Euro zone deflation;
- ‘Secular stagnation’;
- The size of the debt overhang;
- Complacent markets;
- House price bubbles;
- Ageing populations.
Other than making the fair observation that stock markets (for example) are not entirely correlated to economic performance – an observation for which euro zone equity investors must surely be hugely grateful – we offer the following response.
- Geopolitical risk, like the poor, will always be with us.
- Yes, the prices for oil and natural gas could spike, but as things stand WTI crude futures have fallen by over 15% from their June highs, in spite of the clear geopolitical problems. And the US fracking revolution, in combination with fast-improving fundamentals for solar power, may turn out to be a secular (and disinflationary) game-changer for energy prices.
- China, however, is tougher to dismiss. If we had any meaningful exposure to Chinese equity or debt we would be more concerned. But we don’t, so we aren’t.
- Five of Jeremy Warner’s ‘threats’ are inextricably linked. The pending normalisation of monetary policy in the UK and US clearly threatens the integrity of the credit markets. It’s worth asking whether either central bank could possibly afford to let interest rates rise. This begets a follow-on question: could the markets afford to let the central banks off the hook ? Could we, in other words, finally see the return of the long absent and much desired bond market vigilantes ? That monetary policy rates are so low is a function of the growing prospect of euro zone deflation (less of a threat to solvent consumers, but deadly for heavily indebted governments). Absent a capitulation by the Bundesbank to Draghi’s hopes or intentions for full-blown QE, it’s difficult to see how the policy log-jam gets resolved. But since all German government paper out to three years now offers a negative yield, it’s difficult to see why any euro zone debt is worth buying today for risk-conscious investors. Cash is probably preferable and gives optionality into the bargain. ‘Secular stagnation’ is now a fair definition of the euro zone’s economic prospects. But all things lead back to Warner’s point 7: the size of the debt overhang. Since this was never addressed in the immediate aftermath of the Global Financial Crisis, it’s hardly a surprise to see its poison continue to drip onto all things financial. And since the policy response has been to slash rates and keep them at multi-century lows, it’s hardly a surprise to see property prices in the ascendant.
- Complacent markets ? Check. But stocks have lost a lot of their nerve over the last week. Not before time.
- Ageing populations ? Yes, but this problem has been widely discussed in the investment community over the past two decades – it simply isn’t new news.
We saw one particularly eye-catching chart last week, via Grant Williams, comparing the leverage ratios of major US financial institutions over recent years (shown below).
Source: Grant Williams, ‘Things that make you go Hmmm…’
The Fed’s leverage ratio (total assets to capital) now stands at just under 80x. That compares with Lehman Brothers’ leverage ratio, just before it went bankrupt, of just under 30x. Sometimes a picture really does paint a thousand words. And this, again, brings us back to the defining problem of our time, as we see it: too much debt in the system, and simply not enough ideas about how to bring it down – other than through inflationism, and even that doesn’t seem to be working quite yet.
In a recent interview with Jim Grant, Sprott Global questioned the famed interest rate observer about the likely outlook for bonds:
“What would a bear market in bonds look like? Would it be accompanied by a bear market in the stocks?
“Well, we have a pretty good historical record of what a bear market in bonds would look like. We had one in modern history, from 1946 to 1981. We had 25 years’ worth of persistently – if not steadily – rising interest rates, and falling bond prices. It began with only around a quarter of a percent on long-dates US Treasuries, and ended with about 15% on long-dated US Treasuries. That’s one historical beacon. I think that the difference today might be that the movement up in yield, and down in price, might be more violent than it was during the first ten years of the bear market beginning in about 1946. Then, it took about ten years for yields to advance even 100 basis points, if I remember correctly. One difference today is the nature of the bond market. It is increasingly illiquid and it is a market in which investors – many investors – have the right to enter a sales ticket, and to expect their money within a day. So I’m not sure what a bear market would look like, but I think that it would be characterized at first by a lot of people rushing through a very narrow gate. I think problems with illiquidity would surface in the corporate debt markets. One of the unintended consequences of the financial reforms that followed the sorrows of 2007 to 2009 is that dealers who used to hold a lot of corporate debt in inventories no longer do so. If interest rates began to rise and people wanted out, I think that the corporate debt market would encounter a lot of ‘air pockets’ and a lot of very discontinuous action to the downside.”
We like that phrase “a lot of very discontinuous action to the downside”. Grant was also asked if it was possible for the Fed to lose control of the bond market:
“Absolutely, it could. The Fed does not control events for the most part. Events certainly will end up controlling the Fed. To answer your question – yeah. I think the Fed can and will lose control of the bond market.”
As we have written on innumerable prior occasions, we wholeheartedly agree. Geopolitics, energy prices, demographics – all interesting ‘what if’ parlour games. But what will drive pretty much all asset markets over the near, medium and longer term is almost entirely down to how credit markets behave. The fundamentals, clearly, are utterly shocking. The implications for investors are, in our view, clear. And as a wise investor once observed, if you’re going to panic, panic early.
As stated in the preceding column, here, eminent labor economist Jared Bernstein recently called, in the New York Times, for the dethroning of “King Dollar,” claiming that the reserve currency status of the dollar has cost the United States as many as “six million jobs in 2008, and these would tend to be the sort of high-wage manufacturing jobs.”
Six million is about as many jobs as presidents Bush and Obama together, over 13+ years, created. So this is a big claim. Whether or not one accepts the magnitude of the jobs deficit proclaimed by Dr. Bernstein, reserve currency status comes with heavy costs.
As former president of the Federal Reserve Bank of Dallas Bob McTeer wrote in a Forbes.com column entitled Reserve Currency Status — A Mixed Blessing:
The advantages of reserve currency status for the dollar are well known. The world’s willingness to accumulate dollar reserves in the post World War II period first removed and later reduced the requirement of maintaining balance of payments equilibrium, or, more specifically, current account balance. By removing or weakening this restraint, U.S. policymakers had more freedom than policymakers in other countries to pursue strictly domestic objectives. We ran current account deficits year after year, balanced, or paid for, by capital inflows from our trading partners. The good side of that was that we could import real goods and services for domestic consumption or absorption and pay for them with paper, or the electronic equivalent. In other words, our contemporary standard of living was enhanced by others’ willingness to hold our currency without “cashing it in” for goods and services, or, before 1971, gold.
The bad side of our reserve currency status, although seldom recognized, was that the very leeway that enhanced our current standard of living built up debt (and/or reduced foreign assets) to dangerous levels. I remember well when, in 1985, the United States ceased being a net creditor nation to the rest of the world and, instead, became a net debtor nation. Our net indebtedness has only grown over the years, and hangs over us like the legendary sword of Damocles.
Sword of Damocles? Lehrman, in his Money, Gold, and History states:
[W]hen one country’s currency — the dollar reserve currency of today — is used to settle international payments, the international settlement and adjustment mechanism is jammed — for that country — and for the world. This is no abstract notion. …
The reality behind the “twin deficits” is simply this: the greater and more permanent the Federal Reserve and foreign reserve facilities for financing the U.S. budget and trade deficits, the greater will be the twin deficits and the growth of the Federal government. All congressional, administrative and statutory attempts to end the U.S. deficit have proved futile, and will prove futile, until the crucial underlying flaw — namely the absence of an efficient international settlements and adjustment mechanism — is remedied by international monetary reform inaugurating a new international gold standard and the prohibition of official reserve currencies.
