“By sacrificing quality an investor can obtain a higher income return from his bonds. Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds. While, taken as a whole, they may work out somewhat better in terms of overall return than the first-quality issues, they expose the owner to too many individual risks of untoward developments, ranging from disquieting price declines to actual default.”
They call them ‘junk bonds’ for a reason. They now constitute an offence against linguistic decency: ‘high yield’ no longer even is. Consider the chart below:
BofA Merrill Lynch High Yield Master II Index (spread vs US Treasuries)
(Source: BofA Merrill Lynch, St. Louis Federal Reserve)
(The index in question is a benchmark for the broad high yield bond market.) Not for nothing did the Financial Times report at the weekend that “Retail investors are getting increasingly nervous about high-yield bonds”.
They should also be getting increasingly nervous about government bonds. Consider, first, this chart:
(Source: Thomson Reuters, Credit Suisse)
In the entire history of the UK Gilt market, yields have never been as low. This suggests that Gilt buyers at current levels are unlikely to enjoy an entirely blissful investment experience.
Just to round up this analysis of bond investor hyper-exuberance, consider this last chart, which puts interest rates (in this case, the UK base rate) in their historical context:
UK base rates, 1700 to 2014
(Source: The Bank of England, Church House)
(*The Bank Rate has comprised variously the Bank Rate, Minimum Lending Rate, Minimum Band 1 Dealing Rate, Repo Rate and Official Bank Rate.)
There is one (inverse) correlation in investment markets that is pretty much iron-clad. If interest rates go up, bond prices go down. This is entirely logical, since the coupon payments on bonds are typically fixed. If interest rates rise, that stream of fixed coupon payments loses its relative attractiveness. The bond price must therefore fall to compensate fixed coupon investors. So now ask yourself a question: in what direction are interest rates likely to go next ? Your answer may have some bearing on your preferred asset allocation.
Bond investors may be acting rationally inasmuch as they believe that central banks will keep interest rates “lower for longer”. But even more rational investors are now starting, loudly, to question the wisdom of central banks’ maintenance of emergency monetary stimulus measures, at least five years after the Global Financial Crisis flared up. Speaking at the ‘Delivering Alpha’ conference covered by CNBC, respected hedge fund manager Stanley Druckenmiller commented as follows:
“As a macro investor, my job for 30 years was to anticipate changes in the economic trends that were not expected by others – and therefore not yet reflected in securities prices. I certainly made my share of mistakes over the years, but I was fortunate enough to make outsized gains a number of times when we had different views from various central banks. Since most investors like betting with the central bank, these occasions provided our most outsized returns – and the subsequent price adjustments were quite extreme. Today’s Fed policy is as puzzling to me as during any of those periods and, frankly, rivals 2003 in the late-stages to early-2004, as the most baffling of a number of instances I have in mind. We at Duquesne [Capital Management] were mystified back at that time why the funds rate was one percent with the ‘considerable period’ attached to it, given the vigorous economic growth statistics available at the time. I recall walking in one day and showing my partners a bunch of charts of economics statistics of that day and asking them to take the following quiz: Suppose you had been on Mars the last five years and had just come back to planet Earth. I showed them five charts and I said, ‘If you had to guess, where would you guess the Federal funds rate was?’ Without exception, everyone guessed way north of one percent, as opposed to the policy at the time which was a verbal guarantee that they would stay at one percent for a ‘considerable period of time.’ So we were confident the Fed was making a mistake, but we were much less confident in how it would manifest itself. However, our assessment by mid-2005 that the Fed was fueling an unsustainable housing Bubble, with dire repercussions for the greater economy, allowed our investors to profit handsomely as the financial crisis unfolded. Maybe we got lucky. But the leadership of the Federal Reserve did not foresee the coming consequences as late as mid-2007. And, surprisingly, many Fed officials still do not acknowledge any connection between loose monetary policy and subsequent events..”
