Editor’s note: This article was previously published here at Goldmoney.com. It is republished with thanks.
Geopolitical and market background
I have been revisiting estimates of the quantities of gold being absorbed by China, and yet again I have had to revise them upwards. Analysis of the detail discovered in historic information in the context of China’s gold strategy has allowed me for the first time to make reasonable estimates of vaulted gold, comprised of gold accounts at commercial banks, mine output and scrap. There is also compelling evidence mine output and scrap are being accumulated by the government in its own vaults, and not being delivered to satisfy public demand.
The impact of these revelations on estimates of total identified demand and the drain on bullion stocks from outside China is likely to be dramatic, but confirms what some of us have suspected but been unable to prove. Western analysts have always lagged in their understanding of Chinese demand and there is now evidence China is deliberately concealing the scale of it from us. Instead, China is happy to let us accept the lower estimates of western analysts, which by identifying gold demand from the retail end of the supply chain give significantly lower figures.
Before 2012 the Shanghai Gold Exchange was keen to advertise its ambitions to become a major gold trading hub. This is no longer the case. The last SGE Annual Report in English was for 2010, and the last Gold Market Report was for 2011. 2013 was a watershed year. Following the Cyprus debacle, western central banks, seemingly unaware of latent Chinese demand embarked on a policy of supplying large quantities of bullion to break the bull market and suppress the price. The resulting expansion in both global and Chinese demand was so rapid that analysts in western capital markets have been caught unawares.
I started following China’s gold strategy over two years ago and was more or less on my own, having been tipped off by a contact that the Chinese government had already accumulated large amounts of gold before actively promoting gold ownership for private individuals. I took the view that the Chinese government acted for good reasons and that it is a mistake to ignore their actions, particularly when gold is involved.
Since then, Koos Jansen of ingoldwetrust.ch has taken a specialised interest in the SGE and Hong Kong’s trade statistics, and his dedication to the issue has helped spread interest and knowledge in the subject. He has been particularly successful in broadcasting market statistics published in Chinese to a western audience, overcoming the lack of information available in English.
I believe that China is well on the way to having gained control of the international gold market, thanks to western central banks suppression of the gold price, which accelerated last year. The basic reasons behind China’s policy are entirely logical:
- China knew at the outset that gold is the west’s weak spot, with actual monetary reserves massively overstated. For all I know their intelligence services may have had an accurate assessment of how much gold there is left in western vaults, and if they had not, their allies, the Russians, probably did. Representatives of the People’s Bank of China will have attended meetings at the Bank for International Settlements where these issues are presumably openly discussed by central bankers.
- China has significant currency surpluses under US control. By controlling the gold market China can flip value from US Treasuries into gold as and when it wishes. This gives China ultimate financial leverage over the west if required.
- By encouraging its population to invest in gold China reduces the need to acquire dollars to control the renminbi/dollar rate. Put another way, gold purchases by the public have helped absorb her trade surplus. Furthermore gold ownership insulates her middle classes from external currency instability which has become an increasing concern since the Lehman crisis.
For its geopolitical strategy to work China must accumulate large quantities of bullion. To this end China has encouraged mine production, making the country the largest producer in the world. It must also have control over the global market for physical gold, and by rapidly developing the SGE and its sister the Shanghai Gold Futures Exchange the groundwork has been completed. If western markets, starved of physical metal, are forced at a future date to declare force majeure when settlements fail, the SGE and SGFE will be in a position to become the world’s market for gold. Interestingly, Arab holders have recently been recasting some of their old gold holdings from the LBMA’s 400 ounce 995 standard into the Chinese one kilo 9999 standard, which insures them against this potential risk.
China appears in a few years to have achieved dominance of the physical gold market. Since January 2008 turnover on the SGE has increased from a quarterly average of 362 tonnes per month to 1,100 tonnes, and deliveries from 44 tonnes per month to 212 tonnes. It is noticeable how activity increased rapidly from April 2013, in the wake of the dramatic fall in the gold price. From January 2008, the SGE has delivered from its vaults into public hands a total of 6,776 tonnes. This is illustrated in the chart below.
This is only part of the story, the part that is in the public domain. In addition there is gold imported through Hong Kong and fabricated for the Chinese retail market bypassing the SGE, changes of stock levels within the SGE’s network of vaults, the destination of domestic mine output and scrap, government purchases of gold in London and elsewhere, and purchases stored abroad by the wealthy. Furthermore the Chinese diaspora throughout South East Asia competes with China for global gold stocks, and its demand is in addition to that of China’s Mainland and Hong Kong.
The Shanghai Gold Exchange (SGE)
The SGE, which is the government-owned and controlled gold exchange monopoly, runs a vaulting system with which westerners will be familiar. Gold in the vaults is fungible, but when it leaves the SGE’s vaults it is no longer so, and in order to re-enter them it is treated as scrap and recast. In 2011 there were 49 vaults in the SGE’s system, and bars and ingots are supplied to SGE specifications by a number of foreign and Chinese refiners. Besides commercial banks, SGE members include refiners, jewellery manufacturers, mines, and investment companies. The SGE’s 2010 Annual Report, the last published in English, states there were 25 commercial banks included in 163 members of the exchange, 6,751 institutional clients accounting for 81% of gold traded, and 1,778,500 clients of the commercial banks with gold accounts. The 2011 Gold Report, the most recent available, stated that the number of commercial bank members had increased to 29 with 2,353,600 clients, and given the rapid expansion of demand since, the number of gold account holders is likely to be considerably greater today.
About 75% of the SGE’s gold turnover is for forward settlement and the balance is for spot delivery. Standard bars are Au99.95 3 kilos (roughly 100 ounces), Au99.99 1 kilo, Au100g and Au50g. The institutional standard has become Au99.99 1 kilo bars, most of which are sourced from Swiss refiners, with the old Au99.95 standard less than 15% of turnover today compared with 65% five years ago. The smaller 100g and 50g bars are generally for retail demand and a very small proportion of the total traded. Public demand for smaller bars is satisfied mainly through branded products provided by commercial banks and other retail entities instead of from SGE-authorised refiners.
Overall volumes on the SGE are a tiny fraction of those recorded in London, and the market is relatively illiquid, so much so that opportunities for price arbitrage are often apparent rather than real. The obvious difference between the two markets is the large amounts of gold delivered to China’s public. This has fuelled the rapid growth of the Chinese market leading to a parallel increase in vaulted bullion stocks, which for 2013 is likely to have been substantial.
By way of contrast the LBMA is not a regulated market but is overseen by the Bank of England, while the SGE is both controlled and regulated by the People’s Bank of China. The PBOC is also a member of both its own exchange and of the LBMA, and deals actively in non-monetary gold. While the LBMA is at arm’s length from the BoE, the SGE is effectively a department of the PBOC. This allows the Chinese government to control the gold market for its own strategic objectives.
Identifiable demand is the sum of deliveries to the public withdrawn from SGE vaults, plus the residual gold left in Hong Kong, being the net balance between imports and exports. To this total must be added an estimate of changes in vaulted bullion stocks.
SGE gold deliveries
Gold deliveries from SGE vaults to the general public are listed both weekly and monthly in Chinese. The following chart shows how they have grown on a monthly basis.
Growth in public demand for physical gold is a reflection of the increased wealth and savings of Chinese citizens, and also reflects advertising campaigns that have encouraged ordinary people to invest in gold. Advertising the attractions of gold investment is consistent with a deliberate government policy of absorbing as much gold as possible from western vaults, including those of central banks.
Hong Kong provides import, export and re-export figures for gold. All gold is imported, exports refer to gold that has been materially altered in form, and re-exports are of gold transited more or less unaltered. Thus, exports refer mainly to jewellery which in China’s case is sold directly into the Mainland without going through the SGE, and re-exports refer to gold in bar form which we can assume is delivered to the SGE. Some imported gold remains on the island, and some is re-exported from China back to Hong Kong. This gold is either vaulted in Hong Kong or alternatively turned into jewellery and sold mostly to visitors from the Mainland buying tax-free gold.
The mainstream media has reported on the large quantities of gold flowing from Switzerland to Hong Kong, but this is only part of the story. In 2013, Hong Kong imported 916 tonnes from Switzerland, 190 tonnes from the US, 176 tonnes from Australia and 150 tonnes from South Africa as well as significant tonnages from eight other countries, including the UK. She also imported 337 tonnes from Mainland China and exported 211 tonnes of it back to China as fabricated gold.
Hong Kong is not the sole entry port for gold destined for the Mainland. The table below illustrates how Hong Kong’s gold trade with China has grown, and its purpose is to identify gold additional to that supplied via Hong Kong to the SGE. Included in the bottom line, but not separately itemised, is fabricated gold trade with China (both ways), as well as the balance of all imports and exports accruing to Hong Kong.
The bottom line, “Additional supply from HK” should be added to SGE deliveries and changes in SGE vaulted gold to create known demand for China and Hong Kong.
SGE vaulted gold
The increase in SGE vaulted gold in recent years can only be estimated. However, it was reported in earlier SGE Annual Reports to amount to 519.55 tonnes in 2008, 582.6 tonnes in 2009, and 841.8 tonnes in 2010. There have been no reported vault figures since.
The closest and most logical relationship for vaulted gold is with actual deliveries. After all, public demand is likely to be split between clients maintaining gold accounts at member banks, and clients taking physical possession. The ratios of delivered to vaulted gold were remarkably stable at 1.05, 1.03, and 0.99 for 2008, 2009 and 2010 respectively. On this basis it seems reasonable to assume that vaulted gold has continued to increase at approximately the same amount as delivered gold on a one-to-one basis. The estimated annual increase in vaulted gold is shown in the table below.
The benefits of vault storage, ranging from security from theft to the ability to use it as collateral, seem certain to encourage gold account holders to continue to accumulate vaulted metal rather than take personal possession.
Supply consists of scrap, domestically mined and imported gold
Scrap is almost entirely gold bars, originally delivered from the SGE’s vaults into public hands, and subsequently sold and resubmitted for refining. Consequently scrap supplies tend to increase when gold can be profitably sold by individuals in a rising market, and they decrease on falling prices. There is very little old jewellery scrap and industrial recycling is not relatively significant. Official scrap figures are only available for 2009-2011: 244.5, 256.3 and 405.8 tonnes respectively. I shall therefore assume scrap supplies for 2012 at 430 tonnes and 2013 at 350 tonnes, reflecting gold price movements during those two years.
Scrap is refined entirely by Chinese refiners, and as stated in the discussion concerning mine supply below, the absence of SGE standard kilo bars in Hong Kong is strong evidence that they are withheld from circulation. It is therefore reasonable to assume that scrap should be regarded as vaulted, probably held separately on behalf of the government or its agencies.
China mines more gold than any other nation and it is generally assumed mine supply is sold through the SGE. That is what one would expect, and it is worth noting that a number of mines are members of the SGE and do indeed trade on it. They act as both buyers and sellers, which suggests they frequently use the market for hedging purposes, if nothing else.
Typically, a mine will produce doré which has to be assessed and paid for before it is forwarded to a refinery. Only when it is refined and cast into standard bars can gold be delivered to the market. Broadly, one of the following procedures between doré and the sale of gold bars will occur:
- The refiner acts on commission from the mine, and the mine sells the finished product on the market. This is inefficient management of cash-flow, though footnotes in the accounts of some mine companies suggest this happens.
- The refiner buys doré from the mine, refines it and sells it through the SGE. This is inefficient for the refiner, which has to find the capital to buy the doré.
- A commercial bank, being a member of the SGE, finances the mine from doré to the sale of deliverable gold, paying the mine up-front. This is the way the global mining industry often works.
- The government, which ultimately directs the mines, refiners and the SGE, buys the mine output at pre-agreed prices and may or may not put the transaction through the market.
I believe the government acquires all mine output, because it is consistent with the geopolitical strategy outlined at the beginning of this article. Furthermore, two of my contacts, one a Swiss refiner with facilities in Hong Kong and the other a vault operator in Hong Kong, tell me they have never seen a Chinese-refined one kilo bar. Admittedly, most one kilo bars in existence bear the stamp of Swiss and other foreign refiners, but nonetheless there must be over two million Chinese-refined kilo bars in existence. Either Chinese customs are completely successful in stopping all ex-vault Chinese-refined one kilo bars leaving the Mainland, or the government takes all domestically refined production for itself, with the exception perhaps of some 100 and 50 gram bars. Logic suggests the latter is true rather than the former.
Since the SGE is effectively a department of the PBOC, it must be at the government’s discretion if domestic mine production is put through the market by the PBOC. Whether or not Chinese mine supply is put through the market is impossible to establish from the available statistics, and is unimportant: no bars end up in circulation because they all remain vaulted. It is material however to the overall supply and demand picture, because global mine supply last year drops to about 2,490 tonnes assuming Chinese production is not available to the market.
Geopolitics suggests that China acquires most, if not all of its own mine and scrap production, which accumulates in the vaulting system. This throws the emphasis back on the figures for vaulted gold, which I have estimated at one-for-one with delivered gold due to gold account holder demand. To this estimate we should now add both Chinese scrap and mine supply. This would explain why vaulted gold is no longer reported, and it would underwrite my estimates of vaulted gold from 2011 onwards.
Further comments on vaulted gold
From the above it can be seen there are three elements to vaulted gold: gold held on behalf of accountholders with the commercial banks, scrap gold and mine supply. The absence of Chinese one kilo bars in circulation leads us to suppose scrap and mine supply accumulate, inflating SGE vault figures, but a moment’s reflection shows this is too simplistic. If it was included in total vaulted gold, then the quantity of gold held by accountholders with the commercial banks, as reported in 2009-11, would have fallen substantially to compensate. This cannot have been the case, as the number of accountholders increased substantially over the period, as did interest in gold investment.
Therefore, scrap and mined gold must be allocated into other vaults not included in the SGE network, and these vaults can only be under the control of the government. It will have been from these vaults that China’s sudden increase in monetary gold of 444 tonnes in the first quarter of 2009 was drawn, which explains why the total recorded in SGE vaults was obviously unaffected. So for the purpose of determining the quantity of vaulted gold, scrap and mined gold must be added to the gold recorded in SGE vaults.
Though it is beyond the scope of this analysis, the existence of government vaults not in the SGE network should be noted, and given cumulative mine production over the last thirty years, scrap supply and possibly other purchases of gold from abroad, the bullion stocks in these government vaults are likely to be very substantial.