By pinning down the future price level by gold convertibility, the immediate effect of international monetary reform will be to end currency speculation in floating currencies, and terminate the immense costs of inflation hedging. Gold convertibility eliminates the very costly exchange of currencies at the profit-seeking banks. Thus, new savings will be channeled out of financial arbitrage and speculation, into long-term financial markets.
Increased long-term investment and improvements in world productivity will surely follow, as investment capital moves out of unproductive hedges and speculation — made necessary by floating exchange rates — seeking new and productive investments, leading to more quality jobs.
The sobering views expressed by McTeer and by Lehrman more than neutralize Heritage Foundation’s Bryan Riley and William Wilson’s valiant championship of the dollar’s reserve currency status, in opposition to Bernstein. Heritage’s championship is gallant but … unpersuasive.
John Mueller, who served as gold standard advocate Jack Kemp’s chief economist and now as the Ethics and Public Policy Center’s Lehrman Institute Fellow in Economics and Director, Economics and Ethics Program, crisply observes in an interview for this column:
As Kenneth Austin lucidly reminded us, it is a necessity of double-entry bookkeeping that any increase in foreign official dollar reserves equals the increase in combined US current and private capital account deficits. Denying the connection requires magical thinking. The entire decline in the international investment position since 1976 is due to Congress’s borrowing from foreign central banks–that is, the dollar’s official reserve currency role–while the books of private US residents with the rest of the world have remained close to balance.
There are differing schools of thought among the gold standard’s most prominent adherents as to the significance of merchandise deficit account. Their theoretical differences about current accounts are likely to prove, operationally, immaterial.
Both the Forbes and Lehrman schools share mortal opposition to mercantilism. Both passionately oppose the cheapening of the dollar. Both see the gold standard as a critical mechanism to restoring the brisk growth of, as Lehrman termed it, “quality jobs” … and the restoration of median family income growth that began, profoundly, to stagnate with Nixon’s destruction of Bretton Woods.
In this columnist’s own earnest, if much less erudite, view the most significant element of the reserve currency curse derives from how it subtracts capital from the real, e.g. goods and services, economy. Corporate earnings are taken, in return for local currency, into the coffers of the relevant international central bank. That central bank then promptly loans the proceeds directly to the federal government of the United States by purchase of treasury instruments.
The way the world of central banking works thus subverts a process extolled by Adam Smith (in the context of his analysis of the benefits of fractional reserve money) in Wealth of Nations. Smith:
When, therefore, by the substitution of paper, the gold and silver necessary for circulation is reduced to, perhaps, a fifth part of the former quantity, if the value of only the greater part of the other four-fifths be added to the funds which are destined for the maintenance of industry, it must make a very considerable addition to the quantity of that industry, and, consequently, to the value of the annual produce of land and labour.
The mechanics of the reserve currency system preempt these funds’ ready availability for “the maintenance of industry.” The mechanics of the dollar as a reserve asset, therefore, finance bigger government while insidiously preempting productivity, jobs, and equitable prosperity.
This columnist agrees wholeheartedly with Bernstein on what seem his three most important points. The reserve currency status of the dollar causes American workers, and the world, big problems. The exorbitant privilege deserves and demands far more attention than it receives. Moving the dollar away from being the world’s reserve currency would be a great deal easier than many now assume.
Bernstein, in his blog, identifies four mechanisms as “out there” (without explicitly endorsing, or critiquing, them): by legislation (which this columnist views as playing with tariff fire); taxation (thereby “raising the price of currency management,” which this columnist finds hardly an obvious source of job creation); reciprocity (demanding the right to buy foreign treasuries); and an international reserve currency.
Mueller says of Bernstein’s legislative and tax proposals, “you simply can’t solve a monetary problem with a fiscal solution.”
As for reciprocity, the United States Treasury, even under a Joe Biden or even a Bernie Sanders presidency, is never going to turn away ready lenders. This homely truth seems about as self-evident as it gets. Beyond that, even if China were to undertake market-oriented reforms — and, according to the Wall Street Journal, the political winds seem to be blowing the other way just now — the RMB accounts for only 1.64% of global payments. It is not even close to being a power player. Beyond the beyond … it is well beyond dubious to expect international central banks enthusiastically to bulk up on the debt instruments of the People’s Republic of China for the indefinite future.
An “international reserve currency,” however, is a sound proposition if well designed. Proposing SDRs for that role does not hold up. As then-Treasury Secretary Tim Geithner, during a hearing of the House Appropriations Subcommittee on Foreign Operations on March 9, 2011, stated, “There is no risk of the SDR playing that [a reserve currency] role. The SDR is not a currency. It’s a unit of account. And it can’t provide the role that many people aspire to it. There is no risk of that happening.” Mueller, elucidating why this is so, states:
It’s not possible to solve the problems caused by tying other nations’ domestic currencies to one nation’s inconvertible domestic currency (the dollar), by tying them all to a basket of inconvertible domestic fiat currencies–that is, to a subset of themselves. The result has no anchor. And the world economy always gravitates to a single “final asset,” because using several multiplies transactions costs.
There appear to be but two technically plausible ways of getting there. One is Nobel economics laureate Robert Mundell’s proposal of a world currency. The other, of course, represents a sort of “reversion to the mean.” Restore a 21st century international gold standard.
While the gold standard is very unfashionable it by no means is absurd. Then-World Bank Group president Robert Zoellick, in 2010, was dead on when he observed in an FT column that “Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.” About a year later, the Bank of England issued a startling but meticulous white paper demonstrating that the “Federal Reserve Note standard” materially has underperformed, in every area considered, both the Bretton Woods gold-exchange standard and the classical gold standard itself.
As previously referenced in this column Bundesbank president Jens Weidmann, in a 2012 speech, forthrightly stated:
Concrete objects have served as money for most of human history; we may therefore speak of commodity money. A great deal of trust was placed in particular in precious and rare metals – gold first and foremost – due to their assumed intrinsic value. In its function as a medium of exchange, medium of payment and store of value, gold is thus, in a sense, a timeless classic.
The gold standard, notwithstanding Churchill’s not-to-be-repeated 1925 blunder, is in no way a prescription for austerity. The classical gold standard, properly constructed, is a recipe for workers, and median income families, to flourish economically.
We have not flourished, consistently, since its last remnants were destroyed by President Nixon on August 15, 1971. So… what to do?
The first thing to do is to address the important issue, squarely. By shrewdly posing the right question Jared Bernstein has raised the odds, perhaps significantly, that we finally will find our way to the right answer. Getting out of the woods may be no more complicated than following JFK/LBJ economic advisor Walter Heller’s most famous dictum: “Put aside principle and do what’s right.”
Adroitly resolving the reserve currency issue as part of implementing an international reserve currency is far more likely to be fruitful in generating quality jobs, by the millions, than are earnest jeremiads, such as that by Dr. Bernstein himself, that “American political elites have completely failed to understand what the Fed should be doing right now.” Relying on central bankers consistently to get discretionary management right represents a triumph of hope over experience. Or as novelist Rita Mae Brown memorably observed, “insanity is doing the same thing over and over again but expecting different results.”