“I hope we can all agree that these once-in-a-century emergency measures are no longer necessary five years into an economic and balance sheet recovery. There is a heated debate as to what a ‘neutral’ Fed funds rate would be. We should be debating why we haven’t moved more meaningfully towards a neutral funds rate. If for no other reason, so the Fed will have additional weapons available if the outlook darkens again. Many Fed officials and other economists defend their current policies by claiming the economy is better than it would have been without their ongoing stimulus. No one knows for sure, but I believe that is logical and correct. However, I also believe if you’d asked the same question in 2006 – that the economy was better in 2004 to 2006 than it would have been without the monetary stimulus that preceded it. But was the economy better in total from 2003 to 2010 – without the monetary stimulus that preceded it? The same applies today. To economists and Fed officials who continually cite that we are better off than we would have been without zero rate policies for long, I ask ‘Why is that the relevant policy time frame?’ Five years after the crisis, and with growing signs of economic normalization, it seems time to let go of myopic goals. Given the charts I just showed and looking at economic history, today’s Fed policy seems not only unnecessary but fraught with unappreciated risk. When Ben Bernanke and his colleagues instituted QE1 in 2009, financial conditions in the real economy were in a dysfunctional meltdown. The policy was brilliantly conceived and a no-brainer from a risk/reward perspective. But the current policy makes no sense from a risk/reward perspective. Five years into an economic and balance sheet recovery, extraordinary money measures are likely running into sharply diminishing returns. On the other hand, history shows potential long-term costs can be quite severe. I don’t know whether we’re going to end with a mal-investment bust due to a misallocation of resources; whether it’s inflation; or whether the outcome will actually be benign. I really don’t. Neither does the Fed.”
No more charts. If these three don’t get the message across, nothing will.
The bond environment, ranging from high yield nonsense to government nonsense, is now fraught, littered with uncertainty and unexploded ammunition, and waiting nervously for the inevitable rate hike to come (or bracing for a perhaps messy inflationary outbreak if it doesn’t). There are clearly superior choices on a risk-reward basis; we think Ben Graham-style value stocks are the logical and compelling alternative.
Professor Paul Krugman is leaving Princeton. Is he leaving in disgrace?
Not long, as these things go, before his departure was announced Krugman thoroughly was indicted and publicly eviscerated for intellectual dishonesty by Harvard’s Niall Ferguson in a hard-hitting three-part series in the Huffington Post, beginning here, and with a coda in Project Syndicate, all summarized at Forbes.com. Ferguson, on Krugman:
Where I come from … we do not fear bullies. We despise them. And we do so because we understand that what motivates their bullying is a deep sense of insecurity. Unfortunately for Krugtron the Invincible, his ultimate nightmare has just become a reality. By applying the methods of the historian – by quoting and contextualizing his own published words – I believe I have now made him what he richly deserves to be: a figure of fun, whose predictions (and proscriptions) no one should ever again take seriously.
Princeton, according to Bloomberg News, acknowledged Krugman’s departure with an extraordinarily tepid comment by a spokesperson. “He’s been a valued member of our faculty and we appreciate his 14 years at Princeton.”
Shortly after Krugman’s departure was announced no less than the revered Paul Volcker, himself a Princeton alum, made a comment — subject unnamed — sounding as if directed at Prof. Krugman. It sounded like “Don’t let the saloon doors hit you on the way out. Bub.”
To the Daily Princetonian (later reprised by the Wall Street Journal, Volcker stated with refreshing bluntness:
The responsibility of any central bank is price stability. … They ought to make sure that they are making policies that are convincing to the public and to the markets that they’re not going to tolerate inflation.
This was followed by a show-stopping statement: “This kind of stuff that you’re being taught at Princeton disturbs me.”
Taught at Princeton by … whom?
Paul Krugman, perhaps? Krugman, last year, wrote an op-ed for the New York Times entitled Not Enough Inflation. It betrayed an extremely louche, at best, attitude toward inflation’s insidious dangers. Smoking gun?
Volcker’s comment, in full context:
The responsibility of the government is to have a stable currency. This kind of stuff that you’re being taught at Princeton disturbs me. Your teachers must be telling you that if you’ve got expected inflation, then everybody adjusts and then it’s OK. Is that what they’re telling you? Where did the question come from?