Western gold flows to China
We are now in a position to estimate Chinese demand and supply factors in a global context. The result is summarised in the table below.
Chinese demand before 2013 had arrived at a plateau, admittedly higher than generally realised, before expanding dramatically following last April’s price drop. Taking the WGC’s figures for the Rest of the World gives us new global demand figures, which throw up a shortfall amounting to 9,461 tonnes since the Lehman crisis, satisfied from existing above-ground stocks.
This figure, though shocking to those unaware of these stock flows, could well be conservative, because we have only been able to address SGE deliveries, vaulted gold and Hong Kong net flows. Missing from our calculations is Chinese government purchases in London, demand from the ultra-rich not routed through the SGE, and gold held by Chinese nationals abroad. It is also likely that demand from the Chinese diaspora in SE Asia and Asian is also underestimated by western analysts.
There are assumptions in this analysis that should be clear to all. But if it only serves to expose the futility of attempts in western capital markets to manage the gold price, the exercise has been worthwhile. For much of 2013 commentators routinely stated that Asian demand was satisfied from ETF redemptions. But as can be seen, ETF sales totalling 881 tonnes covered only one quarter of the west’s shortfall against China, the rest coming mostly from central bank vaults. Anecdotal evidence from Switzerland is that the four major refiners have been working round-the-clock turning LBMA 400 ounce bars into one kilo 9999 bars for China. They are even working with gold bars that are battered and dusty, which suggests the west is not only digging into deep storage to satisfy Chinese demand at current prices, but digging a hole for itself as well.
China is now overtly pushing for the US dollar to be replaced as the world’s reserve currency.
Xinhua, China’s official press agency on Sunday ran an op-ed article which kicked off as follows:
As U.S. politicians of both political parties are still shuffling back and forth between the White House and the Capitol Hill without striking a viable deal to bring normality to the body politic they brag about, it is perhaps a good time for the befuddled world to start considering building a de-Americanized world.
China does have a broad strategy to prepare for this event. She is encouraging the creation of an international market in her own currency through the twin centres of Hong Kong and London, side-lining New York, and she is actively promoting through the Shanghai Cooperation Organisation (SCO) non-dollar trade settlement across the whole of Asia. She has also been covertly building her gold reserves while overtly encouraging her citizens to accumulate gold as well.
There can be little doubt from these actions that China is preparing herself for the demise of the dollar, at least as the world’s reserve currency. Central to insuring herself and her citizens against this outcome is gold. China has invested heavily in domestic mine production and is now the largest producer at an estimated 440 tonnes annually, and she is also looking to buy up gold mines elsewhere. Little or none of the domestically mined gold is seen in the market, so it is a reasonable assumption the Government is quietly accumulating all her own production without it becoming publicly available.
Recorded demand for gold from China’s private sector has escalated to the point where their demand now accounts for significantly more than the rest of the world’s mine production. The Shanghai Gold Exchange is the mainland monopoly for physical delivery, and Hong Kong acts as a separate interacting hub. Between them in the first eight months of 2013 they have delivered 1,730 tonnes into private hands, or an annualised rate of 2,600 tonnes.
The world ex-China mines an estimated 2,260 tonnes, leaving a supply deficit for not only the rest of gold-hungry South-east Asia and India, but the rest of the world as well. It is this fact that gives meat to the suspicion that Western central bank monetary gold is being supplied keep the price down, because ETF sales and diminishing supplies of non-Asian scrap have been wholly insufficient to satisfy this surge in demand.
So why is the Chinese Government so keen on gold? The answer most likely involves geo-politics. And here it is worth noting that through the SCO, China and Russia with the support of most of the countries in between them are building an economic bloc with a common feature: gold. It is noticeable that while the West’s financial system has been bad-mouthing gold, all the members of the SCO, including most of its prospective members, have been accumulating it. The result is a strong vein of gold throughout Asia while the West has left itself dangerously exposed.
The West selling its stocks of gold has become the biggest strategic gamble in financial history. We are committing ourselves entirely to fiat currencies, which our central banks are now having to issue in accelerating quantities. In the process China and Russia have been handed ultimate economic power on a plate.
This article was previously published at GoldMoney.com.
Since our last attempt at a textual analysis of where the economic pain threshold lies for China’s rulers, the intervening period has been punctuated by a flurry of meetings, pronouncements, prognostications, and policy precursors.
The net result? That anxieties are certainly rising; that there are some signs of intense political manoeuvring; but that Xi and Li have so far largely stuck to their guns.
Taking the politics first, two items stand out: the news that court proceedings will shortly commence against the disgraced Bo Xilai – wherein he will face charges mostly relating to corruption and the abuse of power – and the post-dated report of a meeting with Henry Kissinger at which former President and éminence grise, Jiang Zemin, fully endorsed the policies of his successor-but-one.
The timing of the first seems nicely calculated to neutralize critics on the left of the party and to preclude any haggling over Bo’s fate from taking place at the upcoming Beidaihe party summit, thus leaving the agenda free to thrash out the nitty-gritty of economic policy ahead of the crucial autumn Plenum.
The second, by contrast, seems to rule out any open, factional divide between pro- and anti-reformers and, taken with Xi’s subsequent re-iteration of his call to ‘deepen reform and opening up’, provides another re-run of the manner in which Deng Xiaoping outflanked Jiang himself on his famous ‘Southern Tour’ of 1992 (an event symbolically commemorated by Xi on his scene-setting first excursion from Beijing after being sworn in as General Secretary in December).
On that earlier occasion, Deng ringingly declared to the back-sliders who were threatening to unravel his grand designs that ‘whoever does not support reforms should step down’ – an implied threat whose resonance will surely not be lost on any of today’s doubters.
Categorizing this as a ‘strategic decision’, last week Xi urged ‘a spirit of reform and innovation’ and for the Party to display ‘ever more political courage and wisdom.’
‘China must break the barriers from entrenched interest groups to further free up social productivity and invigorate creativity,’ he went on. ‘There is no way out if we stay still or head backward.’
Again, the official press coverage of Tuesday’s Politburo meeting was replete with the usual litany regarding fine-tuning, prudent monetary policy, fiscal adjustment, greater efficiency, scientific developments, etc., etc. But, again it emphasized that macro policy should be stable (read my lips: ‘no – monster – stimulus’) and micro policies should be active.
Along these lines, Premier Li had already unveiled a mini-package which sought to ease taxes on SMEs, to expedite the formalities associated with the export trade, and to move up consideration of further railway construction out in the under-developed Wild West of the country. But, far from a reversion to type, this was seemingly so underwhelming that since he announced this, the prices of the likes of steel, coal, aluminium, and copper have severally resumed their slide.
Even the resort to fiscal policy seems to envisage a refreshingly different approach, coming as it does with an avowed intent to limit the budget deficit and reduce spending while alleviating the tax burden where possible. Is this a hint that Beijing will pursue a proper, stimulatory austerity of less government on both sides of the ledger in place of the deadening ‘fauxterity’ of less rapidly increasing outlays mixed with swingeing tax rises currently being practiced in the West? One would certainly like to think so.
Taken with the diktat which aims to address at least some of the worst heavy incidences of industrial over-capacity (a move said to be ‘key to restructuring’ in Xi’s own emphasis), the buzzword for policy seems to be what Li termed ‘sustained release’ – i.e., that there will be no big, blockbuster launches if indiscriminate lending or spending, but instead a steady drumbeat of hopefully therapeutic micro-measures.
On top of that, there was an intriguing reference to the idea of ‘enhancing a sense of urgency’ which was closely linked to the vow ‘to firmly grasp the opportunity for major enhancements’. Does this mean that Xi and Li are cleverly playing the anxieties of the moment in order to lessen resistance to their program of change? That through a strategy of masterly inactivity they will first disabuse the hordes of disobedient local cadres and SOE oligarchs of the presumption that they are all Too Big To Fail, leaving them no option but to adapt to the new policy thrust as the only alternative road to promotion and self-enrichment? It would certainly be nice to think so.
Along these lines, it surely cannot be a coincidence that the press has been filled with cautionary tales deriving from the bankruptcy just declared by Detroit. Nor that a veritable army of 80,000 audit officials is being mustered to go out and assess the true level of local government indebtedness across all levels from the smallest township to the largest central city. The result cannot fail to be chastening even if it is deemed not to reach the CNY20-25 trillion which lies at the top end of some estimates. No doubt there will be sufficient violations of central policy, accounting practice, and banking regulation, not to mention outright criminality for the tally to give Xi and Li a powerful means of seeing that their wishes will henceforth be complied with.
Before we leave this issue, there is one broader point which we must make: namely, that this thoughtlessly regurgitated idea that what China needs is more ‘consumption’ and less ‘saving’ is nothing more than yet another dangerous Keynesian canard.
What the country needs – what any country needs – is more consumer satisfaction, agreed! But how this is to be most sustainably (not to mention most equitably) achieved is to ensure that the greatest possible fraction of production is geared to that end above all others. It should then be obvious that this is an endeavour that cannot fail to require investment: rationally-undertaken, market-oriented, ex ante, private savings-funded, entrepreneurially-directed investment of a kind that has been all too lacking in China, perhaps, but investment all the same – and a good deal of it, too, in a country where the average person suffers a standard of living still far below what could so easily be his to enjoy.
So, firstly, let’s be honest and reclassify all the sub-marginal, no-return-on-capital, ‘empty-asset’ ‘investment’ as what it really is – state-led CONSUMPTION and we will at once clear up a good deal of semantic confusion and hence lessen our chance of chasing off down the wrong macro-aggregate pathway.
China’s personal consumption may well be depressed below its potential – though the fact that households appear to save around a quarter of their income is not wholly exceptional in fast-developing countries, for how else is the growth to be funded? No, the real crux of the matter is that China’s collective consumption (largely undertaken by soft-budget SOE’s and deficit-junkie governments) is far too high and so thoroughly lacking in genuine prospective return to be further borne. It should therefore be no part of policy to increase blindly the degree of exhaustive consumption – especially where this is financed via the top-down suppression of interest rates and by wholesale misallocations of a cartelized, ex nihilo creation of credit.
Of course, the making of such a shift will be by no means a trivial task either to initiate or to see through to its end if only because the piling up of IOUs and the complex layering of both direct and hidden subsidies which has enabled so much mindless, Krude Keynesian, Keystone Krugmanite, New Deal reduplication to take place has also provided employment for one multitude, a core of seemingly reliable customers for another, and – alas! – an unavoidable outlet for the hard-won savings of them both. Not only the most shameless and venal of the princelings will therefore have a strong, vested interest in trying to perpetuate the existing schema, however much people may be aware that it cannot be continued indefinitely.
As the stilted language of the communiqués puts it, the external situation is also ‘complicated’- in other words the patterns of trade upon which China and its neighbours have built so much of their recent prosperity are now displaying at best a dispiriting stagnation and at worst an outright decline.
Thailand is a case in point: exports to China thence are back to 2010 levels and are falling at the fastest pace since the Crash itself. For all the ballyhoo about ‘Abenomics’ the specious glimmer of recovery there seems little more than money illusion. Industrial production has started to droop one more while, when rebased in the US dollars which are the regional standard, even exports are sickly – those to the rest of Asia are falling at their fastest rate since the Crash, also, to lie a good fifth lower than they did at the 2011 recovery peak.
No wonder the latest PMI fell 1.6 points to a 5-month low. Among the components, export orders were weak – mainly thanks to China – and there was evidence of a developing margin squeeze. As the report noted:-
Increases in the cost of raw materials due in turn to the yen’s weakness was cited as a key driver of rising input prices, which increased for the seventh consecutive month. Inflationary pressures were evident to a lesser degree in output prices, which grew at a slower pace than in June.
Weak PMIs were not exactly a rare occurrence, either. China, Taiwan, and South Korea all produced multi-month, contraction level lows.
What is perhaps of more concern is that, according to the latest IIF survey of emerging markets, not only were funding conditions in Asia becoming more straitened in the second quarter (in fact there were the worst of the four geographical divisions in the questionnaire), but loan demand was actually falling in all categories except real estate (where else?). Not a happy portent for vigorous second half growth and with it an enhanced call upon resources.
Over the past four decades the global economy has largely experienced prolonged imbalances, with countries running large current account deficits in symbiotic relationships with those running large surpluses. In our recent HindeSight Investor Letter – Top of the BoPs we revisit our long held belief that the current monetary order as defined by a constellation of exchange rate arrangements between the major global currencies, and which maintained these imbalances artificially, has led to excessive global liquidity and credit creation. This in turn drove a litany of asset price bubbles.
The bursting of these asset bubbles has continued in a series these past two decades, each one’s demise leading to more disruptive policy responses which have only succeeded in igniting yet more bubbles, only for those too to fail.
Finally in 2008 we witnessed the finale of decades of credit creation, rising in what appeared to be a crescendo of credit excess and widespread asset booms. We saw this event as the death throes of an unstable monetary regime, only then to see an unprecedented global reaction by policymakers in a coordinated fashion to keep the global system alive. For a moment here today, there are those who dare to believe they have succeeded, with rising equity markets a testimony to a reviving global economy. Nothing could be further from reality.
We stand by our assessment that the disproportionate reaction of central bankers and policymakers alike has merely succeeded in compounding and exacerbating the error of this highly imbalanced monetary system. Recent events in emerging countries are a manifestation of the continuing unravelling of our monetary order.
In another recent HindeSight letter we described how the world is faced with a binary situation of global deflation or hyperinflation. We believe the odds have tilted firmly towards deflation. It would appear the unwinding of the global imbalances that led to the 2008 crisis is continuing unabashed, irrespective of the recent monetary excess used to abate them.
Large current account deficits led to unsustainable debt creation and as a consequence the trade deficit countries were the first to experience a severe financial crisis, but now on the other side of the equation the surplus countries are experiencing their reaction to the crisis. For balance of payments have two components to the equation both the financiers and the borrowers, so by definition changes in savings and investments in one such country has a profound impact on those of another.
The recent instability in emerging market economies and especially China is a direct consequence of these global imbalances which became stymied briefly by global bail-outs only to have been left in a more vulnerable economic position. The deleveraging process which began in 2008 has been a slow burner but is likely now in full swing. The deflationary risks are very high.