Let us take Keynes, in The Economic Consequences of the Peace, chapter VI, to heart:
Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. 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. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. … 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.
As Steve Forbes pithily puts it, “You’ve got to get the money right.” Time to lift the reserve currency curse. Time to fix the dollar.
Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/09/30/the-rise-and-fall-and-rise-and-fall-of-king-dollar-part-2/
Dr David Andolfatto, who is Vice President of the St. Louis Fed, has been one of the most forward-looking people at central banks around the world when it comes to crypto-currencies. Here he speaks with Max Rangeley, Editor at The Cobden Centre, and gives his views on what Bitcoin means for commerce, finance, and the dollar itself.
Max: How have you found the reactions to Bitcoin within the Fed?
David: Bitcoin is barely on the radar screen for most Fed researchers and policymakers. This is to be expected, given the large size of the Fed’s balance sheet and the debate over how to conduct monetary policy with the existence of large excess reserves. But I am aware of a small group of researchers scattered throughout the Fed system that seem interested in the Bitcoin phenomenon. Some, like Francois Velde of the Chicago Fed, have written nice primers on the phenomenon. I am also aware of a cryptocurrency workshop that meets monthly at the New York Fed. The reaction of most people (who study it) might be described as “academic agnosticism” in the sense that people are curious, but not enthusiastically in favor or against the idea.
Max: How do you see Bitcoin being used in the future? Do you foresee private currencies being commonly used on the high street alongside state-backed currencies, or remaining largely online phenomena?
David: Who can say how the future will evolve, especially in this space? My best guess is that Bitcoin will find a niche market. It’s cool to use bitcoin to pay for your Starbucks latte on university campuses (this is what my university is doing). It may very well find a place on the high street, at least among some shops catering to the “cool” crowd. But for advanced economies, at least, it is hard to see how consumers will benefit directly by using bitcoins instead of dollars or pounds. As Satoshi Nakamoto wrote in his seminal 2008 paper introducing Bitcoin, “…the [current] system works well enough for most transactions…”
Max: If the use of private currencies became more widespread, do you think that central banks would ever track monetary aggregates in circulation, even if just approximately, much as M2, M3 etc are tracked now?
David: Anything is possible, but I doubt it. One issue is that there many of these “wildcat” currencies, with more appearing every day (every online game has its own currency for example, as do most social media sites). In a sense, these currencies are “local” monies (much like the local currencies that have always existed, like the Ithaca hour, for example). I’m not sure how a statistical agency could keep track of all these little local currencies, or whether it would even be worthwhile to do so. But who knows?
Max: If private currencies were to become widely used around the world, do you think that this could have an effect on the business cycle, since central banks would not have as much control over monetary factors?
David: I do not think it would have much of an effect on the business cycle, which I think is rooted more in “real” and “financial” factors, rather than “monetary” factors, per se.
Max: You mentioned in your presentation on Bitcoin that although supply is fixed, demand can fluctuate significantly, which causes volatility, would you say this is a weakness inherent in private currencies, or is there the possibility that algorithms could evolve to incorporate a degree of elasticity?
David: Remember that Bitcoin is *more* than a private currency: it is a payment system and monetary policy with *no trusted intermediary* involved. Most private currencies entail the use of trusted third parties. EVE online, for example, an online game founded in 2003 has evidently managed its money supply in a manner that keeps its value relatively stable. It may be possible to code an “elastic money supply” rule in the Bitcoin protocol, but it is not immediately clear to me how this might work. Injecting new money into the system would be easy. The tricky part would be in how to destroy money (having the algorithm debit Bitcoin wallets that are secured by private keys).
Max: You mentioned that you welcome the competition for central banks; if private currencies became widely used, could it chip away at American supremacy, a degree of which is based on the dollar, the so-called “exorbitant privilege”?
David: In my view, America supremacy is not based on the dollar. The status of the dollar simply reflects American supremacy, which is based fundamentally on the structure of that economy (something “real” not “monetary”). The America dollar already faces stiff competition from a variety of alternative candidates, including the Yen, the Euro, and gold. If gold cannot displace the USD, why would we expect Bitcoin to?
The Wall Street Journal, recently, in The Return of the Greenback, observed that “the resurgent dollar has logged its longest winning streak in 17 years, rising against a broad basket of currencies for nine straight weeks.” This has led to, perhaps irrational, exuberance from supply side titans Larry Kudlow and Steve Moore.
Cheapening the dollar is a bad thing, unequivocally. It does not necessarily follow that making the dollar dearer is a good thing. And there is a frequently unnoticed factor at work: the dollar’s status as the world reserve currency. Dr. Jared Bernstein, senior fellow with the Center on Budget and Policy Priorities, and, previously, chief economist to Vice President Biden and executive director of the White House Task Force on the Middle Class, boldly claims that the dollar’s reserve currency status has cost America 6 million jobs. This is a startling, and potentially important, claim.
We live in a world monetary system that makes the U.S. dollar its official reserve currency. About 60% of international central bank reserves are Yankee dollars. Some, both right and left, in America and abroad, consider the reserve currency status of the dollar a bug in the software of our world monetary system. Getting this fixed is, in the opinion of some consequential thinkers, of capital importance for the generation of quality jobs, and equitable prosperity, in America and the world.
The reserve currency status of the dollar, particularly as a potential factor in wage stagnation, has profound political implications. Dispirited voters yearn for leadership that actually understands how to get the economic tide to lift all boats again. Notwithstanding his promotion of some marked policy differences with this columnist, this columnist says three cheers for Dr. Bernstein for squarely pushing the reserve currency question into play.
Dr. Bernstein stirred up a healthy argument in an August New York Times op-ed entitled Dethrone ‘King Dollar.’ Bernstein:
[T]he new research reveals that what was once a privilege is now a burden, undermining job growth, pumping up budget and trade deficits and inflating financial bubbles. To get the American economy on track, the government needs to drop its commitment to maintaining the dollar’s reserve-currency status.
Bernstein draws on an interesting, and thoughtful, paper by economist Kenneth Austin in The Journal of Post Keynesian Economics. Austin dramatically illustrates the explosion of international dollar reserves and explores the possible significance to our economy. Bernstein performs a signal public service by placing this into the policy discourse. Bernstein:
Mr. Austin argues convincingly that the correct metric for estimating the cost in jobs is the dollar value of reserve sales to foreign buyers. By his estimation, that amounted to six million jobs in 2008, and these would tend to be the sort of high-wage manufacturing jobs that are most vulnerable to changes in exports.
Bernstein’s proposal drew a tart riposte at Café Hayek from Don Boudreaux and another from the Heritage Foundation’s Daily Signal by Bryan Riley and William Wilson.
Shortly after Bernstein’s proposed dethroning of ‘King Dollar’ Larry Kudlow and Steve Moore, in their NRO column, joyfully celebrated The Return of King Dollar:
[W]hen the dollar crashed in the 1970s — especially relative to gold — the economy collapsed into a crippling stagflation. From 1999 to 2009, the dollar index dropped by almost 40 percent, with only a brief surge between 2004 and 2006. The economy and wages were sluggish at best.
The relationship between a strong currency and prosperity is lost on the many nations that adhere to the mercantilist model whereby a devalued currency supposedly gives a country a competitive edge by making exports cheaper. …
Kudlow and Moore deserve praise for their opposition to cheapening the dollar. That said, cheering on a “strong” dollar intellectually is akin to calling for a longer inch or a heavier ounce as a recipe to — magically — make us richer.