Is Krugman leaving in disgrace? Krugman really is a disgrace … both to Princeton and to the principle of monetary integrity. Eighteenth century Princeton (then called the College of New Jersey)president John Witherspoon, wrote, in his Essay on Money:
Let us next consider the evil that is done by paper. This is what I would particularly request the reader to pay attention to, as it was what this essay was chiefly intended to show, and what the public seems but little aware of. The evil is this: All paper introduced into circulation, and obtaining credit as gold and silver, adds to the quantity of the medium, and thereby, as has been shown above, increases the price of industry and its fruits.
“Increases the price of industry and its fruits?” That’s what today is called “inflation.”
Inflation is a bad thing. Period. Most of all it cheats working people and those on fixed incomes who Krugman pretends to champion. Volcker comes down squarely, with Witherspoon, on the side of monetary integrity. Krugman, cloaked in undignified sanctimony, comes down, again and again, on the side of … monetary finagling.
Krugman consistently misrepresents his opponents’ positions, constructs fictive straw men, addresses marginal figures, and ignores inconvenient truths set forward by figures of probity such as the Bank of England and theBundesbank, thoughtful work such as that by Member of Parliament (with a Cambridge Ph.D. in economic history) Kwasi Kwarteng, and, right here at home, respected thought leaders such as Steve Forbes and Lewis E. Lehrman (with whose Institute this writer has a professional affiliation).
Professor Krugman, on July 7, 2014, undertook to issue yet another of his fatwas on proponents of the classical gold standard. His New York Times op-ed, Beliefs, Facts and Money, Conservative Delusions About Inflation, was brim full of outright falsehoods and misleading statements. Krugman:
In 2010 a virtual Who’s Who of conservative economists and pundits sent an open letter to Ben Bernanke warning that his policies risked “currency debasement and inflation.” Prominent politicians like Representative Paul Ryan joined the chorus.
Reality, however, declined to cooperate. Although the Fed continued on its expansionary course — its balance sheet has grown to more than $4 trillion, up fivefold since the start of the crisis — inflation stayed low.
Many on the right are hostile to any kind of government activism, seeing it as the thin edge of the wedge — if you concede that the Fed can sometimes help the economy by creating “fiat money,” the next thing you know liberals will confiscate your wealth and give it to the 47 percent. Also, let’s not forget that quite a few influential conservatives, including Mr. Ryan, draw their inspiration from Ayn Rand novels in which the gold standard takes on essentially sacred status.
And if you look at the internal dynamics of the Republican Party, it’s obvious that the currency-debasement, return-to-gold faction has been gaining strength even as its predictions keep failing.
Krugman is, of course, quite correct that the “return-to-gold faction has been gaining strength.” Speculating beyond the data thereafter Krugman goes beyond studied ignorance. He traffics in shamefully deceptive statements.
Lewis E. Lehrman, protege of French monetary policy giant Jacques Rueff, Reagan Gold Commissioner, and founder and chairman of the Lehrman Institute, arguably is the most prominent contemporary advocate for the classical gold standard. Lehrman never rendered a prediction of imminent “runaway inflation.” Only a minority of classical gold standard proponents are on record with “dire” warnings, certainly not this columnist. So… who is Krugman talking about?
Of the nearly two-dozen signers of (a fairly mildly stated concern) open letter to Bernanke which Krugman cites as prime evidence, only one or two are really notable members of the “return-to-gold faction.” Perhaps a few other signers might have shown some themselves in sympathy the gold prescription. Most, however, were, and are, agnostic about, or even opposed to, the gold standard.
Indicting gold standard proponents for a claim made by gold’s agnostics and opponents is a wrong, cheap, bad faith, argument. More bad faith followed immediately. Whatever inspiration Rep. Paul Ryan draws from novelist Ayn Rand, Ryan is by no means a gold standard advocate. And very few “influential conservatives” (unnamed) “draw their inspiration” from Ayn Rand.