Top of the Pops was a legendary British music chart television show which began weekly broadcasts on the BBC in 1964, and finally wound down its music decks in July 2006. The show comprised performances from leading selling music artists and always culminated with an airing of the number one best selling single of the week, after a rundown of the top 30 singles. So popular was the show that it became a major UK export franchise, with its iconic logo emblazoned over TV screens globally.
Like all great cultural institutions the music was both a representation and manifestation of its ages, shaping popular culture and generations alike. No more emblematic of its age were the Punk rock bands of the 70s, both here in the UK and the US; the ‘Sex Pistols’ and ‘The Clash’, the UK vanguard, and across the Atlantic the ‘Television’ and the ‘Ramones’. Hard-edged, shouted vocals amongst a cacophony of relentless drumming, heavy bass and repetitive electric guitar chords, they bore witness to an anti-establishment movement seemingly disenfranchised with the economic misery of the time.
‘Blitzkrieg Bop’ by the Ramones exemplified the mood of the era, its title inspiration coming from the German World War II tactic, blitzkrieg, which literally means ‘lightning war’. Drawing our own inspiration from Blitzkrieg Bop we echo their rally cry - ‘Hey! Ho! Let’s go’ as we re-delve into the area of global imbalances which seems to have taken a back-seat in the debate on the continuing crisis these past few years. We will observe those countries with vulnerable balance of payments in our very own version of Top of the Pops, Top of the BoPs (Balance of Payments) if you will, to see which are exhibiting financial and trade stresses.
We have found balance of payment imbalances to be a superb leading indicator of economic stress, both in the emerging and developed markets, by which we could make investment and trading decisions. They are the thermometer by which we can first observe the very real signs of a monetary system in turmoil. In keeping with our musical theme, we wanted to make reference to another iconic UK show, but this time that of BBC radio and not TV; it’s called Desert Island Discs.
Desert Island Discs marginally pre-dates the auspicious events of the Bretton Woods conference of 1944, when allied nations gathered in New Hampshire to formulate the terms of an agreement on how to regulate the international monetary system, after the likely conclusion of World War II. The show began in 1942 and endures today, each week inviting a distinguished guest to envisage that they are a castaway on a desert island; who having chosen eight pieces of music, a book and a luxury item to take with them to the island are then asked to review their life in reference to excerpts of these choices.
Although not quite existing as long as the show (according to the Telegraph it’s the longest running radio show in the UK), if we at Hinde Capital were to be castaway on a desert island, in our own version of the game Desert Island Economic Discs* – the ten macroeconomic ‘records’ we would take with us as an excerpt to a life, in this case a country, would be:
1. Current account balance as a % of GDP (and commensurate capital account)
2. Debt as % of GDP (Debt composition as % of GDP)
3. Current account balance as a % of Investment
4. Real Effective Exchange Rate
5. Stock Prices
7. M2/ reserves/ Domestic Credit
9. Short-term capital inflows/GDP
10. Real interest rate on bank deposits
The countries which make our Top of the BoPs, are mainly those of the Emerging Markets. These countries are all exhibiting the hallmarks of a classic balance of payments (BoPs) crisis which have built up over many decades.
These large and persistent trade imbalances have been caused by distortions in financial, industrial, and trade policies. These distortions have prevented adjustments for many years, but large imbalances ultimately are unsustainable because the capital flows that finance the trade imbalances can be reversed only with a reversal of trade imbalances. Eventually these imbalances will adjust in spite of policy and institutional constraints, but in this case the adjustment is often violent and can come in the form of a financial crisis.
A country that appears peaceful and stable may encounter unexpected crises. There are structural problems in China’s economy which cause unsteady, unbalanced and uncoordinated and unsustainable development
Premier Wen Jiabao (2007)
The global crisis is a financial crisis driven primarily by global trade and capital imbalances. This is the macro theme we have pursued these past 7 years. We believe the global crisis is in full swing again and asset prices are in danger of falling globally. Money is less effective at catching the falling knife.
Emerging market countries are exhibiting the signs of crisis-like price action associated with deteriorating balance of payment balances, even though many have built up significant foreign exchange reserves.
Investors and policymakers do not believe this is the beginning of a major EM contagion crisis. They are lulling themselves into a false sense of security. They see the EM market tremors, and do not fear a re-run of the EM crises of old. They are right. This is not (just) going to be an EM crisis. Recent events portend a far more serious crisis is at hand; the unravelling of our global monetary system.
The crux – the EM tremors are really signifying the demise of the credit bubble that began bursting in 2008. This is not the start of the EM crisis. It is the beginning of the end of a credit bubble collapse that began in 2008.
We have witnessed unprecedented global fiscal and monetary stimulus (QE) which was used to arrest a global credit deflation. This led to the development of a truly global bond bubble. As debt levels rose in the developed countries and monetary stimulus was exported (de facto QE) to EM countries it underpinned growth with excess credit.
Since 2003 EM countries have seen US$7 trillion of inflows into their countries and a commensurate appreciation in their currencies; ones that they have struggled to control. These are not just strong flows rather they are astronomical in size and have been achieved by this excessively loose and unconventional monetary policy.
The paradox of such inflows strengthening currency rates is that they have succeeded in stultifying EM export-led growth, despite this supply of credit. The commodity exporters amongst them have been left doubly reeling by the confluence of higher exchange rates and lower demand from a stagnating global economy and in particular China. They have all seen their commodity revenues fall precipitously.
In a re-run of the 1990s the appreciation of the dollar against a rapidly depreciating yen has begun to drag USD Asia higher. This was the trigger for the Asian Tiger currency crisis in 1997. This has been a final nail in the coffin of Sino imperialism, as their export competitiveness is lost too.
In the 1980s it was a hike by the US Fed that triggered the LatAm crisis. Today, the mere whisper of tighter monetary conditions in the US, vis-a-vis a tapering of QE has led to higher bond rates globally. Note tapering is not the same as hiking interest rates.
The consequences of multiple rounds of QE have heightened global risks as it has both exacerbated ‘currency competition’ and hot capital flows into countries seeking desperately for a return both from income and capital growth. This has created major distortions in term rates, equity and bond values, driving them artificially high in price.
These distortions have created risks far greater than the fragilities of EM countries of yesterday years. The system of credit creation has produced unstable growth underpinned with collateral which is both mobile and suspect in its integrity.
Investors have nowhere to turn, emerging market countries growth is faltering in response to export disadvantages brought about by rampant G10 currency devaluations. China is finally succumbing to its side of the global imbalance excesses. First it was the deficit nations now it’s the turn of the creditor nations to falter, primarily China.
Trade flow reversals are leading to massive capital outflows out of EMs and the question remains: will the central banks of these countries sell their FX reserves, UST- bonds and euro government bonds (bunds) to finance this surge in outflows?
It is not clear that renewed global central bank liquidity provision will even stabilise a situation we see as growing dire by the day. China is the driver. All eyes on China.
Western economic commentary on China and Russia is usually coloured by monetarist assumptions not necessarily shared in Moscow and Beijing. For this reason, Russian and Chinese fiscal and monetary policies are misunderstood in financial markets, as well as the reasons their governments buy gold.
China has been notably relaxed about her own people acquiring gold, and the government itself appears to be absorbing all of China’s mine output. Russia is also building her official reserves from her own mine supply. The result over time has been the transfer of aboveground gold stocks towards these countries and their allies. The geo-political implications are highly important, but have been ignored by western governments.
China and Russia see themselves as having much in common: they are coordinating security, infrastructure projects and cross-border trade through the Shanghai Cooperation Organisation. Furthermore, those at the top have personal experience of the catastrophic failings of socialism, which have not yet been experienced in Western Europe and North America. Consequently neither government subscribes to the economic and monetary concepts prevalent in the West without serious reservations.
We saw evidence of this from Russia recently, with Putin’s appointment of his own personal economic adviser, Elvira Nabiullina, as the new head of Russia’s central bank. Ms Nabiullina is on record admiring, among others, the writings of Robert Higgs – a leading US economist of the Austrian School. She is therefore likely to take a strong line against the expansion of bank credit, which is confirmed by Russian commentators who believe she will prioritise reforms to strengthen bank balance sheets.
She is not alone. The People’s Bank of China recently let overnight money-market rates soar to over 20%. The message is clear for those prepared to look for it: they are not going to fuel an extended credit bubble. The two countries have learned how damaging a bank-credit-fuelled business cycle can be, and are determined to restrict bank lending. Western commentators find this hard to understand because it does not conform to the way western monetary policy works.
It seems that the leaders of both Russia and China are also painfully aware of the importance of currency stability in a way the West is not. The comparison with the West’s reckless monetary policies is stark. It follows that Russia and China are increasingly concerned about the major currencies, given both countries have substantial trade surpluses. Their exposure to this currency risk explains their keenness for gold. Furthermore, they know that if the renminbi and the rouble are to survive a western currency crisis, they must have the sound-money credibility provided by a combination of monetary restraint and gold backing. And the reason China is happy to let her citizens plough increasing amounts of their savings into gold is consistent with ensuring her people buy into sound money as well.
While the Chinese and Russian governments are authoritarian mercantilists, there are elements of the Austrian School’s economics in their approach. The tragedy for the West and Japan is they have embarked on the opposite weak-money course that can only end in the ultimate destruction of their currencies, leaving Russia and China as the dominant economic powers.
This article was previously published at GoldMoney.com.
Continued from part 2 …
Finally to China where the only thing to note is that the meme of credit exhaustion is starting to spread, given that every CNY100 of reported GDP in the first quarter required the addition of CNY52 in new credit – much of that flooding back in from abroad to play the property boom.
That this is likely to lead to an implosion in fairly short order seems to have been recognised by the new men in charge. Hence the unusual convening of an April session of the Politburo Standing Committee for a meeting dedicated to the economy. From this there emanated an official press release containing the following injunction:
China needs to cement its domestic economic growth momentum and guard against potential risks in financial sectors
It doesn’t sound as if another dash for growth is on the cards, now does it?
After the rout in the gold and silver market, all we can say is that though conspiracy theories inevitably abound, we have warned on numerous occasions that such a sell-off was always possible given the number of stale, trapped longs who have had no return for months while sitting at very elevated real and nominal valuations – and all in the face of ever-mounting equity rises, to boot. One may or may not care much for the idea of technicals as predictive tools, but, just once in a while, the break of an obvious trend line convinces those who do subscribe and gives rise to an avalanche of me-tooism and that was very much the case in gold and silver.
Since then everyone has come up with their own pet, Just So Story about what or who exactly triggered it. In all likelihood there was a multiplicity of overlapping causes, of which the two most important were probably:-
- the absence of a Risk Off spike on Cyprus (with added piquancy of possible forced reserve sale at the ECB’s behest)
- the absence of an immediate inflationary rally on the BOJ move
More fundamentally, we have to face up to the fact that the Sell Side has simply l-o-v-e-d the fact that commodities are weakening while equities and credit are storming ahead since this enables it to spin a new tale to customers about why they should now revert to type and stick with their traditional, fee-generating asset classes.
Much has been made of the recent raft of negative reports from those who were formerly the bull market’s greatest boosters, but in truth, as consummate salesmen, these worthies are only telling their disappointed customers what they already want to hear. No spiel sells as well as the one which allows an after-the-fact rationalization of an unlooked-for outcome. If you can’t be smart about where the market is going, it at least assuages wounded pride (and patches up a tarnished professional reputation) to sound knowledgeable about where it has been.
All this has contributed to a poisonous mix of factors – fundamental, technical, and sentimental – among which we can include the following shifts.
Firstly, in terms of the guiding mantras which the crowd is so wont to adopt, ‘Peak Oil’ has given way to ‘Shale Glut’ and ‘Super-Cycle’ Chinese gluttony has been transmuted to an expression of faith in the all-seeing Confucian Mandarins who will shrewdly rebalance economy and unleash consumer spending, needing no copper in excess of the present quota to do so. (Big Mining itself has been reinforcing this shift, leading to the unusual result that Big Mining share prices are showing even worse returns than are commodities, despite the overall vogue for equities).
Next, financial momentum itself is now a killer, since the more commodities lag, the more people fear being left behind in any less than full commitment to the incipient equity bubble whose warm glow of instant mark-to-market gains they again avidly crave.
Again, given the appalling price action of late, the same trend chasers who did so much to boost commodities on the way up have been liquidating/shorting stuff and buying financial assets for some time, even before the gold/silver purgative. Their potential overstretch is our present best hope.
Finally, a glance at break-evens shows that inflation fears have dissipated, possibly in a very premature fashion. For our part, we have always argued that the CB actions will be slow burners, as in the 1960s, until debt re-gearing and bank expansion again come to magnify solo CB pumping. It will be the inevitable reluctance to withdraw stimulus that will lead to catastrophe more than the initial decision to provide it and then, as monetary trust first falls and then is entirely lost, velocity will rise, CPI will accelerate, and real commodity prices will turn.
The widespread impatience with the inflationary argument arises partly because no one understands that for there to be ANY price rises, however CPI-modest, in a world awash in un(der)employment and surplus capacity, this can only be evidence of a deliberate monetary excess. Alas, for us, as investors, the fact that we understand the root of this error does not make its consequences any less significant for the pricing calculus with which we must contend or for the timescale over which we must deal with it.
Thus, QExtreme is now exclusively bidding up financial assets (the Herd comfort zone, as we have said) and real estate (the default for the Ordinary Joe). Yet all the while it is preventing a genuine re-invigoration by keeping zombie companies alive and bad governments in funds, thus depressing organic, vigorous ‘growth’ and so acting without immediately igniting an inflationary holocaust which may well require a much longer gestation process than most are prepared to countenance. Not a great near-term mix for tangibles, it must be said.
Besides the ongoing troubles in the eurozone, the other burning issue for investors is, of course, what will emerge from the just-concluded ‘Two Meetings’ in China where the new team of Li Keqiang and Xi Jinping have formally taken up the reins.
Before we make any comments on what has transpired, we must offer the essential caution that all we have so far are words carefully calculated to strike the right notes with an expectant mass audience. To what extent these reflect a genuine intent and what degree of consensus within the Party any such intent might command is entirely unknown and may well remain so at least until after the autumn Plenum of the Party Congress.