No. What is needed is a high integrity, meticulously defined, dollar.
A dollar at the mercy of a freelancing Fed, subject to being whipsawed in value, up or down, is a barrier to commerce. Money, by definition, is a medium of exchange, a store of value and — not be overlooked — a unit of account. There are many empirical data tending to show that only by meticulously maintaining the definition of the unit — for example, by defining the dollar by grains of gold and making it legally convertible thereunto — can good job creation, and equitable prosperity, consistently be achieved.
There is a deep, fascinating, historical context. It extends even to the use of the regal metaphor. Therein rests an irony wrapped in a controversy inside some history.
The history? Keynes employed a regal metaphor (applied to gold rather than currency) in his 1930 tract Auri Sacra Fames in which he writes
… gold, originally stationed in heaven with his consort silver, as Sun and Moon, having first doffed his sacred attributes and come to earth as an autocrat, may next descend to the sober status of a constitutional king with a cabinet of Banks….
The irony? Keynes explicitly mistrusted the Fed. Keynes did not wish to endow the U.S. Federal Reserve with the power that, under then-prevailing circumstances which no longer need apply, a return to the gold standard would have entailed. Keynes, in his 1923 essay, Alternative Aims In Monetary Policy:
It would be rash in present circumstances to surrender our freedom of action to the Federal Reserve Board of the United States. We do not yet possess sufficient experience of its capacity to act in times of stress with courage and independence. The Federal Reserve Board is striving to free itself from the pressure of sectional interests; but we are not yet certain that it will wholly succeed. It is still liable to be overwhelmed by the impetuosity of a cheap money campaign.
Keynes expressed wariness of the risk of currency depreciation (better known as inflation). Sure enough, eventually the Federal Reserve indeed became “overwhelmed by the impetuosity of a cheap money campaign.” The Fed cheapened its product — Federal Reserve Notes — by 85% since 1971 (and by about 95% since the Fed’s inception).
A dollar today is worth a 1913 nickel and a 1971 nickel and dime. This gives a whole new meaning to the phrase “nickeled and dimed to death.”
Cheapening of money is very bad for business. It is really, really, terrible for labor. Ron Paul, call your office: Keynes proved quite right to be dubious about the Fed.
Why do so few of the economists who exalt Keynes share his tough-mindedness toward the Fed? Why do so few grasp the irony of their mesmerized adulation of an institution with such a mediocre (and sometimes catastrophic) track record? Many acorns have fallen far from the tree.
One of the factors in play involves one of the standard tropes of mercantilism, to which Kudlow and Moore allude: the intentional depreciation of a national currency to gain unfair trade advantage. This is what classically was called a “beggar-thy-neighbor” policy. The neighbor, in this instance, is America. Forbes Media chairman, and Editor-in-Chief, Steve Forbes, and Forbes.com columnist Nathan Lewis, both gold standard advocates, are zealous critics of mercantilism (as is this columnist).
Steve Forbes (with Elizabeth Ames) in their recent book Money: How the Destruction of the Dollar Threatens the Global Economy and What We Can Do About It observes:
The neo-mercantilists of the twentieth century may have thought that floating exchange rates would allow countries to correct perceived imbalances with their rivals and bolster their domestic economies. But the monetary system they created was more volatile than the one they had destroyed, with balance harder than ever to achieve.
The turmoil of the post-Bretton Woods era is what sent European nations scurrying for the shelter of a stable currency, setting the stage for the euro. The explosion of currency trading it has wrought has become a huge source of fees for banks. It has helped produce the market swings and giant windfalls so decried by Occupy Wall Street and others. In this dangerous world, monetary policy is deployed as a frequent weapon, nearly always with destructive consequences.”
Nathan Lewis writes, in his Forbes.com column Keynes and Rothbard Agree: Today’s Economics is Mercantilism:
All of today’s premier economic policies, notably monetary manipulation and floating fiat currencies, attempts to “manage the economy” via government deficit spending, and the never-ending concern over “imbalances” in trade, are straight-up Mercantilism.
We really won’t make much progress in our economic understanding until this is recognized. The entirety of today’s Mercantilist agenda should be discarded; first, at an intellectual level, and then at the level of public policy. Britain did this, and went from an economic backwater overshadowed by tiny Holland, to the birthplace of the Industrial Revolution and the center of the largest empire of the nineteenth century.
Forbes and Lewis are skeptical about the power of manipulating currency to achieve trading advantage. The intramural dispute among gold standard advocates around the current account, however, is of mostly academic significance. The respective camps respectfully agree as to most of the disorders caused by paper money. They agree that the remedy to our “Little Dark Age” of wage stagnation lies in the definition of the dollar by gold.
Businessman/scholar Lewis E. Lehrman, founder and chairman of the Lehrman Institute (whose monetary policy website this columnist professionally edits) too is an outspoken critic of mercantilism. Lehrman is the leader of a group of thinkers influenced by the works of his mentor Jacques Rueff, influential French monetary official, public intellectual (Mont Pelerin society member), and iconic classical gold standard advocate.
As for the unjustly obscure Rueff, keen monetary observer Robert Pringle, author of The Money Trap states in his influential blog of the same name:
[Rueff] would have predicted the Global Financial Crisis and economic catastrophe of the past seven years – and would certainly have attributed it to the absence of an international monetary system worth the name. He would have been equally critical of the flawed construction of the euro.
He saw that the globalizing trading regime was fundamentally at odds with mercantilist monetary and exchange rate policies: one aspired to universality and openness, the other pointed to particularization and separation.
More generally, monetary nationalism, unleashed by the absence of a global standard for money, is inconsistent with a liberal order.
Reserve currency status of the dollar, the more emphatically when the dollar is not defined by and redeemable in a fixed weight of gold, is a form of monetary nationalism inconsistent with a liberal order. And according to Bernstein reserve currency status also is costing millions of jobs.
What are some of the costs of the “exorbitant privilege” as the dollar’s reserve currency status was called by then finance minister of France Valery Giscard d’Estaing? Ought now America to give the exorbitant privilege a gold watch and send it into retirement?
To be continued.
Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/09/29/the-rise-and-fall-and-rise-and-fall-of-king-dollar-part-1/
Today’s financial markets are built on the sand of unsound currencies. Consequently brokers, banks and investors are wedded to monetary inflation and have lost both the desire and ability to understand gold and properly value it.
Furthermore governments and central banks in welfare-driven states see markets themselves as the biggest threat to their successful management of the economy, a threat that needs to be tamed. This is the backdrop to the outlook for the price of gold today and of the forces an investor in gold is pitted against.
At the heart of market control is the substitution of unsound currency for sound money, which historically has been gold. Increasing the quantity of currency and encouraging banks to increase credit out of thin air is the principal means by which central banks operate. No matter that adulterating the currency impoverishes the majority of the population: central banks are working from the Keynesian and monetarist manual of how to manage markets.
In this environment an investor risks all he possesses if he insists on fighting the system; and nowhere is this truer than with gold. Gold is not about conventional investing in this world of fiat currencies, it is about insurance against the financial system collapsing under the weight of its own delusions. Regarded as an insurance premium against this risk, gold is common sense; and there are times when it is worth increasing your insurance. In taking that decision, an individual must be able to evaluate three things: the relative quantities of currency to gold, the likelihood of a systemic crisis and the true cost of insuring against it. We shall consider each of these in turn.