Nor are most proponents of the classical gold standard motivated by a fear that paper money is an entering wedge for liberals to “confiscate your wealth and give it to the 47 percent.” A commitment to gold is rooted, for most, in the correlation between the gold standard and equitable prosperity. Income inequality demonstrably has grown far more virulent under the fiduciary Federal Reserve Note regime — put in place by President Nixon — than it was, for instance, under the Bretton Woods gold+gold-convertible-dollar system.
Krugman goes wrong through and through. No wonder Ferguson wrote: “I agree with Raghuram Rajan, one of the few economists who authentically anticipated the financial crisis: Krugman’s is “the paranoid style in economics.” Krugman, perversely standing with Nixon, takes a reactionary, not progressive, position. The readers of the New York Times really deserve better.
Volcker is right. “The responsibility of any central bank is price stability.” Krugman is wrong.
Prof. Krugman was indicted and flogged publicly by Niall Ferguson. Krugman thereafter announced his departure from Princeton. On his way out Krugman, it appears, was reprimanded by Paul Volcker. Krugman has been a disgrace to Princeton. Is he leaving Princeton in quiet disgrace?
Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/07/14/is-paul-krugm
Last Monday’s Daily Telegraph carried an interview with Jaime Caruana , the General Manager of the Bank for International Settlements (the BIS). As General Manger, Caruana is CEO of the central banks’ central bank. In international monetary affairs the heads of all central banks, with the possible exception of Janet Yellen at the Fed, defer to him. And if any one central bank feels the need to obtain the support of all the others, Caruana is the link-man.
His opinion matters and it differs sharply from the line being pushed by the Fed, ECB, BoJ and BoE. But then he is not in the firing line, with an expectant public wanting to live beyond its means and a government addicted to monetary inflation. However, he points out that debt has continued to increase in the developed nations since the Lehman crisis as well as in most emerging economies. Meanwhile the growing sensitivity of all this debt to rises in interest rates is ignored by financial markets, where risk premiums should be rising, but are falling instead.
From someone in his position this is a stark warning. That he would prefer a return to sound money is revealed in his remark about the IMF’s hint that a few years of inflation would reduce the debt burden: “It must be clearly resisted.”
There is no Plan B offered, only recognition that Plan A has failed and that it should be scrapped. Some think this is already being done in the US, with tapering of QE3. But tapering is having little monetary effect, being replaced by the expansion of the Fed’s reverse repo programme. In a reverse repo the Fed gives the banks short-term US Government debt, paid for by drawing down their excess reserves. The USG paper is used as collateral to back credit creation, while the excess reserves are not in public circulation anyway. Therefore money is created out of thin air by the banks, replacing money created out of thin air by the Fed.
Interestingly Caruana dismisses deflation scares by saying that gently falling prices are benign, which places him firmly in the sound money camp.
But he doesn’t actually “come out” and admit to being Austrian in his economics, more an acolyte of Knut Wicksell, the Swedish economist, upon whose work on interest rates much of Austrian business cycle theory is based. This is why Caruana’s approach towards credit booms is being increasingly referred to in some circles as the Mises-Hayek-BIS view.
With the knowledge that the BIS is not in thrall to Keynes and the monetarists, we can logically expect that Caruana and his colleagues at the BIS will be placing a greater emphasis on the future role of gold in the monetary system. Given the other as yet unstated conclusion of the Mises-Hayek-BIS view, that paper currencies are in a doom-loop that ends with their own destruction, the BIS is on a course to break from the long-standing policy of preserving the dollar’s credibility by supressing gold.
Caruana is not alone in these thoughts. Even though central bankers in the political firing line only know expansionary monetary policies, it is clear that influential opinion in many quarters is building against them. It is too early to talk of a new monetary regime, but not too early to talk of the current one’s demise.
“I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. Very low interest rates help to explain the high CAPE. That doesn’t mean that the high CAPE isn’t a forecast of bad performance. When I look at interest rates in a forecasting regression with the CAPE, I don’t get much additional benefit from looking at interest rates… We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. I think, realistically, stocks should be in someone’s portfolio. Maybe lighten up… One thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks – 2000, 2007 and now – it just looks to me like a peak. I’m not saying it is. I would think that there are people thinking – way – it’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”
“Paid promoters have helped push CYNK [CYNK Technology Corp] market cap to $655 million after a 3,650% increase in the share price on Tuesday.