With those qualifications attached, what we can gather from the coverage so far presented is that, by their own admission, the incoming leaders know they face major problems of over-capacity in all manner of key industries—solar, aluminium, steel, etc.—and yet we also know that, despite this week’s ground-breaking bankruptcy of Suntech—old habits die hard when it comes to desisting from propping these industries up. Witness the announcement last week that the State Reserves Bureau would buy one-sixth of the nation’s aluminium and one-eighth of its zinc output this year— a bailout of an ailing sector, however you consider it. Nor does it bode well that steelmakers are pouring record amounts of the alloy a few brief months after many of them were facing ruin (aggregate profits fell a mere 98% last year) and despite a 20% YTD rise in the stocks of cold-rolled coil, a 40% rise in hot-rolled, and 90% rise in those of rebar.
By their own admission, too, the problem of chronic property speculation remains a bugbear and while the optimistic may be happy to wait for the accelerated urbanisation programme (about which no details have, of course, been vouchsafed) to absorb any vacant buildings, they have not yet quite managed to explain how it is that people whose average urban wage is some CNY 40,000 a year will afford all those CNY 20,000/sq m properties currently changing hands in the main urban centres. One means to achieve this financial marvel may well be through the notorious rehypothecated copper dodge (Asian stocks of the metal are up 90% so far in 2013 from the previous three year average) and via mis-invoiced export earnings (q.v., the $25 billion YTD discrepancy between China’s reported exports to HK and the latter’s reported , one-third lower imports therefrom). ‘Reform’ will have to find a way either to close this loophole or make it far less lucrative.
Urbanization may also have a few other hurdles to overcome if we heed the CASS-NDRC joint report on how Beijing’s 20 million inhabitants have already overstrained the land and water resources available to them. More to the point, the authorities have yet to admit that while they keep money and credit growth powering along in the 10s and 20s of percent a year and simultaneously set interest rates at or below the consequent rise in the cost of living, people will naturally look to the property market as a more secure outlet for their surplus cash, whether or not they also hope to get rich quick along the way.
By their own admission, too, fears of financial fragility are rising, as speculation mounts about a coming crackdown on both the notorious LGFVs and the regulation end-running WMPs into which many of these are subsequently bundled. The fact that the new CSRC chairman will be none other than former BOC boss Xiao Gang—the man who dubbed such products ‘Ponzi schemes’ in a recent tirade—might add substance to these rumours.
All this comes at a time when, as our friend Jim Walker at Asianomics pointed out, a report published under the twin auspices of the China Association of Trade in Services and the Chinese Academy of International Trade and Economic Cooperation estimated that the total of accounts receivable on company balance sheets amounts to a vertiginous CNY22 trillion—almost 40% of GDP and pretty much on a par with that extant the much larger United States. If correct, we should compare the 18% reported increase in this book credit (an increment of CNY3.4 trillion) with ’above-scale’ industry reported profits (not an exactly overlapping sample) of around CNY5.5 trillion. Staggering, indeed.
By their own more tacit admission, the authorities are all too aware that they have a problem on their hands with the growing public ire at the polluted state of the environment—a disquiet we could actually read as a sign of substantial material progress having been made, since such concerns are often too much of a luxury for a poor people, too busy scrambling to fill their children’s bellies to fret about the ambient air quality.
For all the anecdotal horror at which we love to gawp, it does not do to be too superior about this. Just 60 years ago, the Great Smog which enveloped London for four cold, December days may have rendered 100,000 ill while contributing to the demise of up to 12,000 afflicted souls. Nor would any of us much care to stroll along the ordure-strewn thoroughfare of a Victorian city, much less eat the food or drink the water on offer there. Yet this, too, was a time of rapid material advance when wealth was being created across the social spectrum, at a hitherto unprecedented rate.
Nevertheless, China’s lack of accountable governance, its absence of private property rights, and its fetish for output regardless of many internal costs, much less external ones, makes this a difficult matter to address. Pampered metropolitan Lefties may bewail the role of capitalism in scarring the face of holy mother Gaia, but for a REAL disregard of one’s surroundings or one’s posterity, you have always had to look to the Collectivists to take the palm in the scorched earth stakes.
As well as extending the rule of law, the state needs to stop subsidizing heavy industry and making power and fuel artificially cheap while, conversely, it needs to insist upon proper waste disposal and to levy (or allow the market to levy, in an ideal world) a proper charge for rendering that detritus harmless. If the Chinese people now want cleaner surroundings, this is what they must demand of their leaders and, by extension, of themselves, but it will not come without some sizeable short– to medium-term sacrifices in growth-for-growth’s sake and therefore in employment. The effect on costs and profitability may be a harder prospect to judge since the bill for some inputs (and for the treatment of many unwanted outputs) will no doubt rise, but the overall call on resources could likewise end up being reduced as efficiencies are incentivised and mindless capacity overlaps eradicated. Along with that fall in demand, the price paid for this lesser but better-utilised quota should move in tandem.
How much if any of this we get is a matter of no little doubt, as we said at the beginning of this article, but the local press is foursquare behind the idea that the new team represents at once a radical change and a reversion to the better management of the system which, so the accepted wisdom holds, was the norm under the aegis of Zhu Rongji—several of whose protégés are to be found in the refreshed line up of officials.
Caixin, for one, had this to say:-
Contrary to the expectations of many investors, policymakers have decided not to seek any big increases in government investment this year. Rather, they want to prevent any possible financial trouble tied to local government debt and the off-balance-sheet operations of commercial banks. That means regulations covering local government financing platforms are likely to be tightened… Also highlighted in the government policy book are plans to seek quality over quantity in economic growth, adjust real estate and business tax structures, control housing prices, and reign in fiscal spending.
Or, as more pithily expressed to Reuters by an anonymous visitor to the National People’s Congress:-
Delegates… were clearly agreed that their biggest risk was doing nothing.
But let’s not rest there. Look at the following extracts from new Premier Li Keqiang’s headline, after-party press conference and judge for yourself which way the wind is blowing:-
“Reforming is about curbing government power, it is a self-imposed revolution, it will require real sacrifice, and this will be painful, but this is what is wanted by the Government and demanded by the people.”
“We need to build a clean government and make our government more credible … The important thing is action—talking the talk is not as good as walking the walk.”
“The highest priority will be to maintain sustainable economic growth.” [emphasis ours]
“We said that in pursing reform we now have to navigate uncharted waters. We may also have to confront some protracted problems. This is because we will have to shake up vested interests… Sometimes stirring vested interests may be more difficult than stirring the soul, but however deep the water may be, we will wade into the water. This is because we have no alternative. Reform concerns the destiny of our country and the future of our nation.”
As he proclaimed at the end of last year:-
Reform is like rowing upstream. Failing to advance means falling back. Those who refuse to reform may not make mistakes, but they will be blamed for not assuming their historical responsibility.
The old saying has it that ‘fine words butter no parsnips’ and there are few less root vegetable-greasing words than those which emanate from a politician’s mouth, but, in light of all the foregoing, it does very much seem as if the CCP regards the present juncture as an existential moment in its 90-odd year history.
Having raised expectations so high and having the luxury of a honeymoon period in their relationship with their long-suffering subjects in which to enact any radical changes, we must assume that the leadership would be very unwise to slip back into business-as-usual anytime soon and so disappoint the hopes of so many.
To what extent reform will be attempted—and how much resolve will be shown when, as is highly likely, the effects of those reforms expose the many interdependent flaws and critical fractures in the system—only time will tell but, one way or another, it is hard to resist the impression that those in China—and, by extension, those of us who make our living trying to account for that nation’s effects on the wider world—are truly about to ’live in interesting times’
For several long months now, the market has been treated to an unadulterated diet of such gross monetary irresponsibility, both concrete and conceptual, from what seems like the four corners of the globe and it has reacted accordingly by putting Other People’s Money where the relevant central banker’s mouth is. Sadly, it seems we are not only past the point where what was formerly viewed as a slightly risqué ‘unorthodoxy’ has become almost trite in its application, but that like the nerdy kid who happens to have done something cool for once in his life, your average central banker has begun to revel in what he supposes to be his new-found daring – a behaviour in whose prosecution he is largely free from any vestige outside control or accountability.
Indeed, this attitude has become so widespread that he and his speck-eyed peers now appear to be engaged in some kind of juvenile, mine’s-bigger-than-yours contest to push the boundaries of what both historical record and theoretical understanding tell us to be advisable. After all, it was sixty years ago now that Mises was telling people, in an article decrying the malign influence of Keynes, that:-
The economists did not contest the fact that a credit expansion in its initial stage makes business boom. But they pointed out how such a contrived boom must inevitably collapse after a while and produce a general depression. This demonstration could appeal to statesmen intent on promoting the enduring well-being of their nation. It could not influence demagogues who care for nothing but success in the impending election campaign and are not in the least troubled about what will happen the day after tomorrow. But it is precisely such people who have become supreme in the political life of this age of wars and revolutions. In defiance of all the teachings of the economists, inflation and credit expansion have been elevated to the dignity of the first principle of economic policy. Nearly all governments are now committed to reckless spending, and finance their deficits by issuing additional quantities of unredeemable paper money and by boundless credit expansion.
In this vein and though we should by now have become numbed to displays of such insistent folly, we cannot but find it a touch ludicrous that the Fed’s Jeremy Stein could give a speech warning about the utterly undeniable dangers of ‘overheating in credit markets’ – presumably with a straight face – only to be pooh-poohed a week or so later by his boss when similar concerns were raised at that latter’s regular meeting with the pampered, corporate welfare insiders at the Treasury Advisor Borrowing Committee.
The wise will take cold comfort from this, being all too cognisant of the fact that our esteemed Fed Chairman – much like his once-revered predecessor in office – has clearly demonstrated, both in the record of his public pronouncements and the belatedly-published transcripts of what he said in camera as the late crisis unfolded, that he is dispositionally unable to recognise the signs of a bubble in a beer glass, much less in a bond price or a balance sheet, since such a phenomenon plays no role in either his dogmatic and mechanistic model of the real world while the possibility that he may be personally in error finds no place in his monumental intellectual conceit.
Adding to the sense that nothing will dissuade these quacks from bleeding and cupping their poor patient until he expires under their assault, in a speech (delivered before a union audience, no less!) that Madame Defarge of the rentier class, Janet Yellen, also vouchsafed the hint that the Fed’s newly-adopted ‘Evans Rule’ – of continued, massive intervention until such time as unemployment subsides below 6 1/2%, assuming that CPI ‘projections’ (Oh, I d-o-o-o love a hard, independently-verifiable, objective target) likewise remain below 2 ½% – was not to be seen so much a ‘threshold’ for restriction as a gentle reminder that a rethink might soon be in order.
Not that the Fed Vice Chair was alone in her infamy. The week’s earlier publication of the Bank of England minutes revealed that there are other central bankers itching to help Wall St. and the City make their bogey for the year. Indeed, it seems that the outgoing Governor had wanted to pre-empt his hubristic successor-elect by easing now and not waiting for said Canadian newcomer to make good his less than modestly declared mission to ‘refound’ the three hundred year-old institution over which he will be suzerain, as part of his personal goal to show the whole of Europe how to ‘get those economies going and fix those financial systems’.
Not content with this, up stepped King’s fellow dove, David Miles, to set out a ‘model’ (roll of the eye-balls) which, by dint of equating the propensity to ‘inflation’ (i.e., to ongoing price rises) not to the supply of money in the system (thereby denying three centuries of theorising) nor with any consideration for the demand for said money (so ignoring the whole 140-odd year history of subjective marginal economics), but solely to the estimated degree of physical and human ‘slack’ in the economy, gave us a QED in favour of more QE.
Having set up the metrics of his toy universe, Mr. Miles told us proudly that he then gave it over to the silicon gods to perform 20,000 iterations with it and arrived – Hey Presto! – at the precise conclusion that the Bank needed to be 16% (sic) more accommodative, in other words, to buy another £60 billion gilts, even though, as our Great Engineer himself admitted:-
The model does not say that asset purchases are the only way this should be achieved. If there are monetary policy tools that are more reliably effective in boosting demand, they should be used. But it is not clear what these are, which is why I have calibrated the model to reflect my own assessment of the evidence of the impact of asset purchases.
As every right thinking person should know (and hence climateers excepted), the principle problem of mathematical computation is encapsulated in the phrase GIGO – Garbage in, Garbage Out. One of the parameters Miles adopts in his latter-day difference engine is that UK GDP ‘should’ run at a steady 3% rate of increase. Since this was roughly the experience of the laughingly-dubbed ‘Great Moderation’ which stretched from the economic travails of the early 90s to the eve of the Crash, this superficially seems to be a reasonable assumption.
What he has overlooked, however, is that while real GDP currently lies some 20% below where an extrapolation of that trend would otherwise suggest, the reckoning of total hours worked in the economy has fully recouped its intervening losses, while, for the past five years of slump and sub-par growth, the RPIX measure of price changes has risen by an average 3.9% p.a. which is the worst performance in 17 years (a ‘remit’-busting failure of policy which, if the yields on gilts maturing in 2055 are any guide, is expected to persist for the entirety of the next four decades!)
Putting these gross aggregates charily together, we can see that, whereas GDP per hour worked rose, with only minor variations, at a trend of 2.5% per annum for the first 37-years of the floating rate era, in the succeeding five years of the crisis, it has declined by 0.8% a year – a fall of a duration and severity unprecedented in the modern record despite the Bank’s fivefold, £325 billion intervention (equivalent to 25% of average GDP over the period and to more than half the state’s cumulative deficit).
So, here’s a question: is it just possible that the long misrule of NeuenArbeiterPartei under the leadership of RobespiBlaire and Culpability Brown (as we always used to refer to them) led to a progressive stultification of the system to the point that the country effectively now lies broken? Sapping entrepreneurial endeavour, burdening the economy with costs and with a mare’s nest of legal and regulatory hindrances, swelling the tax-sucking ranks of patronage amid both the Apparat and the welfare proletariat, this was a reign during which people desperately tried to maintain the illusion of a progressive rise in living standards by incurring crushing levels of debt and relying for nourishment on the bitter fruits of property speculation.
Couple this with the uncomprehending inability of the successor ConDem(n)s to tackle the problems they inherited – as well as with the political elite’s right-on, Davos-man fetish for needlessly driving up energy prices in the service of that jealous pagan deity, Mother Gaia – and you have a nation about whose prospects it is all too easy to despair.
Never mind though, Mr Miles: just run the printing presses a little more – nay! 16% more – prolifically and we have no doubt that all will soon be well again!