The relationship of currency to gold
Not only has the quantity of global currency and bank credit expanded dramatically since the Lehman crisis, it is clear that this is a trend that cannot now be reversed without triggering financial chaos. In other words we are already committed to monetary hyperinflation. Just look at the chart of the quantity of US dollar fiat money and note its dramatic growth since the Lehman crisis in 2008.
Meanwhile, the quantity of above-ground stocks of gold is growing at less than 2% annually. Gold is therefore getting cheaper relative to the dollar by the day. [Note: FMQ is the sum of all fiat money created both on the Fed’s balance sheet and in the commercial banks. [See here for a full description]
Increasing likelihood of a systemic crisis
Ask yourself a question: how much would interest rates have to rise before a systemic crisis is triggered? The clue to the answer is illustrated in the chart below which shows how lower interest rate peaks have triggered successive recessions (blue shaded areas are official recessions).
The reason is simple: it is the accumulating burden of debt. The sum of US federal and private sector debt stands at about$30 trillion, so a one per cent rise in interest rates and bond yields will simplistically cost $300bn annually. The increase in interest rates during the 2004-07 credit boom added annual interest rate costs of a little over double that, precipitating the Lehman crisis the following year. And while the US this time might possibly weather a two to three per cent rise in improving economic conditions, much less would be required to tip other G8 economies into financial and economic chaos.
The real cost of insurance
By this we mean the real price of gold, adjusted by the rapid expansion of fiat currency. One approach is to adjust the nominal price by the ratio of US dollars in circulation to US gold reserves. This raises two problems: which measure of money supply should be used, and given the Fed has never been audited, are the official gold reserves as reported to be trusted?
The best option is to adjust the gold price by the growth in the quantity of fiat money (FMQ) relative to the growth in above-ground stocks of gold. FMQ is constructed so as to capture the reversal of gold’s demonetisation. This is shown in the chart below of both the adjusted and nominal dollar price of gold.
Taken from the month before the Lehman collapse, the real price of gold adjusted in this way is $550 today, based on a nominal price of $1220. So in real terms, gold has fallen 40% from its pre-Lehman level of $920, and has roughly halved from its adjusted high in 2011.
So to summarise:
• We already have monetary hyperinflation, defined as an accelerating debasement of the dollar. And so for that matter all other currencies that are referenced to it are on a similar course, a condition which is unlikely to be halted except by a final systemic and currency crisis.
• Attempts to stabilise the purchasing power of currencies by raising interest rates will very quickly develop into financial and economic chaos.
• The insurance cost of owning gold is anomalously low, being considerably less than at the time of the Lehman crisis, which was the first inkling of systemic risk for many people.
So how is the global economy playing out?
If the economy starts to grow again a small rise in interest rates would collapse bond markets and bankrupt over-indebted businesses and over-geared banks. Alternatively a contracting economy will increase the debt burden in real terms, again threatening its implosion. So the last thing central banks will welcome is change in the global economic outlook.
Falling commodity prices and a flight from other currencies into the dollar appear to be signalling the greater risk is that we are sliding into a global slump. Even though large financial speculators appear to be driving commodity and energy prices lower, the fact remains that the global economy is being undermined by diminishing affordability for goods and services. In other words, the debt burden is already too large for the private sector to bear, despite a prolonged period of zero official interest rates.
A slump was halted when prices collapsed after Lehman went bust; that time it was the creation of unlimited money and credit by the Fed that saved the day. Preventing a slump is the central banker’s raison d’être. It is why Ben Bernanke wrote about distributing money by helicopter as the final solution. It is why we have had zero interest rates for six years.
In 2008 gold and oil prices fell heavily until it became clear that monetary stimulus would prevail. Equities also fell with the S&P 500 Index down 60% from its October 2007 high, but this index was already 24% down by the time Lehman failed.
The precedent for unlimited creation of cash and credit has been set and is undisputed. The markets are buoyed up by a sea of post-Lehman liquidity, are not discounting any trouble, and are ignoring the signals from commodity prices. If the economic downturn shows any further signs of accelerating the adjustment is likely to be brutal, involving a complete and sudden reassessment of financial risk.
This time gold has been in a bear market ahead of the event. This time the consensus is that insurance against financial and systemic risk is wholly unnecessary. This time China, Russia and the rest of Asia are buying out physical bullion liquidated by western investors.
We are being regularly advised by analysts working at investment banks to sell gold. But bear in mind that the investment industry is driven by trend-chasing recommendations, because that is what investors demand. Expecting analysts to value gold properly is as unlikely as farmers telling turkeys the truth about Thanksgiving.
The Democratic Party has made “income inequality” a signature issue for the 2014 (and, presumably, 2016) election cycle. Democrats, en masse, shout “J’accuse!” at Republicans. There is a very different story to tell.
“Income inequality” is a crude, and twisted, heuristic for stagnant median family income. “Income inequality” does not really resonate with voters, asnoted by the Washington Post‘s own Catherine Rampell, with a mountain of evidence showing that Americans don’t begrudge the wealthy their wealth, just are frustrated at the lack of widespread economic opportunity.
So let’s get down to cases. Stagnant median family income is not the GOP’s fault. It’s the Fed who done it.
The Atlantic Media Company’s Quartz recently claimed that the Fed has been intentionally keeping a lid on wages. This has potentially major political implications. Among other things, this view would allow the Republicans to push the discourse back toward the real problem, wage stagnation. It can serve to refocus the Congress on the real solution, restoring real, rule-based, integrity to monetary policy as a way to get America moving again.
A culpable Fed gives irony to the fact that it is the Democrats that protect the Fed as if it were the Holy of Holies of the Temple. What if, as asserted inQuartz, the Fed, by policy, and not the GOP, is the source of wage stagnation? This opens an opportunity for the GOP to parry the political narrative of “income inequality” and feature the real issue on the mind of the voters and forthrightly to address its core cause, poor monetary policy.
This has been slow to happen because Federal Reserve has exalted prestige. The elite media has a propensity to canonize the Chair of the Fed. Media adulation has obscured the prime source of the stagnation besetting American wage earners for the past 43 years.
Paul Volcker’s life was exalted (with some real justification), for instance by New York Times prize-winning journalist Joseph B. Treaster as The Making of a Financial Legend. Downhill from there…
Official picture of Janet Yellen from FRBSF web site
. (Photo credit: Wikipedia)
Chairman Greenspan was featured on the cover of Time Magazine’s February 15, 1999 issue as the most prominent member of “The Committee To Save The World.” One of the greatest investigative journalists of our era, Bob Woodward, wrote a deeply in-the-tank hagiography of Alan Greenspan, entitled Maestro. In retrospect, the halo the media bestowed was faux.
The Atlantic Monthly, in its February 12, 2012 issue, featured Fed Chairman Ben Bernanke on its cover as The Hero. (Hedging its bets, The Atlantic ran a duplicate inside cover referencing him as The Villain.) Author Roger Lowenstein wrote: “Ben Bernanke saved the economy—and has navigated masterfully through the most trying of times.” The adulation for Chairman Bernanke, in retrospect, seems overdone. Even President Obama, at the end of Bernanke’s final term, gave him a not-so-subtle push out the door, as reported by CNN: “He’s already stayed a lot longer than he wanted, or he was supposed to….”