“CYNK had assets of just $39 (no zeroes omitted) as of March 31, 2014 and a cumulative net loss of $1.5 million. The “company” has no revenue.
“CYNK claims that it is “a development stage company focused on social media.” However, the “company” does not even have a website and has just one employee [who acts as President, Chief Executive Officer, Chief Financial Officer, Treasurer and Company Secretary].
“With no assets, no revenue and no product, CYNK has no value. Author expects that CYNK shares are worthless.”
Lord Overstone said it best. “No warning can save people determined to grow suddenly rich.” But there is clearly a yawning chasm between the likes of those folk cheerfully bidding up the share price of CYNK, and prudent investors simply trying to keep their heads above water. What has effectively united these two otherwise disparate communities is today’s central banker. Andy Haldane, the chief economist for the Bank of England, speaking at an FT conference last week, conceded that ultra-accommodative monetary policy had “aided and abetted risk-taking” by investors and that policy makers had wanted to use higher asset prices to try and stimulate the wider economy (that is to say, the economy) into a more robust recovery: “That is how [monetary policy] is meant to work. That’s why we did it.” If the Bank of England had not slashed interest rates and created £375 billion out of thin air, “the UK economy would have been at least 6 per cent smaller than it is today.” A curiously precise figure, given the absence of any counterfactual. But regardless of the economic “benefits” of quantitative easing, Haldane did have the grace to admit that
“That will mean, on average, that financial market volatility will be somewhat greater than in the past. I think it will mean, on average, that those greed and fear cycles in financial markets will be somewhat more exaggerated than in the past. That, for me, is the corollary of the risk migration.”
Which is a bit like an arsonist torching a wooden building and then shrugging his shoulders and saying,
“Well, wood will burn.”
Our central bankers, of course, will not be held accountable when the crash finally hits, even if the accumulated dry tinder of the boom was almost entirely of their own creation. Last week the Bank for International Settlements, the central banker’s central bank, issued an altogether more circumspect analysis of the world’s current financial situation, in their annual report. It concluded, with an entirely welcome sense of caution, that
“The [monetary] policy response needs to carefully consider the nature and persistence of the forces at work as well as policy’s diminished effectiveness and side effects. Finally, looking forward, the issue of how best to calibrate the timing and pace of policy normalisation looms large. Navigating the transition is likely to be complex and bumpy, regardless of communication efforts. And the risk of normalising too late and too gradually should not be underestimated.” (Emphasis ours.)
Translation: ZIRP (Zero Interest Rate Policy – and in the case of the ECB, which has taken rates negative, NIRP) is no longer working – if it ever did. Hyper-aggressive monetary policy has side effects. Getting out of this mess is not going to be easy, and it’s going to be messy. Forward guidance, which was meant to simplify the message, has instead hopelessly confused it. And there are big risks that central banks will lose the requisite confidence to tighten policy when it is most urgently needed, and allow an inflationary genie entirely out of the bottle.
The impact of central banks’ unprecedented monetary stimulus on financial markets is so overwhelming that it utterly negates any sensible analysis of likely macro-economic developments. On the basis that sometimes it’s simply best not to play some games, we no longer try. What should inform investors’ preferences, however, is bottom-up asset allocation and stock selection. The US equity market is clearly poor value at present. That doesn’t mean that it can’t get even more expensive, and the rally might yet have some serious legs. But overvaluation at an index level doesn’t preclude the existence of undervalued stocks well away from the braying herd. (We think the most compelling macro value is in Asia and, if we had to single out any one country, Japan.)
“The central thesis among investors at present is that they have no other choice but to hold stocks, given the alternative of zero short-term interest rates and long-term interest rates well below the level of recent decades..”
“Investment decisions driven primarily by the question “What other choice do I have ?” are likely to prove regrettable. What we now have is a market that has been driven to one of the four most extreme points of overvaluation in history. We know how three of them ended.”