How far we are from the pellucid wisdom of Ludwig von Mises can be gathered from what he told a lay audience, just as the groundwork was being laid for the Great Inflation which would ravage the 1970s and early 80s, viz.:-
The nineteenth century the slogan of those excellent British economists who were titans at criticizing socialistic enthusiasts was: ‘There is but one method of relieving the conditions of the future generations of the masses, and that is to accelerate the formation of capital as against the increase of population.’ Since then, there has taken place a tremendous increase in population, for which the silly term ‘population explosion’ was invented. However, we are not having a ‘capital explosion’, only an ‘explosion’ of wishes and an ‘explosion’ of futile attempts to substitute something else—ﬁat money or credit money—for money.
Meanwhile, Perfidious Albion is left with the sorry combination of activist central bankers, weak growth, a soaring visible trade gap, a record current account deficit, and a scramble to exit positions from those who had previously seen the country as something of a safe haven. With technical indicators already flashing red (if also a touch oversold, at present), is there any floor beneath a currency which its own supposed guardians would dearly love to depreciate further?
Such problems are not confined to the oceanic side of the Channel, of course, as has been highlighted in the deliciously barbed correspondence between the CEO of US tyre company Titan, Morry Taylor, and French industry minister Arnaud Montebourg over that country’s industrial outlook and business climate. Without getting too deeply into the spat, it should be noted that Eurostat data suggest that the French government typically spends (not including ‘investment’) two-thirds more on its almost 63 million citoyens than does the Italian on its 61 million, yet it is the latter who bear the brunt of the criticism.
(In the interests of fair disclosure, the same source shows that we virtuous 62 million Brits enjoy the dubious benefits of 45% more state largesse than do our Italian cousins, if 15% less than our French neighbours and even the ostensibly hard-core Dutch splurge as much on their 17 million as do the afflicted Spanish on their 47 million).
In Spain itself, we have had another failed property lender and the rather cheerless message from embattled Premier Rajoy that ‘there are no green shoots, there is no spring’. On the Western littoral of the peninsula, Portugal has also had to downgrade its forecasts to encompass a deeper shrinkage than was first pencilled in – as a result, by some unforeseeable mischance, of the deeper than anticipated slump which has ravaged the rest of the continent, to which it dispatches 70% of its exports and from which it receives the bulk of its tourists.
In Italy, the chorus of disquiet at the prospect that Il Cavaliere might just attract more votes than anyone else in the weekend elections is swelling to a Verdi-like crescendo (remember that democratic choice is all well and good as long as you vote for the candidate preferred by the global hegemons). More broadly, the signs are not good here either. Retail sales last year were at their lowest level in a decade, while industrial orders fell to their fewest (and at their fastest pace) since the slump, taking them down almost a quarter from their 2007 peak and landing them back where they stood at the very launch of the single currency. Hardly a ringing endorsement of the project!
Thankfully, Germany is potentially providing an offset. We use the qualifier because even if the IfO survey is beginning to show its typical lagged response to a surge in local liquidity, this has yet to translate into business revenues and hence, one has to fear, into earnings. Nonetheless, let’s take cheer where we can: Eurozone biflation is bringing a much-needed cheer to the bosses of the Mittelstand.
Abroad in Asia more attention is suddenly being paid to the fact that Shinzo Abe – after being mugged in the corridors of the recent G20 summit (and possibly warned there that he might need to cultivate some wider good will if he wishes to enlist third-party support in his ongoing dispute with China) – is having to back-pedal a touch in Japan as rumours circulate that he might not even get to appoint the most unredeemed, the wildest-eyed inflationist to the top spot at the BoJ next month.
J is for Japan, but J is also for J-curve – that unfortunate constellation whereby the effects of a lowered currency exert more of an upward influence on the import bill than on contemporaneous export revenues. Hence why the country suffered a record trade deficit last month. The fact that LNG prices in the Pacific basin surged to more than $19/mmbtu this month, even as the yen was shedding 10% of its value vis-à-vis the dollar is but one adverse side-effect of Abe’s quackery.
In the near-term, it may be that the accounts of a number of Japanese corporates are unduly flattered by the translation effect, but we doubt they themselves will be fooled by such transitory gains into a radical alteration of their business plans. What should be made clear here is that in volume terms Japanese exports are 10% lower than they were at the post-Fukushima rebound, one sixth lower than the last, pre-Crash spike, and no greater than they were in early 2006 (on a price-adjusted basis, the trajectory of imports is not wholly dissimilar).
Nor has the return from the Lunar New Year break seen China add any further fuel to the flames, either. To the contrary, yet another ‘decisive’ edict has been issued in the (so far vain) attempt to crack down on the nation’s re-inflating property bubble. Adding to a growing presentiment that the central bank may act to head off what looks like an outpouring of new credit from the banks these past 8 weeks, it has this week withdrawn a record CNY910 billion from the market. The smart money now has it that current PBOC chief Zhou Xiaochuan will be promoted to a level of party seniority sufficient to obviate the need to retire now that he has celebrated his sixty-fifth birthday, implying that there will be no radical loosening of policy on that account, either.
He might need to act soon: the new vogue measure of ‘total social financing’ recorded a 160% yoy jump in January while the pace of boring old bank lending so far this year has been similarly robust and could come in as much as 40%-50% above the combined Jan-Feb total for 2011. At this rate, there will be no notable diminution to the already incredible CNY110 trillion in reported urban fixed-asset investment undertaken these past four years – an amount equal to 145% of the US private economy and a number which has risen more than tenfold in a decade and which accounts for three-fifths of ‘national-scale’ industrial profits.
Whether this will be complicated by the problematical local government debt pile remains to be seen, but one sign that this is becoming a hot button issue is that the China Banking Regulatory Commission has just issued a directive insisting that any new loans extended to LGFVs must be covered by existing cash flows and that the projects for which the funds are intended must generate returns, while what it termed “irregular” lending to these vehicles was henceforth prohibited. That will be fun, given that the recently published provincial budget outlooks suggest the fact that more than half of their loans are due to mature this year.
In response to worries that the regime might act to rein in such developments, the Shanghai Comp underwent its biggest single-day plunge in 15 months, steel futures slipped to complete a 6% drop on the week, copper gapped lower to its weakest close of 2013, and rubber suffered further, making a 10% peak-trough decline from its pre-holiday highs. The FTSE A600 Bank index has, meanwhile, dropped 14%. With Komatsu telling us sales of diggers halved in the last nine-months of 2012 and rivals Caterpillar reporting its worst 3-month regional sales performance (-12%YOY) outside of either the GFC or the Asian Contagion of 1997-8, and with Foxconn announcing a hiring freeze, what little anecdotal evidence we can muster in this period of news blackout is not overwhelmingly positive.
On a broader front, ahead of the all-important National People’s Congress next month, the local press is positively buzzing with assorted calls for ongoing reform – even to the point of positing the formation of a new super-bureaucracy to supersede the NDRC in this task. President Xi and his allies have presumably had something to do with this campaign and the man himself has naturally been very active in trying to secure his power base in the run up to his full inauguration, but much will remain up in the air until the proceedings have been completed and we get a first look at his first full exercise of power.
Never mind, ever alert to the people’s needs, the planners have just announced that they are taking forceful steps to counter the awful quality of the air in China’s choking megalopolises – they have issued a fatwah banning urban barbeques!
Though it might seem a churlish observation to make amid so much barely-suppressed exuberance about the prospect for the markets in 2013, in many respects the past twelve months have shown much the same pattern as has marked each of the preceding four years. Characterized by the grinding hysteresis which we foresaw as far back as the end of 2008, this has broadly materialized in the form of rallies which stretch from one year end into the succeeding spring before a sell-off occurs which then extends into late summer-early autumn, whereupon the cycle reverts to rally and so on round again.
Each time the Groundhog recovery in asset prices has been based upon the delivery of a stimulus from one or other of the major central banks which has temporarily brightened sentiment – and even improved the macro numbers for a while – before what a physiologist would call a ‘tolerance’ of the credit injection has set in, the economic data has deteriorated, and the unresolved and unliquidated problems which still linger from the preceding Boom have surfaced again to frustrate the optimists.
Last year began amid ever more undeniable evidence that China was suffering a mini crisis of its own, with profits evaporating, unpaid bills mounting, and trade stagnating, while the disparities between Europe’s sorely-afflicted south and its better-placed north blew up in to surging sovereign spreads and a €1 trillion-plus mountain of blocked credits piled up across the T2 system. A further hiccup was then suffered as the two main American political parties acted out their tired old kabuki over the dire state of the nation’s budget.
However, on all three continents, the Keystone Kops aboard the imperilled paddy wagon just managed to wrench the wheel over in time to avoid the looming cliff edge.
For their part, the Chinese did exactly what they assured us they were not going to do and launched a vast new wave of stimulus in order to ease the new regime into office. Eastward, across an increasingly tense stretch of sea, the soon-to-be-Premier of Japan browbeat the BOJ into conducting an escalating series of interventions while, the other side of the wide Pacific, the defeat-disheartened Republicans bent the knee to their triumphantly re-elected opponent and quailed at the thought of being blamed for slashing government spending while the cynically–opportunist Bernanke Fed exploited a patch of economic softness to go all-in with a promise of unlimited bond buying.
In Europe meanwhile, ECB Chief Mario Draghi declaimed with a truly operatic flourish that he would ‘do whatever it takes’ to keep the cash flowing to the olive basket and so magically relieved the tension in the Eurozone in true Wizard of Oz style.
After a last lurch down around the time of the US presidential vote, the markets have responded with increasing enthusiasm to the realisation that disaster has been postponed once more (if, sadly, not definitively averted). Hope has sprung eternal as stock markets have rallied, junk and emerging market debt spreads have collapsed, volatility has been crushed, and the erstwhile safe havens – such as US Treasuries and gold – have begun progressively to lose their allure.
Alas and alack, as a reflection of the growing disenchantment with what have frankly been the disappointing returns offered by the asset class over the past eighteen months, commodities have taken a deal longer than the other ‘Risk On’ assets to respond to this perceived good news, only beginning to hold their own (on a relative basis) as the new year began.
And so, at January’s close, we found ourselves flushed with the glow of higher prices and complacent in the face of further central bank largesse. Adding to the urge is the undeniable fact that we are all heartily tired of sitting on a stockpile of boring old, precautionary cash for quarter after fretful quarter.
Around such intangibles a new consensus has formed that equities are king, bonds are dead, and commodities—if we must pay them any heed at all—are the things to buy to protect against those few dark clouds, no bigger than a man’s hand, which serve to remind us that central banks cannot go on indefinitely adding money to the system at or below zero real interest rates while budget deficits yawn in undiminished magnitude without risking a conflagration of values too awful to fully contemplate.
The irony is, of course, that the thing most likely to blow these few wisps of cumulus up into a terrifying inflationary gale is simply that people come to express more and more confidence that neither this eventuality, nor its gloomy deflationary opposite, will come to pass and so the money which is currently only burning a hole in their trouser pockets is brought out to set light to the world at large.
While we must be careful not to be trampled in such a bullish stampede by standing too incautiously in its path, there are both flaws to the premises on which such a Blue Sky mentality has been founded and more immediate concerns that the eagerness to believe has become so widespread and the voices of dissent so lacking that everyone is already leaning over the starboard side of what has therefore become an alarmingly heeling ship, one all to ready therefore to be tipped overboard with the first contrary gust of wind.
Let us (briefly) take China. Still in a policy hiatus due to the regime change and about to enter the macroeconomic purdah of the Lunar New Year, that has not precluded the Herd from wilfully taking as bullish a view as possible about likely developments there – even to the point that one senior analyst from a major bank could bring himself to tell his audience at a mining conference that to him the outlook for the commodity market was very much like it was in 2002 (from which secondary low, the reader might recall, it embarked on what some measures show was the best nine years in its history!)
It seems that nothing will stop the idiot savants – as well as the consciously misleading – from plugging whatever numbers the state propaganda machine churns out straight into their ‘models’ in order to lend some spurious gloss of calculation to such pronouncements, no matter how unreliable, contradictory, or plain incredible these may be.
Take the Chinese GDP number for the broadest of these: Officially, last year’s nominal total came to CNY51.9 trillion, an increase of 9.8% or CNY4.6 trillion on 2011’s count. Yet, by adding up the individual data produced separately by the nation’s constituent 31 provinces and autonomous regions, we can calculate that the annual sum reached to CNY57.7 trillion (11% higher), and that growth accelerated to 11.1% yoy, representing an increment of CNY5.8 trillion which was a quarter larger than that given by the official tally. Spreadsheets, anyone?
By now it has become almost trite to compare the electricity stats with those for GDP or industrial production, yet we have a rather worrying disconnect in other areas of energy use, too. Industry up by a double-digit amount alongside a gain in refined oil product use of no more than half of that (5.2% yoy), of which diesel consumption barely ahead at 1.5%? Makes perfect sense to me!
Then we have the miraculous rebound in ‘profits’ posted in December (and we will risk a roll of the eyes by asking, once again, how can businesses even begin to compute earnings on a monthly basis?). Setting the seal on QIV’s auspicious rebound and so helping the Shanghai Composite to a further 8% gain, December’s winnings were supposedly a cool 68% greater than the average of the previous three months; revenues were no less than 13% higher and, hence, margins were reported to have jumped by half from 6.5% to 9.7%. Oh, for such levels of operational gearing in an expanding market!
In the short run, what may come to haunt the China bulls is the fact that even this brief relaxation of policy has unleashed the same old dark forces of shopping basket inflation and property speculation. For example, the all-important pork price has risen by more than 10% in the past two month, prompting a release of supplies from the central reserve to try to quell the surge.
More worrying still – especially given the news that the much-bruited property tax will not now be rolled out across the country – land sales in China’s ten main cities were up by a factor of 3.6 last month from January 2012, according to the Shanghai E-house Real Estate Research Institute. Given that the area sold increased ‘only’ 77%, this also implies that the average price paid more than doubled. Stop-Go rules OK!
In light of this what would have been merely risible if it did not simultaneously display China’s increasingly belligerent response to foreign criticism alongside an utter lack of economic understanding, the mouthpiece People’s Daily this week carried an aggressive repudiation of assertions that the country’s monetary incontinence posed a threat to global stability.