It’s Janet Yellen’s turn for media canonization. This is premature.
Madame Yellen’s institutional loyalty and obvious decency command this columnist’s respect. Her intentions present as — profoundly — good. That said, the road to a well-known, notorious, destination is said to be paved with good intentions. Moreover, canonization demands that a miracle be proven. None yet is in evidence.
The canonization of Madame Yellen began in earnest with an August 24 article in Politico by Michael Hirsch, The Mystery Woman Who Runs Our Economy. The process was taken up to the next level the very next day in an article by Matt Phillips in Quartz, Janet Yellen’s Fed is more revolutionary than Ben Bernanke’s ever was.
Hirsch tees it up in Politico nicely:
As has been written, Yellen is clearly passionate about the employment problem. It was no accident that the theme of this year’s Jackson Hole meeting was “labor market dynamics,” and the AFL-CIO’s chief economist, Bill Spriggs, was invited while Wall Street economists were not.
Yellen is also very cagey about whether that’s happening or not: She’s playing her own private game of chicken with inflation, indicating that she wants to see more wage growth for workers (another thing that’s hard to track ahead of time) before she raises rates. Beneath the careful analysis and the caveat-freighted sentences, the bottom line seems to be: “We’re making this up as we go along.”
Phillips, in Quartz, observes that it has been Fed policy to suppress wages for two generations. Phillips:
From her position as the world’s single most powerful economic voice, the chair of the US Federal Reserve, Janet Yellen, is forcing the financial markets to rethink assumptions that have dominated economic thinking for nearly 40 years. Essentially, Yellen is arguing that fast-rising wages, viewed for decades as an inflationary red flag and a reason to hike rates, should instead be welcomed, at least for now.
It might sound surprising to most people who work for a living, but for decades the most powerful people in economics have seen strong real wage growth—that is, growth above and beyond the rate of inflation—as a big problem.
Phillips then gets to the point, providing what passes for economic wisdom among the enablers of the Fed’s growth-sapping (including wage-enervating) interventions.
Since the end of the Great Inflation, the Fed—and most of the world’s important central banks—have gone out of their way to avoid a replay of the wage-price spiral. They’ve done this by tapping on the economic brakes—raising interest rates to make borrowing more expensive and discourage companies from hiring—as wages started to show strong growth.
Phillips provides this exaltation of Janet Yellen:
If she’s right, and American paychecks can improve without setting off an inflationary spiral, it could upend the clubby world of monetary policy, reshape financial markets, and have profound implications for everything ….
Higher real wages, without exacerbating inflation, indeed would be something to cheer. That, demonstrably, is possible. The devil is in the details.
There’s persuasive, even compelling, evidence that the international monetary system is better governed by, and working people benefit from, a smart rule rather than the discretion of career civil servants, however elite. An important Bank of England paper in 2011, Financial Stability Paper No. 13, contrasts the poor performance, since 1971, of the freelancing Fed with the precursor Bretton Woods, and with classical gold standard, rules. This paper materially advances the proposition of exploring “a move towards an explicit rules-based framework.”
A rule-based system would represent a profound transformation of how the Fed currently does its business. House Financial Services Committee Chairman Jeb Hensarling (R-Tx) said, in a recent hearing, that “The overwhelming weight of evidence is that monetary policy is at its best in maintaining stable prices and maximum employment when it follows a clear, predictable monetary policy rule.”
Madame Yellen stated that “It would be a grave mistake for the Fed to commit to conduct monetary policy according to a mathematical rule.” Contrast Madame Yellen’s protest with a recent speech by Paul Volcker in which he forthrightly stated: “By now I think we can agree that the absence of an official, rules-based cooperatively managed, monetary system has not been a great success. In fact, international financial crises seem at least as frequent and more destructive in impeding economic stability and growth. … Not a pretty picture.”
Madame Yellen’s ability to achieve her (postulated) goal of rising real wages in a non-inflationary environment likely depends on who is right here, Yellen or Volcker. It is a key issue of the day. The threshold issue currently is framed as between “a clear, predictable monetary policy rule” and the discretion of the Federal Open Market Committee. The available rules are not limited to mathematical ones but, to achieve real wage growth and equitable prosperity, the evidence fully supports the proposition that a rule is imperative.
Returning America to consistently higher real wage growth is a Holy Grail for this columnist. Equitable prosperity, very much including the end of wage stagnation, is a driving objective for most advocates of a rule-based system, very much including advocates of “the golden rule.”
Getting real wages growing is a laudable, and virtuous, proposition. Premature canonization, however, is a flattering injustice to Madame Yellen … and to the Fed itself. The Federal Reserve is lost in a wilderness — “uncharted territory” — partly, perhaps mainly, of its own (well-intended) concoction.
The road to the declaration of sainthood requires, according to this writer’s Catholic friends, documentation of miracles. If this writer may be permitted to play the role of advocatus diaboli for a moment … no American Economic Miracle — akin to the Ludwig Erhard’s German “Economic Miracle,” the Wirtschaftswunder, driven by currency reform — yet appears in evidence.
Expertise, which Chair Yellen certainly possesses in abundance, can lead to hubris … and hubris in disaster as it did in 2008. Good technique is necessary but not sufficient.
As this writer elsewhere has noted,
Journalist Edwin Hartrich tells the following story about Erhard …. In July 1948, after Erhard, on his own initiative, abolished rationing of food and ended all price controls, Clay confronted him:
Clay: “Herr Erhard, my advisers tell me what you have done is a terrible mistake. What do you say to that?”
Erhard: “Herr General, pay no attention to them! My advisers tell me the same thing.”
Erhard, famously, proved right, his experts, wrong.
Madame Yellen by dint of her decency and intellect may yet prove capable of restoring the Great Moderation … and the real wage growth, with low inflation, that went with that. Yet, at best, Great Moderation 2.0 would be, as was its predecessor, a temporary, rather than sustainable, solution. “Making it up as you go along” is a proposition fraught with peril.
At worst, if Madam Yellen has, as observers such as Forbes.com‘s John Tamny detect, a proclivity for cheapening the dollar as a path to real wage growth she easily could throw working people out of the frying pan and into the fires of inflation. Moreover, the Fed’s proclivities toward central planning may be one of the most atavistic relics of a bygone era. Central planning, by its very nature, even if well meant, always suppresses prosperity. As the sardonic statement from the Soviet Union went, “So long as the bosses continue to pretend to pay us we will pretend to work.”
Some who should know better ignorantly, and passionately, still are stuck in William Jennings Bryan’s rhetorically stirring but intellectually vacuous 1896 declaration, “You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold.” This is a plank that won Bryan his party’s nomination and cost him the presidency… three times. The electorate knows that cheapening the money is the problem, not the solution.
The Fed, not the gold standard, pressed down the crown of thorns upon labor’s brow. The GOP, rather than playing rope-a-dope on “income inequality,” would do well to dig down to find the monetary rule with which to restore a climate of equitable prosperity and real wage growth. Results, not intentions, are what counts.