Putting the cart firmly before the horse, the editorial argued that if a company had made a hypothetical land purchase ten years ago and if, on going public this year, that same land had been valued higher by a factor of 2,000 (sic!), if the central bank did not issue new money to the tune of around a quarter of that latest appraisal, the increase would be ‘just a bubble’!
No, really! We are not making this up as you can see here:- http://tinyurl.com/amzaczh
On top of this, the writer contended, ‘price reforms can also lead to a substantial increase in the demand for money’ since, he went on, if prices rise, both companies and consumers have to pay more, ergo more money is patently needed – a problem which is moreover said to be ‘unique to China’! Truly, to invert Milton Friedman, monetary inflation is everywhere a real side problem!
Heaping a cloud-capped Pelion of further confusion upon this already lofty Ossa of muddle-headedness, a separate justification for the deluge is apparently that while America’s attempts of the last four years at disaster recovery have naturally focused on its predominant, highly-leveraged financial sector – meaning that every new, FRB-printed dollar could be multiplied up sixty times (sic) – poor, old, metal-bashing China, by contrast, has been doomed to rely on a mere 4:1 multiplier to assist its key industrial base (the limitation being imposed lest it blew its companies’ balance sheets up to imprudent levels of gearing) and hence it had to keep its central bank’s printing presses fifteen times as busy as those of the Fed!
Working up a full head of steam, the author closed this truly Swiftian self-parody with one last, glorious volley of logical howlers, by asserting that the crisis-averting increase in money supply has increased the risk (but only the risk, you will note) of debt expansion before the authorities became ‘scared’ enough to tighten policy and thus to usher in a ‘slump in domestic stock markets, a surge in loan demand, persistently high interest rates, and such financial risks as usurious loans, shadow banking, and trust loan expansion.’
Well, yes, but surely those were merely the unfortunate side effects of an attempt to address the dangerously building excess before the system exploded under its own pressure? No, this hero of socialism-with-Chinese-characteristics confidently concludes, ‘…the greater risk lies in an increasingly weak real economy.’
And this is the spokesman for a preternaturally-gifted ruling elite which is supposed to be reforming and rebalancing its economy in a ‘scientific’ manner and whose rarefied heights of dispassionate calculation we benighted Westerners cannot ever hope to match? Heaven help us all!
But if the ongoing suspension of disbelief regarding China is one of the great enormities of the current mini-bull market, the effort to disregard the sorry history of Japan’s last two decades by a semi-mystical appeal to the half-remembered exploits of eighty years ago is surely the other.
For now it seems, after twenty-plus years of evergreening loans while covering whatever real verdure there was in swathes of economically otiose concrete, the ‘one more heave’ generalship of the LDP will finally enact all of Paul Krugman’s wildest fantasies by further unbalancing its budget – this time with the untrammelled assistance of the central bank – and thereby repeat Finance Minister Korekiyo Takahashi’s feat of ‘rescuing’ his country from the clutches of the Great Depression.
That Takahashi’s real achievements are still somewhat moot is, of course, besides the point even though debate still rages about whether it was his 60% devaluation of the yen in late 1931; his reliance on proto-Keynesian pump priming and his insistence that the BoJ monetize at least some of the resulting deficits (not a small fraction of which were incurred by the country’s simultaneous annexation of Manchuria); his elimination of the capitalists’ ‘wasteful competition’ via his promotion of industrial cartelisation; or whether it was simply that the wider world was already coming out of the worst of its trough by the time his policies were being put into effect. Suffice it to say that a multitude of PhD dissertations and many a professorial citation count still depends on the construction of intricate counterfactuals about this episode, together with the conducting of exhaustive econometric testing of this ultimately untestable dispute.
We should perhaps first pause to take note that Takahashi is an unlikely hero, given that he once declared, in reminiscence of his mentor: ‘After two days of talking with Maeda, I realized that my concept of the state was shallow. The state was not something separate from the self. The state and the self were the same thing.’ Mussolini would have been proud of him.
Moreover, this particular ‘genius’ seems to have subscribed to the same old canards of the underconsumptionist school, with all of its superficial appeals to the so-called circular flow mechanism. Hence, we have this pronouncement from the lips of the great man:-
If someone goes to a geisha house and calls a geisha, eats luxurious food, and spends 2,000 yen, we disapprove morally. But if we analyze how that money is used, we find that the part that paid for food helps support the chef’s salary, and is used to pay for fish, meat, vegetables, and seasoning, or the costs of transporting it. The farmers, fishermen, and merchants who receive the money then buy clothes, food, and shelter. And the geisha uses the money she receives to buy food, clothes, cosmetics, and to pay taxes. If this hypothetical man does not go to a geisha house and saves his 2,000 yen, bank deposits will grow, but the efficacy of his money will be lessened. But he goes to a geisha house and his money is transferred to the hands of farmers, artisans, and fishermen. It goes in turn to various other producers and works twenty or thirty times over. From the individual’s point of view, it would be good to save his 2,000 yen, but when seen from the vantage point of the national economy, because the money works twenty or thirty times over, spending is better.
No wonder his shade is being summoned as the tutelary deity of what is inevitably being termed ‘Abenomics’. Martin Wolf must be positively beaming with delight.
Our own thoughts on this matter should need little exposition so let us content ourselves by citing the wise words of a man who is being sacrificed to this kami of inflationism, outgoing BOJ head Masaaki Shirakawa. In a speech given almost two years ago, he pointed up the dangers of overplaying the supposed similarities between 1930s Japan and the country of the 2010s before issuing a stark warning regarding the dangers of embarking upon a like course to that followed on that earlier occasion:-
As many of you know, Mr. Takahashi was assassinated in 1936 by militarists when he was trying to stop ever-growing demand for military spending, and the course of events led to the eventual rampant inflation. I would argue that the introduction of the scheme of the Bank’s underwriting of government securities itself paved the way for eventual ballooning of fiscal spending, precisely because the scheme lacked the checking process through the market mechanism.
We often use the words of ‘entrance’ and ‘exit’ to discuss the conduct of monetary policy nowadays. In that terminology, we should interpret that the ‘entrance’ of the introduction of the Bank’s underwriting of government bonds in the early 1930s led to the ‘exit’ of the failure in containing growing demand for fiscal expenditure. In retrospect, we should note that the Bank’s underwriting of government bonds started as a ‘temporary measure’.
Though Mr. Takahashi stated that he issued government bonds by a means of the Bank’s underwriting just temporarily in his address at a Diet session, history tells us that it was not temporary.
For reference, the toxic legacy of a government debt of 200% of GDP (sound familiar?), a vast monetary overhang, and shrunken markets eventually cast the defeated nation into a rapid inflationary whorl. After a one third reduction in 1946 as a result of that year’s currency conversion and capital levy, money supply shot back up by a factor of six between the end of that year and 1951/2, as official wholesale prices rose one hundredfold (even if the more representative black market ratio was closer to a more proportionate fivefold).
As a noted economist of the time, Martin Bronfenbrenner, remarked:
no serious attempt was made… to control either the volume of currency printed or the volume of bank deposits created to support not only the Government deficit but also the similar deficits of private firms
We can only hope that the contemporary Japanese will not suffer too much from what seems to be an active programme of decontrolling such an efflux.
And what of those hoping for a mercantile boost for Japan as the currency falls at its second fastest rate of the past generation? Well, perhaps it will turn out not to be the smartest thing to prosecute a policy guaranteed to increase input costs from abroad during a period when the country’ trade gap is the highest on record, when the terms of trade have already fallen by a fifth over the cycle, and when the ratio of imports to national income has only briefly been exceeded at any time in the modern era for the four quarters leading up to 2008’s global peak.
Rather than waiting in vain for some instant miracle, it would be as well to heed the caution of Toshiba Executive Vice President Makoto Kubo who told a press conference recently that:
The semiconductor-related business will benefit from a weak yen, but the rapid fall in the currency will increase costs because it uses a massive amount of electricity.
Or might we be led to doubt by noting, as was long ago remarked:
…‘because each farmer and the situation in each farm village differs, it would be wrong to impose a comprehensive relief program. Each region has its unique disease. We must begin by investigating these sicknesses and applying the correct cures. If we scatter money uniformly from the centre to the regions, we cannot eliminate the diseases.
Who said that, you ask? Why, a certain beatified inflationist by the name of Korekiyo Takahashi.
Back in that other Sick Man of the global economy, there has finally been a minor test of the complacency which has increasingly categorized the European scene. Naturally, since Draghi’s deus ex machina nothing very concrete has been achieved, for all the endless summitry and fevered shuttle diplomacy, as joblessness has climbed, state indebtedness has worsened, and business confidence has further eroded.
Cyprus is only the latest to be – or not be, depending on the swing of the political weathercock – a potentially ‘systemic’ problem. Italy is on the verge of another Dantean descent into political chaos as the same-old, derivatives-enabled fudging of the account books to which the Japanese were so prone has come to haunt the Urprovinz of European banking. This, even though the cynic might enquire as to why a (quasi-)private European bank shouldn’t do what so many of its sovereign overlords once did with the help of exactly the same sorts of TBTF pirates to ensure that they met the Maastricht criteria for euro-entry?
Though this may only comprise the latest of a long line of financial imbroglios, the political repercussions stretch further, not only by giving the irrepressible Silvio Berlusconi one last chance to strut his hour upon the stage, but in calling into question either or both of the competence and integrity of the current head of the ECB, a man who happened to be in office with the local central bank at the time. With an even more socially-incendiary corruption scandal having recently erupted in Spain – implicating many of the kingdom’s nomenklatura in a seedy little brown envelope scheme – it may be that another round of drama will ensue in the Eurozone after months of spread-tightening quietude.
Conversely, unease among the moral hazard jockeys has been sown by the steps taken by the Dutch government in taking over the failed mortgage company SNS Reaal (no, property crashes are not just an Anglo-Latin phenomenon). As part of this, at long last – almost five years too late, some might say – the subordinate bond holders have been made to share the pain of a bail-out. So, finally, someone has had the cojones to follow the lead of the doughty Danes and intrepid Icelanders and put a great, fat slug of risk back from whence it should never have been removed.
Adding to the general angst, Germany and Finland have seized upon the action to join the Netherlanders in calling for the good and great to advance the implementation of a tougher rescue regime from the formerly proposed temporal wilderness of 2018 to a politically imminent (if still Augustinian ’Not yet, O Lord’) starting point of 2015 – though why this should happen any later than a week next Wednesday is beyond us!
Ironically, all this has blown up as the banks have brashly repaid some €130-odd billion of last year’s LTRO funding – a close and suggestive mirror of the €125 billion reduction in the big four TARGET2 creditors’ balances (and, hence, of the EUR130 billion drop in Spain and Italy’s debits) which has taken place since the summer. Given that the euro has itself become the forex market’s new RORO bell-whether, a disruption in Spanish and Italian asset markets, Eurobanking stocks, or the currency itself could therefore see a widespread series of interlocking liquidations if confidence is not quickly restored.
It’s nice that such doubts resurface when US equity margin debt has hit its highest dollar amount since the 2007 top (indeed, it may well be a good deal higher than these December figures, given that the last three weeks have seen what look like record, pro rata inflows). Moreover equity mutual fund liquid assets have hit their own record low-equalling proportion of total assets and a multi-year low one of market cap: the bullish combo of high leverage and a reduced margin of safety has only previously been matched in the blow-off high of summer 2007.
Notwithstanding the fact that S&P reported that the credit quality of leveraged loan and high-yield bond issuers is deteriorating, with downgrades outnumbering upgrades for the first time since 2009 and with the growth in debt outpacing that of cash flow for U.S. leveraged-loan issuers, junk bond yields have hit a record low while EM bond spreads stand at their narrowest since 2007. Volatility in stock and bonds, oil and gold, have also gone off the bottom of the chart thereby implying that no-one wants to buy protection in what is seen to be an unimpeded one-way path to the sunlit uplands where bogies are made by all and sundry, skilled or no.
Yes, we have clear signs of a breakout (at long last) from the channel drawn off the 2011 high which has been constraining industrial commodities (though neither these nor the broader CCI combo have yet quite breached the pennants drawn off their 2008/9 extremes) and, yes again, we can project up from this to new cyclical highs if we measure from the 2009 lows via the intervening consolidation; and, yes, ‘overbought’ can easily become more ‘overbought’ until a shock to sentiment occurs but, but, but…. the danger must surely be that everyone has already positioned so far for this best of all possible worlds, so well ahead of the expected CB largesse upon which much of this has been predicated, that disappointment looms even if its trigger remains to be determined.
What we have to try to gauge is whether this is really the long-awaited easy money blow-off move, or whether we will once again be nursing our disappointments, come the Dog Days of summer. If the market can shake off the last few days’ attack of nerves then we might at least muster the confidence to play an extension of this tactical rally before we have to decide upon its candidacy for the much more significant role presaged by the likes of no lesser mortals than Ray Dalio and Bill Gross.
If, conversely, the few, hardy sellers win this particular round, we can resign ourselves to having nothing better to which to look forward than to suffer another tedious bout of up-and-down, cyclical déjà vu
“A formidable set of difficulties is encountered when we ask what there is left of the notion of monetary neutrality for a society which has once, for whatever reason, been thrown off the rails of steady advance, or for one which, like our own, has never really succeeded in adhering to them.
Does it… imply the maintenance of the situation existing at the moment, or the restoration of some previously existing situation, or the attainment of some situation never hitherto obtained?”
Sir Dennis Robertson, A Survey of Modern Monetary Controversy, 1937
“Mr. Harrod… pins his faith chiefly to a policy of government borrowing, initiated at the very onset of the recession, to finance both a carefully prepared plan of capital works and also if necessary the maintenance of consumption… so soon as the transition is effected, the borrowing policy is to be reversed. It is not easy to square this programme with the pessimism of Mr. Harrod’s central analysis and indeed in the end he admits that he feels bound to contemplate the possibility that the government debt may on balance continually increase.
After all, he consoles us, there are worse things than debt, alias the ownership of claims to income by poets and other worthy people; and fortunately it will be possible to combine the apotheosis of the rentier with his euthanasia”
Sir Dennis Robertson, Harrod: The Trade Cycle, 1937
Much to everyone’s relief – if to few people’s real surprise – the official Chinese numbers for the fourth quarter ‘improved’ from the previous trimesters’ mini-slough, with GDP accelerating from 7.4% yoy to 7.9% and industrial production ending the year at a 10.3% rate which was the fastest in nine months.
As usual, these data came with any number of attached caveats. Was it really possible, for example, that heavy industry grew at just under 10% in 2012 as a whole, while only using 3.8% more electrical power? Could this be done while rail freight actually dipped by 1.5% over the year or container traffic at the nation’s two biggest ports of Shanghai and Shenzhen only managed a combined 2.1% increase?
It does seem a touch problematical, doesn’t it?
Then again, what we do know – as we laid out in our last weekly edition [Material Evidence 13-01-25] – is that both fiscal outlays and credit provision grew markedly in the final quarter. Nevertheless, what we must look askance at is what supposedly resulted – the credibility-stretching 22% gain in profit and 15.6% jump in revenues (neither figure annualized) enjoyed by the SOE’s between the last three months of the year and the prior three. In yuan terms, we are asked to accept that QIV’s increment to revenues was the greatest on record; that to its profits, one not beaten since the first half of 2009 when the economy was roaring out of the post-Lehman slump.
What is also noticeable is that gross urban fixed asset investment for the year amounted to a massive Y34 trillion which, while computed on a different basis from the GFCF component of the number, represents a record high 70% of GDP. Moreover, the marginal extra UFAI undertaken in 2012 versus 2011 amounted to Y6.3 trillion (or +21%), which was a cool 136% of the Y4.9 trillion in declared extra nominal GDP (+9.8%), a surproportion only previously in evidence during the great reflation between June’09-June’10 – an episode to which much official hand-wringing has been devoted for having sown many of the troubles of misplaced investment and widespread peculation which so plagues the economy today.
Furthermore, the past twelve months’ cumulative CNY1.46 trillion positive trade balance was the largest since September 2009 and its YOY growth of CNY440 billion accounted for almost 10% of incremental GDP, the largest such contribution since 2007 despite the intent to focus henceforth on domestic, not foreign, sources of growth.
So, even if we take the Chinese numbers at face value (and all we have to say here is ‘Caterpillar’), the much vaunted ‘rebalancing’ would seem to have been postponed, once again, for reasons of short-term political expediency.
Any more confident analysis of China is being complicated by the fact that not only are the various institutions which comprise its leadership giving off conflicting signals – not least the obvious clash between the schedule of eye-wateringly expensive infrastructure schemes and the financial authorities’ moves to limit local governmental abuse of Off Balance Sheet platforms – but it is almost certain that we must wait until the formal handover of power in March for any major new policy initiatives to be given a more concrete form.
In the meanwhile, the market’s attention has been turned out past the Diaoyu/Senkaku islands towards a formerly slumbering Japan.
Not that the simmering territorial dispute is to be too lightly dismissed – not now we have Chinese militarists issuing nuclear-tipped warnings to the Australians not to run with the US ‘tiger’ or the hated Japanese ‘wolf’, or while Japanese foreign officials criss-cross the sea lanes seemingly intent on marshalling all of China’s fractious neighbours behind them – but the immediate focus has been the Bank of Japan’s capitulation to the Abe government’s threats to pack its governing council with Yes men and to rewrite the law defining its powers if it did not throw its weight behind the latest attempt to deprive the archipelago’s many pensioners – as well as its other purchasers of imported stuffs – of a living income.
Not that this is how the matter is being presented, of course, as the dark forces of global Keynesianism exult at the prospect of yet another New Deal being launched somewhere in the world. After all, it must be about time that oneof them actually ‘did what it said on the tin’ and restored prosperity by means of a clod-hopping bout of fiscal-monetary intervention to a people from whom it was taken by an earlier series of similarly ill-judged interventions from on high.
Given the already heated political situation in the region, the timing could be better, particularly with regard to a yen whose 10-week decline has only been exceeded (benignly) in the reversal of safe haven flows once the Lehman crisis began to abate and (less happily) during the Sakakibara episode in 1995 which arguably set the stage for the global instability of 1997-98. Already, Japan’s neighbours and export competitors – the equally growth-scarce Korea and Taiwan – have begun to make noises about the policy implications, while the Bundesbank’s Jens Weidmann has also expressed hopes that this does not mean a return to the dark days of competitive devaluation.
But, more fundamental than this is the very question of what the Bank and the LDP think they can achieve. Does the country really need any further, grandiose, state-financed spending programmes even if it could apparently bear to spend Y200 trillion (sic) on disaster-’toughening’ schemes, according to Abe advisor Satoshi Fujii? Can the country really be languishing so badly under the crushing burden of nominal interest rates which have barely inched above the giddy heights of 1% at the short end and 2.5% at the long these past fifteen years? Is the fall off in exports really either attributable to – or curable by – developments in the level of a real exchange rate which at its most unfavourable lay only 0.5 sigmas above its stationary, three-decade mean?
For now, the system has held together, with JGBs rallying under the same old QE rationale that has kept US yields from backing up in the face of yawning deficits. Given the presence of a non-price-sensitive buyer, wielding an inexhaustible cheque book, one would have to be truly foolhardy to short the bonds in one’s own currency though it is quite another matter if you come at them from abroad and later hope to spend the returns in your own, foreign domain.
It would not, however, be too wise for the authorities to flout the wishes of their long-suffering citizens, especially not when they have such a deep, vested interest in seeing neither their money, nor the banks and government debt which provide its backstop undermined. At a massive 115% of GDP, M1 money plays a bigger role in the economy than it does in most other developed nations (c.f., the ~50% in the Eurozone, or the ~20% which prevails in the US). As such, it makes up 55% of household financial assets and over 70% of financial net worth, with another 25% of the total exposed directly or otherwise to government debt.
For their part, banks hold over Y400 trillion in JGBs to back up their customers’ deposits, a total which is perhaps eight times larger than their equity capital (meaning a 180bp back up in 10-year yields would effectively wipe them out, if properly marked to market), while other financial institutions hold as much again. This is clearly not a country where one should knowingly tinker with people’s faith in either of these instruments – cash or bonds – in the pursuit of a serially failed and oft-vitiated nostrum.
Perhaps that is why the BOJ seems to have both postponed the onset of its Fed-like QEternity programme to 2014 and to have hedged about the wider terms of its abasement with a number of caveats. Even though it has committed to covering not just the deficit twice over this year, but actually the entirety of government outlays, its outgoing governor did publicise the valid objections of board members Kiuchi and Sato, while reserving to the Bank the right to ‘ascertain whether there is any significant risk to the sustainability of economic growth, including from the accumulation of financial imbalances‘ and to attempt to hold the government to its pledge to ‘flexibly manage macroeconomic policy but also [to] formulate measures for strengthening competitiveness and [the] growth potential of Japan’s economy‘ while ensuring it will ‘steadily promote measures aimed at establishing a sustainable fiscal structure with a view to ensuring the credibility of fiscal management’.
Good luck with that, we would be tempted to say, but the more fundamental point is not whether we gaijin think (along with the likes of Kyle Bass) that all this must soon break apart, but rather when Japanese banks, Japanese insurers and pension providers and, above all, Japanese individuals lose faith in their own money. Here, we might note that they have been quiet net sellers of JGBs for a few quarters now, their actions only being offset by the increased absorption of the BOJ itself. One thing is for sure; the ‘end to deflation’ will not be a gentle or controllable affair, if and when it comes, nor will its impact be limited to Japan alone.
An Inflationist’s Charter
Beyond the fact that most of the biens pensants have uncritically accepted that Japan is finally ‘doing the right thing’ in acting in this manner and aside from the rather incongruous paranoia they nonetheless seem to share about whether perfidious Nippon will steal a march on them as the yen falls under the programme’s influence, renewed mutterings have emerged regarding the advisability of moving towards some form of NGDP targeting everywhere else within their purlieu.
Though there are a few rags of respectability to this concept, to most of those who espouse it these serve only to clothe the stark nakedness of what is, at root, yet another inflationary nostrum. After all, what is the point of being a member of the clerisy if you do not have some blinding wheeze to advocate as a means of extracting the world from its present mess without first having to face the reality that indebtedness is too high, capital has been misallocated on a grand scale, and that – by and large – we have all been seduced by both easy credit and the promise of unearned welfare into living just a little too much for the pleasures of the moment given the paltry gains concurrently being made in our real incomes.
The scanty raiments of reason associated with this canard are those which seek to limit fluctuations emanating from the monetary side of the economy not just by controlling an ‘M’ (upon whose exact composition, naturally, very few agree!) but also the rate at which it courses through the system (its ‘velocity’, if you must). Given that even the later Hayek mused aloud about whether this might not, in fact, be advisable (though most of those citing him conveniently forget to mention that he immediately went on to express grave doubts as to how exactly such a programme would be implemented), the idea has had a certain fatal allure even for those who generally would not endorse any more intrusive forms of monetary engineering.
But, even if we concede this point – arguendo – to the fractional free bankers, if to no others, the ugly truth is that the kind of automatic, bottom-up, self-governing mechanism which the likes of George Selgin argue their system would comprise is not at all what is being envisaged at present. Instead, the likes of incoming BOE governor Mark Carney – a man conveniently escaping the worst consequences of the bout of Dutch disease allied to a housing bubble to which his policies have contributed in his own land – do not just want to stabilize NGDP, but to target its growth AND, moreover to move it back towards the trend it was following before the Crash.
For example, in the US, the 1984-2008 log trend ran at around 5.5% p.a.: currently, we find ourselves some 15% below that trajectory trend, while growing at approximately 4% pa.
Ergo, to get back on trend in, say, three years’ time would require a growth spurt amounting to 45% – or almost 10% p.a. What sort of money growth do you suppose we are talking about to achieve THAT? And how much will arrive simply in the form of higher prices and not increased output, given that this is the sort of growth rate last seen in the Great Inflation of 1970-80?
For comparison, the UK faces a similar arithmetic, finding itself 16% below the pre-Crash trend and growing at less than half the prior pace, which means a 12% per year burst is needed, faster than was achieved during the booming 1980s when the RPI index ended up rising at a double digit rate. Then there is Europe. How are we to assure that the sorely-afflicted Latins reap the main benefit of any ECB largesse without blowing the still-affluent Teutons through the roof, especially given the fact that a three-year return to trend would have to double the pre-Lehman speed of increase?
Laying aside the question of what distortions and inducements to further capital wastage would occur were such at thing to be attempted on the necessary scale and quelling all doubts as to the advisability of even seeking to return to a trend which was artificially boosted by the nitro of the largest, arguably the most damaging, credit bubble in history, the very concept of NGDP suffers from problems of accuracy of measurement, representativeness, and timeliness.
NGDP under-represents the total flow of money in an economy by a good 50-60% by focusing only on the arbitrary Keynes-Kuznets final spending components and hence by ignoring activity in the more volatile, higher-order goods sectors whose smooth functioning are intrinsic to the very business of continued wealth creation and income generation.
Thus, even if we were to embark upon some semblance of this folly, the least we could do is to gauge our success with reference to the development of the more timely and accurate measurement of overall business revenues, not NGDP. Taking either sales themselves or, where not so readily available, an adjusted gross output measure as a proxy for these, it is also notable that the biggest present laggards in the US are to be found in residential construction, finance, non-food retail and – yes – government, while manufacturing has not only been growing faster than before the crash, but now lies only 4% or so below trend. Extractive industries are, of course, blazing the way forward as America’s energy revolution takes hold.
Thus, it could be argued that, however painful the process is for those who either work to a foreshortened, political timeframe or else who itch to earn some fleeting glory by ‘making the most of a good crisis’, the US is sluggish only in the areas which were responsible for the worst of the pre-crisis excess and conversely is doing pretty well, thank you, in the formerly neglected ones wherein tomorrow’s prosperity may be rebuilt. Pray tell how we are going to encourage this commendable re-orientation by lumping them all together and inflating the hell out of asset prices in order to make their aggregate rise more rapidly?
When Tomorrow Comes
In his recent allusion to this argument, there was a good deal of belated merit in what Raghuram Rajan had to say about why ‘stimulus has failed’. While it is always heartening to see one of the nomenklatura express such good sense in public, it never comes without a certain sense of frustration for, as readers of this publication will know only too well, we have been travelling – largely unaccompanied – this same road to Damascus for many a long year now.
That said, indulge us while we rehearse the main line of reasoning, once more, in the interests of clarity.
When large scale borrowing takes place beyond people’s ex-ante willingness to save (i.e., to abstain from complete, much less beyond-income, gratification), the builders and the buyers, the fabricators and the food shoppers will eventually find they are working at cross purposes and basing their (often unconscious) estimates of future income and outgo on premises which run into conflict with one another and to schedules which cannot be synchronized as they should.
Such borrowing may arise of its own volition – especially under the promise of a technological or territorial ‘New Era’ – but, ultimately, it must rest on the willingness of the commercial banks to create sufficient means to underpin it and they, in their turn, are no less dependent on the central bank and its regulatory peers committing sins of omission, if not of outright commission, in allowing such a pervasive and prolonged departure from the desirable norm as will eventually end in a general ruin.
Borrowing in this manner means that more are ‘bringing spending forward’ than are postponing it. Thus, as a group we end up anticipating and alienating too much of what is, after all, an uncertain future income stream in order to indulge ourselves today. Worse yet, this communal Rake’s Progress means that we are all but ensuring that our future income will indeed fall short of what it is we – and our lenders – expect when we mortgage so much of it to them in the present.
Activity of this kind is bad enough when the borrowing is mainly directed at over-consumption of ephemeral goods and services – whether by governments or by private individuals – but at least such a ‘simple’ inflation (to use the Austrian parlance) can be easily recognised for the evil it is and can be hardly less easily dealt with. In principle, the same should apply when the objects of desire are more durable, even if the dangers here are compounded (a) by the monetary authority’s reluctance to countenance any action to prevent the rise in such politically-sensitive things as house prices and (b) by the high loan-income ratio and higher loan-to-value leverage often extended upon what always seem such sturdy forms of collateral.
In contrast, when the borrowing is devoted to building out industrial capacity – when it represents ‘cyclical’ inflation, as we would say – the scope for error becomes much larger even as it is insidiously less apparent. This is because the market for the planned new output lies not only further out into an unknowable future which is very unlikely to reflect the current pretensions of even the most confident of prognosticators, but because that market is only indirectly linked to the final consumer and is therefore all the more highly contingent upon the actions of others – whether suppliers, customers, competitors, providers of complementary goods, and users of similar resources, not to mention regulators, politicians, and warlords.