There is abundant evidence that the right rule-based system would not be a “grave mistake” but a smart exit ramp back to growth of real wages. Anything the Fed does that departs from a dollar price rule is anti-equitable-prosperity. Anything else hurts all, labor and capital. The Congress, under the leadership of Chairmen Garrett (R-NJ) and Hensarling (R-Tx), whose committee has in front of it the Federal Reserve Accountability and Transparency Act and Joint Economic Committee Chairman Kevin Brady’s (R-Tx) Centennial Monetary Commission, at long last, is bestirring itself. Now is the right time to amp up the crucial debate over monetary policy … by enacting both of these pieces of legislation.
After closing at 3.03% in December 2013 the yield on the 10-year US T-Note has been trending down, closing at 2.34% by August this year. Many commentators are puzzled by this given the optimistic forecasts for economic activity by Fed policy makers.
According to mainstream thinking the Central Bank is the key factor in determining interest rates. By setting short-term interest rates the Central Bank, it is argued, through expectations about the future course of its interest rate policy influences the entire interest rate structure.
Following the expectations theory (ET), which is popular with most mainstream economists, the long-term rate is an average of the current and expected short-term interest rates. If today’s one-year rate is 4% and next year’s one-year rate is expected to be 5%, the two-year rate today should be (4%+5%)/2 = 4.5%.
Note that interest rates in this way of thinking is set by the Central Bank whilst individuals in all this have almost nothing to do and just form mechanically expectations about the future policy of the Central Bank. (Individuals here are passively responding to the possible policy of the Central Bank).
Based on the ET and following the optimistic view of Fed’s policy makers on the economy some commentators hold that the market is wrong and long-term rates should actually follow an up-trend and not a down-trend.
According to a study by researchers at the Federal Reserve Bank of San Francisco (FRBSF Economic Letter – Assessing Expectations of Monetary Policy, 8 of September 2014) market players are wrongly interpreting the intentions of Fed policy makers. Market players have been underestimating the likelihood of the Fed tightening its interest rate stance much sooner than is commonly accepted given Fed officials’ optimistic view on economic activity.
It is held that a disconnect between public expectations and the expectations of central bank policy makers presents a challenge for Fed monetary policy as far as the prevention of disruptive side effects on the economy is concerned on account of a future tightening in the interest rate stance of the Fed.
We suggest that what matters for the determination of interest rates are individuals’ time preferences, which are manifested through the interaction of the supply and the demand for money and not expectations regarding short-term interest rates. Here is why.
The essence of interest rate determination
Following the writings of Carl Menger and Ludwig von Mises we suggest that the driving force of interest rate determination is individual’s time preferences and not the Central Bank.
As a rule people assign a higher valuation to present goods versus future goods. This means that present goods are valued at a premium to future goods.
This stems from the fact that a lender or an investor gives up some benefits at present. Hence the essence of the phenomenon of interest is the cost that a lender or an investor endures. On this Mises wrote,
That which is abandoned is called the price paid for the attainment of the end sought. The value of the price paid is called cost. Costs are equal to the value attached to the satisfaction which one must forego in order to attain the end aimed at.
According to Carl Menger:
To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well being in a later period……..All experience teaches that a present enjoyment or one in the near future usually appears more important to men than one of equal intensity at a more remote time in the future
Likewise according to Mises,
Satisfaction of a want in the nearer future is, other things being equal, preferred to that in the farther distant future. Present goods are more valuable than future goods.
Hence according to Mises,
The postponement of an act of consumption means that the individual prefers the satisfaction which later consumption will provide to the satisfaction which immediate consumption could provide.
For instance, an individual who has just enough resources to keep him alive is unlikely to lend or invest his paltry means.
The cost of lending, or investing, to him is likely to be very high – it might even cost him his life if he were to consider lending part of his means. So under this condition he is unlikely to lend, or invest even if offered a very high interest rate.
Once his wealth starts to expand the cost of lending, or investing, starts to diminish. Allocating some of his wealth towards lending or investment is going to undermine to a lesser extent our individual’s life and well being at present.
From this we can infer, all other things being equal, that anything that leads to an expansion in the real wealth of individuals gives rise to a decline in the interest rate i.e. the lowering of the premium of present goods versus future goods.
Conversely factors that undermine real wealth expansion lead to a higher rate of interest rate.
Time preference and supply demand for money
In the money economy individuals’ time preferences are realized through the supply and the demand for money.
The lowering of time preferences, i.e. lowering the premium of present goods versus future goods, on account of real wealth expansion, will become manifest in a greater eagerness to lend and invest money and thus lowering of the demand for money.
This means that for a given stock of money there will be now a monetary surplus.
To get rid of this monetary surplus people start buying various assets and in the process raise asset prices and lower their yields, all other things being equal.
Hence, the increase in the pool of real wealth will be associated with a lowering in the interest rate structure.
The converse will take place with a fall in real wealth. People will be less eager to lend and invest thus raising their demand for money relative to the previous situation.
This for a given money supply reduces monetary liquidity – a decline in monetary surplus. Consequently, all other things being equal this lowers the demand for assets and thus lowers their prices and raises their yields.
What will happen to interest rates as a result of an increase in money supply? An increase in the supply of money, all other things being equal, means that those individuals whose money stock has increased are now much wealthier.
Hence this sets in motion a greater willingness to invest and lend money.
The increase in lending and investment means the lowering of the demand for money by the lender and by the investor.
Consequently, an increase in the supply of money coupled with a fall in the demand for money leads to a monetary surplus, which in turn bids the prices of assets higher and lowers their yields.
As time goes by the rise in price inflation on account of the increase in money supply starts to undermine the well being of individuals and this leads to a general rise in time preferences.
This lowers individuals’ tendency for investments and lending i.e. raises the demand for money and works to lower the monetary surplus – this puts an upward pressure on interest rates.
We can thus conclude that a general increase in price inflation on account of an increase in money supply and a consequent fall in real wealth is a factor that sets in motion a general rise in interest rates whilst a general fall in price inflation in response to a fall in money supply and a rise in real wealth sets in motion a general fall in interest rates.
Explaining the fall in long-term interest rates
We suggest that an uptrend in the yearly rate of growth of our monetary measure AMS since October 2013 was instrumental in the increase in the monetary surplus. The yearly rate of growth of AMS jumped from 5.9% in October 2013 to 10.6% by March and 10.3% by June this year before closing at 7.6% in July.
Furthermore, the average of the yearly rate of growth of the consumer price index (CPI) since the end of 2013 to July this year has been following sideways trend and stood at 1.6%, which means a neutral effect on long-term yields from the price inflation perspective. Also the average of the yearly rate of growth of real GDP, which stood at 2.2% since 2013, has been following a sideways movement – a neutral effect on long term rates from this perspective.
Hence we can conclude that the rising trend in the growth momentum of money supply since October last year was instrumental in the decline in long-term rates.
Summary and conclusions
Since December 2013 the yields on long-term US Treasuries have been trending down. Many commentators are puzzled by this given the optimistic forecasts for economic activity by Fed policy makers. Consequently, some experts have suggested that market players have been underestimating the likelihood of the Fed tightening its interest rate stance much sooner than is commonly accepted. We hold that regardless of expectations what ultimately matters for the long-term interest rate determination are individuals’ time preferences, which is manifested through the interaction of the supply and the demand for money. We suggest that an up-trend in the yearly rate of growth of our monetary measure AMS since October 2013 has been instrumental in the increase in the monetary surplus. This in turn was the key factor in setting the decline in trend in long-term interest rates.