Again, while the problems increase the ‘higher’ such an enterprise lies ‘up’ the productive structure, away from the ultimate storefront, it is often here that the longest and largest financial commitments must be made, making the receipt of any false signals, in the form of overeasy credit conditions and overbouyant equity markets, not only more decisive as to its to its inception, but all the more perditious once ground has actually been broken.
When ‘tomorrow’ finally comes – as it progressively, day by day, must do – we are then all too apt to find that increasingly onerous degree of debt service to which we have blithely been contracting leaves us too little left over to spend on the consumables so called into being, meaning that the scale and composition of the capital stock laid down when we earlier availed ourselves of all that temptingly easy money can not hope to find a retrospective justification.
One way or other, a recognition must now be made of the magnitude of our error and if not blame, at least responsibility, must be apportioned where it is due; losses must be realised; and titles transferred as quickly as possible not only in order to make a fresh start at the earliest possible juncture – one which will ipso facto be based on a much more sober reckoning of our wants and means – but so that the effort to escape or to procrastinate does not itself forge a chain with which to weigh us further down. Write-offs and write-downs are much more salutary and far less invidious than the determined application of transfer politics by the horde of economically-illiterate careerists who populate the chambers of the legislature.
At this point, we are poorer than we assumed we would be and we may even be absolutely poorer than we were before we strayed off the path of intertemporal co-ordination which is illuminated by the beacons of self-regulating, time preference-determined ‘natural’ interest rates. Though it may seem callous to call now for a ‘liquidation’ of our mistakes, it is the attempt to camouflage this wherein the most pressing dangers lie. The so-called ‘secondary depression’ which are told to avoid at all costs is one thing (and it is still not proven that, only assuming a core quantity of money supply is assured, Pigou – or ‘real balance’ – effects will not cause this to blow itself out so long as prices are sufficiently flexible downwards in the slump to increase that unshrunken kernel’s overall purchasing power), but the progressive petrification of the whole spirit of free enterprise which is its alleged preventative is quite another.
Pricing out Recovery
Alongside the clamour for more monetary monkey business, much lip service is also being paid to the need for ‘structural reform’ and, in the Austrian sense of increasing responsiveness and removing barriers to initiative – what Fritz Machlup called an ‘Auflockerung’ – this is indeed a necessity. But this is not something which will be enacted by governments eager to extend corporate welfare to failed Wall St. Banks, uncompetitive French car companies, needlessly duplicated Chinese steel manufacturers and the like. Nor are they and their central banking friends likely to aid the requisite process of ‘recalculation’ – of working out what one should pay for something today and what one is likely to get for it or the things fashioned from it, tomorrow if interest rates are being falsified, taxation is volatile (upwards, at least), and exchange rates are subject to sudden wrenching shifts.
At bottom, to be coherent, interest rates should correspond to the price ratio between present and future goods and the eagle-eyed entrepreneur is the man who can recognise an arbitrageable disparity between the two in specific instances and hence can put something which is currently being undervalued to a better, alternative use. But, if he judges the spread between current inputs and his expected, risk-adjusted output is too narrow to be worth his effort, he will not be willing to provide an income to those selling the first, or employment to those who might otherwise make a living by transforming them under his guidance into the second.
Yet much of the thrust of today’s rabid Rooseveltianism is conspiring to keep this critical spread overly compressed and entrepreneurs understandably coy to embark upon major new undertakings.
- Raw inputs cost too much because of easy money, ZIRP storage arbitrage, green rent-seeking, and welfare-subsidized consumption
- Labour remains expensive due to dole-encouraged withholding and the high ancillary costs imposed by an overweening and unaffordable state apparatus
- Expected returns on capital – outside of those to be gained by gaming the capital markets, that is – are depressed by the anti-capitalist thrust of taxation and the regulatory and legal flux to which entrepreneurs are being subjected to an unnecessarily elevated degree
- The prospective flow of sales receipts is also being diluted by the presence of so much state- and bank-supported, sub-marginal deadwood in the market.
One of the features of a slump in which can be found the seeds of a subsequent regeneration is that the inputs to a more sustainable and inherently profitable production process can be had cheaply. To this end the irrational fear of the bogeyman of ‘deflation’ is itself the root cause of the process by which the aptitude for change and the appetite for risk can become quasi-permanently suppressed.
Bankruptcy breaks up unviable capital combinations and frees up willing workers for the business of founding new industries and of identifying and satisfying new tastes, a point that Ludwig Lachmann was every ready to extol. ‘Capital’ is a concept; it is a dynamic, it is not an inert, physical lump of easily-stilled mechanisms. In the right hands, yesterday’s failed crop can become the fertilizer of tomorrow’s harvest as long as its owners are encouraged to realize their losses and to sell it on to those with a better vision of how to utilize it at a price commensurate with the new endeavour’s chances of success.
Sadly beguiled by their own theoretical cleverness, those setting policy today are so fixated on the idea of forcing people to buy things just to be rid of the excess money which is being forced upon them and so dead set against anything actually costing less than it used to, no matter how ludicrous the previous valuation or how commercially wrong-headed the purpose to which it was being dedicated, that their own efforts at ‘stimulus’ are forestalling this act of revaluation and release – this recapitalization of the decapitalized – and so are turning them instead into the greatest mass sedative ever prescribed to the mercantile classes.
The Big Freeze
In our Austrian narrative of a ‘cyclical’ inflation, fiduciary (unsaved) credit is preferentially funnelled towards investment in new capacity and expanded business. This soon leads to an unlooked-for degree of competition for resources with the earners of increased wages who are mostly still unsated in their demand for the existing array of consumables, items which the expansionists are either not planning to provide just yet, if at all. Such a conflict of desire can only end up in widespread over-extension; in the appearance of large quantities of ‘frozen’ capital; and hence in disappointed creditors and investors amid a general disco-ordination of plans.
In contrast to such an overheated condition, much of today’s unsaved credit is being directed at ensuring that zombie companies can display the barest signs of animation so as to enable their bankers to justify the ‘evergreening’ of their loans. Working on a cash basis, possibly too unprofitable to pay tax, certainly not amortizing their debt and probably bleeding capital by eating into their depreciation allowances, such ICU-institutions do little more than clutter up their lenders’ balance sheets, cling on to experienced and diligent staff, occupy prime property, burn electricity, and buy in stock – and so deny their more vibrant, self-reliant counterparts, whose innate abilities are greater but who have to operate on a fully commercial basis, the room and the means to grow.
Every great efflorescence of life, every great evolutionary advance in the long and violent history of dear old Mother Earth has come in the wake of a mass extinction. Without the Alvarez meteorite, after all, we hairless apes would probably not be here to debate the finer points of how our policies are only serving to maintain the economic dinosaurs in command of their niche, far beyond their natural span.
Making matters worse, the remainder of the credit inflation is being monopolised by incontinent states and their skulk of rent-seeking jackals, elites whose intrinsic capital efficiencies are vanishingly small (if not actually negative) and whose activities are therefore particularly likely to contribute to capital consumption.
Here we are faced with the awful irony that, in their manful attempt to lighten the load of indebtedness, central banks are helping generate ever more debt. Whereas the money they are creating is supposed to be a final means of settlement which extinguishes debt at the completion of a contracted period of service, it is instead giving rise to more of that which must, one day, be settled. Hence the source of that widely-shared and intensely pernicious confusion of what are static accounting identities in the macro reports with the dynamic process of economic life. We do not need someone else to borrow in our place if we choose to pay down our debts: if we sell without buying in order to discharge our obligations, our satisfied creditor now has both the wherewithal and the available wares to buy in our stead. Even if we find, alas, that we cannot fulfil our contract, to substitute another claim for it by transferring it to some larger, less constrained entity such as the state is to fall for a sunk cost fallacy. We took and used the present goods over which command was given us by our lender and we turned out not to be able to replace them: thus they are irrevocably lost, no matter what anyone cares to scribble in the pages of their accounting ledger.
Unable as we are to see this, we will continue to invest in negative productivity and purposely to select against the fittest. Instead of a classic Austrian overheating, we now have an Ice Age: instead of a credit bubble, we have a debt black hole.
Just as in Japan, we have transferred private actor difficulties into public sector ones where no legal framework exists to resolve the resulting problems. Worse than this, we now face a classic ‘public choice’ trap, to introduce the concept elucidated by the late, great James Buchanan.
Once we decide to move private liabilities onto the public balance sheet instead of swiftly excising them in the crisis, not only are the protocols for later resolution sorely lacking, but the incentives are almost entirely absent, too. Being ‘public’ debts which no individual entity can be said to have incurred, there is too diffuse a sense of responsibility for them – if not an outright tragedy of the commons. Since there are no identifiable culprits for the evils they entrain, outside the hated ‘capitalist’ caricatures of popular invective, it is all too easy for the economic illiterates in parliament to pretend that they were in no way responsible for the debt the incoming regime has inherited (even if often in great part from its own former time in office).
Wedded to the state’s arbitrary ability to impose financing charges on third parties (and the fact that pressure-group politics will see the regime’s court favourites and swing voters militate not to bear any concentration of this cost) is the fact it runs completely counter to political ambition to say “we will do less - less intervention, less spending, less feather-bedding – than the losers you just ejected”.
Given a further boost by the almost universal faith in half-fdigested Keynesian nostrums (exemplified perhaps by the recent apoptheosis of the dreadful old Leftie patriarch, Robert Skidelsky), we are about to discover that by saving the banks, we are destroying the pension and insurance companies upon whom the average man is no less reliant. As a result, many of our present day states are fast approaching the limits of budget credibility and so have no choice but to resort more and more to seigniorage in order to survive. Some would, indeed, already have exhausted that reservoir, too, were it not that such infernal devices as TARGET2 allow them to draw heavily upon the reputation and good-standing of their neighbours.
That this policy has not yet led to a resurgence of old-fashioned, shopping-basket price rises (even if, in contrast, its malign, if seductive, effect on asset prices is not to be denied) is largely down to luck.
An increase in the supply of money leads to higher prices only to the extent its recipients’ desire to hold it does not increase in due proportion. What we have seen in the past four years is that, largely, it has. Firstly, higher degrees of credit have lost much of their superficial sheen of ‘moneyness’ since the collapse, meaning that the parties to an exchange are now far less willing to rely upon the ready negotiability and unquestioned fungibility of lesser IOUs as a means of settlement than they were during the boom. Secondly, the banks themselves have not been able to throw off so many of their more dubious accommodations into the ask-no-questions-tell-no-lies underworld of a now-moribund ABS market. Adding to the squeeze, as we have already set out, they have encumbered their balance sheets with a host of low-grade borrowers at the same time that both regulatory capital requirements and wholesale market funding possibilities have become a good deal less conducive to blind expansion than they were in the Blue Sky days of yore. Thus, a greater proportion of a money supply which is having to ‘do more work’ than has been the norm is being generated ‘outside’ the commercial banks rather than ‘inside’ them – i.e., by the central banks through their vastly expanded range of operations.
This, too, is a case of lowest common denominator lending, since what these central banks prefer to monetize above all is government (and quasi-government) debt. In this way they are temporarily satisfying people’s heightened need for money by removing the worst constraints from those closet Jacobins who, we have argued above, are the very people obstructing the process of recuperation and regeneration.
With a nod to the ideas of Axel Leijonhufvud, what this also may imply is that the income-constrained recipients of welfare (personal or corporate) are the agents least likely to cling on to any of their dole, while the still-healthy who receive it at one remove are fast becoming Ricardian equivalence hoarders – knowing, as they do, that, as the only obviously identifiable sources of wealth and with very little patronage to shield them, Leviathan will soon come ravening after them. So, with the associated opportunity costs eradicated by the central banks’ flawed attempts at stimulus, they are clutching tight to their caches of sterile silver ahead of the day when they fear they must render it up wholesale to an aggressively insistent Caesar.
Beyond the Impasse
Thus we have the paradox that, on the one hand, we must be grateful that the central banks are finding too few takers for the snake oil of inflation to do its corrosive work because the supposed solution it offers is not only arbitrary and dishonest, but because it also confounds accounting and so destroys capital and wastes further resources – progressively the moreso, the more rapid and variable its rate of propagation. That it also tends to favour the least savoury elements of society (i.e., the plutocrats and the politically-protected), means that any stay of execution is further to be welcomed on moral, as well as on material, grounds.
On the other hand, the maintenance of ZIRP – and its extension across the maturity spectrum is doing little to help and much to harm. Some say it counter-intuitively promotes saving as those who still can set more current income aside to make up for the lowered returns they receive on their nest eggs. If only this were so, for even though this is something the mainstream perversely insists on decrying, it is actually the wellspring of our well-being. Your author, however, doubts it does much to promote saving in any productive sense: instead it serves to keep capital locked up in dead undertakings and so slowly bleeds the rest of us dry, therefore destroying real savings, not adding to them and continuing the recession, not curtailing it.
At some point, this dangerous impasse will have to be resolved, either in an admission that macroeconomic means have failed and that renaissance must at last be sought – as we have long argued – in providing a more conducive microeconomic milieu (an epiphany which will be a long time coming since it implies the headlong retreat of the Provider State militant) or, alas, in a ‘flight to real values’ and a conflagration of financial claims to wealth amid the rubble of a monetary collapse.
But perhaps we must not be too hasty in calling for the turning point to arrive. Japanese experience teaches us that the stand-off can be maintained for nigh-on a generation if the benefits of slow price declines (not ‘deflation’, please) become widely recognised and if people further accept that if the state is to subsume their unserviceable private debt contracts while not taxing the skin from their backs in order to do so, they must volunteer to surrender up a good part of their income to it by continually adding to their holdings of its obligations (both dated – JGBs – and perpetual – currency). Of course, it helps if the people in question are both productive and thrifty enough to have no need for external finance and possess a high home-bias in their investments and so are not overly susceptible to sudden reversals of sentiment on the part of the hot-money crowd.
As for the rest of us – who are not necessarily endowed with such commendable attributes of forbearance – whether we further resist it or no, everything points to the conclusion that the Mighty Ozzes at the central banks have not yet lost their will for the struggle and that the creeping ‘euthanasia of the rentier’ and ‘monetary policy à outrance’ will be further prosecuted, no matter how high the cost or how exiguous the results.
Such is the curse of the Platonic arrogance of our masters and their willing enablers.