Low interest rates contribute to weak labour markets
In the latter part of August, the cream of the world’s central bankers convened at the annual Kansas City Fed gathering at Jackson Hole, Wyoming. Every year the Conference has a theme. Last year’s was Quantitative Easing (QE): when and how it would end. This year’s topic was unemployment, under the rather grandiose title “Re-Evaluating Labour Market Dynamics”.
Ms Yellen, chair of the Federal Reserve, seemed at last to acknowledge one of this Newsletter’s recurring concerns; namely, that official unemployment data mislead because they ignore the number of citizens so disaffected with prospects that they no longer register as looking for work. She is warming towards a new Fed Board developed Labour Market Conditions Index (LMCI) which takes account of workforce participation rates and various other measures. She considers LMCI a better indicator of employment market strength or weakness than the raw unemployment percentage number. By this measure, unemployment is still substantially above the pre-crisis level. Accordingly, Ms Yellen remains concerned about the present strength of the US recovery:
“the recent behavior of both nominal and real wages point to weaker labor market conditions than would be indicated by the current unemployment rate”;
Nonetheless, she indicated that interest rates would rise if future, stronger than expected, labour market data were reported.
Similar concerns are now paramount among UK central bankers. The Bank of England now overtly links its ‘forward guidance’ about the timing of interest rate increases to evidence of growth in wage levels.
The ECB’s President Mario Draghi had absorbed the summer’s deterioration in European data suggesting that another slowdown is underway. Only this time, it is impacting primarily the core, France and Italy, and even Germany. Finance Minister Schaeuble recently said that ‘the ECB have already done enough’ so Germany is firmly against more stimulus at this stage.
President Draghi’s speech put labour market worries at the forefront of Europe’s problems. In Europe there was a second surge in unemployment 3 years after the financial crisis. From early 2011, when it became apparent that a number of countries would, without bailouts, default or renege on sovereign debt, heavy job losses drove up the Eurozone average to levels that have only recently topped out. Draghi took the opportunity of the profile of this occasion once again to express doubts whether unleashing QE in the Eurozone would make any difference to labour market conditions, because national governments have failed to implement substantive structural reforms. Like a physical trainer addressing a group of failed slimmers after 3 years of group therapy, he berated that he has done all he could do in the group sessions, those dissatisfied with their progress should look to themselves.
Although these presentations reveal doubts among leading central bankers that near zero interest rate policies (ZIRP) may not result in economic stimulus, there is still a gulf between these doubts and the scepticism about ZIRP policies, doubt that have been strongly expressed by the Bank for International Settlements (see our July Newsletter).
An even stronger counter view is beginning to gather mainstream support; namely, that ZIRP is a primary cause of the continuing weak labour market conditions. The reasoning is as follows. By reducing the cost of borrowing money substantially below its ‘market’ level, capital goods for businesses have become disproportionately cheap compared with the cost of employing people. When weighing up the cost/ benefit of, say, installing a machine to sell tickets in train stations compared with employing staff to do the same job, low interest rates reduce the cost of the machine option. Businessmen make such decisions using discounted cash flow analysis, whereby future costs are assessed a present value using average market interest rates over the term. So ZIRP has a double whammy effect; not only is the borrowing cost of the machine lower, but by applying a discount rate of close to zero to the employee option, the present value cost of the stream of wages is increased. This may go some way towards explaining the trend of low to moderate-income jobs being replaced by machines in areas such as supermarket checkout services as well as transport ticketing.
This is a classic “misallocation” as per Austrian economics. It follows that, when rates rise, firms will find their overall operations burdened by excessive (now expensive) capital equipment. What they will then want are more productive employees. However, the lack of skilled workers–those out of the labour force for several years tend to be less productive–will make competition for skilled labour intense, wage pressures will rise, and the combination of excess capital capacity and rising wage pressures will intensify the stagflation we have already seen to date (see our July Newsletter).
Concerns about Repo Market Disruptions.
In August, concerns were reported that the US repo market, one of the largest engines of liquidity in global capital markets, was experiencing disruptions to its otherwise smooth functioning owing to a reduction in repo activity by banks. Banks explained this by citing increased capital costs under the recently introduced Leverage Ratio (see our February Newsletter).
Before considering this further, since repo transactions can be confusing, let us set out an example. A repo counterparty, say an investment fund, might hold a 5-year US Treasury bond. There has traditionally been a deep and liquid market enabling the fund to enter into a contract with, say, a bank to sell and buy back the bond, usually on a very short-term basis (overnight). However, medium term funding can be obtained by rolling the position every day. The sale and repurchase price are pre-agreed, the differential constitutes the return to the provider of cash. Banks have been encouraged to play the role of repo cash provider (otherwise known as Reverse repo Counterparty) as the market for derivatives, particularly interest rate swaps (IRS), has grown.
Thus it can be seen that not only have banks been lured to the repo market by the modest net interest income generated by being the repo cash provider against very low credit risk, but also because repos provide a steady source of government bonds that are useful for other hedging activities of the bank itself.
So why are they now pulling back? Even though the Basel Capital weighting applied to banks’ holdings of non-defaulted government bonds is zero, such holdings are indeed caught by the Leverage Ratio. Therefore, there will be a cost from the new rule’s effective date of 1 January 2015.
But is the pullback entirely attributable to new regulations, as claimed in the mainstream press? We are not so sure. There also appears to be a shortage of available collateral (Treasury bonds) in the maturities most popular with market participants. Perhaps this results from the Federal Reserve’s mopping up of so much of the US Treasury security market via its QE programme. The result is that banks providing cash into the transaction in which the underlying security is becoming scarce (e.g. 5 years), now expect to make a negative return on the loan of the cash. The loss would materialize if the price they will have to pay in the market to buy back the bond for delivery back to the counterparty has risen owing to scarcity. In these circumstances, it is hardly surprising that banks would prefer to deposit their cash with the Federal Reserve at a better rate of return and without the negative Leverage ratio consequences.
Under normal market conditions, repo provides a cheap and easy way to releverage an asset. If trend described in the previous paragraph persists, does it presage the start of wholesale reductions in systemic leverage? We doubt it. The thrust of ‘legal’ financial innovation, especially since the outbreak of the crisis, has been for banks to find new ways of leverage through collateral transformation, swapping collateral with each other in ways that either slip by, or are tacitly approved by regulators. One such example is asset rehypothecation, which we discussed in our January Newsletter.
Finally, is this repo market disruption an ‘unintended consequence’ of the new Leverage Ratio regulations? The prevailing view appears to be negative. A small number of senior US Reserve bank governors have long memories of the 2008 crisis, and fear a recurrence of the repo market seizure. Sceptics may take the view that those bank governors are overly focussed on the symptoms of that crisis rather than on its cause. As has been amply documented, at the peak of the crisis (before any talk of bailouts), repo and other markets froze up because a number of insolvent counterparties reneged on obligations to deliver cash or collateral, triggering a collapse in confidence upon which these interbank markets rely. Shrinking the repo market will not prevent a recurrence of system wide crisis when such insolvency worries resurface.
[Editor's note: Please find the IREF Newsletter here]