The conclusion seems clear to us. If one chooses to invest at all, invest on the basis of valuation and not on indexation (the world’s largest stock market, that of the US, is one of the most seemingly conspicuously overvalued). As an example of the sort of valuations currently available away from the herd, consider the following. You can buy the US S&P 500 index today with the following metrics:
Price / earnings: 18.2
Price / book: 2.76
Dividend yield: 1.89%
Meanwhile, Greg Fisher in his Halley Asian Prosperity Fund (albeit currently closed) is buying quality businesses throughout Asia on somewhat more attractive valuations. (By geography, the fund’s largest allocations are to Japan, Vietnam and Malaysia.) The fund’s current metrics are as follows:
Average price / earnings: 7
Average price / book: 0.8
Average dividend yield: 4.5%.
But the realistic prospect of growth is also on the table. The fund’s average historic return on equity stands at 15%.
Pay money. Take choice.
[Editor's Note: this piece, by Steve H Hanke, Professor of Applied Economics and Co-Director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at The Johns Hopkins University in Baltimore, was previously published at Cato.org and Globe Asia. Please also see our earlier postings here at The Cobden Centre on Mark Skousen's intrepid work on GDE. As Lord Kelvin said, "To measure is to know". ]
In late April of this year, the Bureau of Economic Analysis (BEA) at the U.S. Department of Commerce announced that it would start reporting a new data series as part of the U.S. national income accounts. In addition to gross domestic product (GDP), the BEA will start reporting gross output (GO). This announcement went virtually unnoticed and unreported — an unfortunate, but not uncommon, oversight on the part of the financial press. Yes, GO represents a significant breakthrough.
A brief review of some history of economic thought will show just why GO is a big deal. The Classical School of economics prevailed roughly from Adam Smith’s Wealth of Nations time (1776) to the mid-19th century. It focused on the supply side of the economy. Production was the wellspring of prosperity.
The French economist J.-B. Say (1767-1832) was a highly regarded member of the Classical School. To this day, he is best known for Say’s Law of markets. In the popular lexicon — courtesy of John Maynard Keynes — this law simply states that “supply creates its own demand.” But, according to Steven Kates, one of the world’s leading experts on Say, Keynes’ rendition of Say’s Law distorts its true meaning and leaves its main message on the cutting room floor.
Say’s message was clear: a demand failure could not cause an economic slump. This message was accepted by virtually every major economist, prior to the publication of Keynes’ General Theory in 1936. So, before the General Theory, even though most economists thought business cycles were in the cards, demand failure was not listed as one of the causes of an economic downturn.
All this was overturned by Keynes. Kates argues convincingly that Keynes had to set Say up as a sort of straw man so that he could remove Say’s ideas from the economists’ discourse and the public’s thinking. Keynes had to do this because his entire theory was based on the analysis of demand failure, and his prescription for putting life back into aggregate demand — namely, a fiscal stimulus (read: lower taxes and/or higher government spending).
Keynes was wildly successful. With the publication of the General Theory, the supply side of the economy almost entirely vanished. It was replaced by aggregate demand, which was faithfully reported in the national income accounts. In consequence, aggregate demand has dominated economic discourse and policy ever since.
Among other things, Keynes threw economics into the sphere of macro economics. It is here where economic aggregates are treated as homogenous variables for purposes of analysis. But, with such innocent looking aggregates, there lurks a world of danger. Indeed, because of the demand-side aggregates that Keynes’ analysis limited us to, we were left with things like the aggregate sizeof consumption and government spending. The structure of the economy — the supply side — was nowhere to be found.
Yes, there were various rear-guard actions against this neglect of the supply side. Notable were economists from the Austrian School of Economics,such as Nobelist Friedrich Hayek. There were also devotees of input-out put analysis, like Nobelist Wassily Leontief. He and his followers stayed away from grand macroeconomic aggregates;they focused on the structure of the economy. There were also branches of economics — like agricultural economics– that were focused on production and the supply side of the economy. But,these fields never pretended to be part of macroeconomics.
Then came the supply-side revolution in the 1980s. It was associated with the likes of Nobelist Robert Mundell. This revolution was carried out, in large part, on the pagesof The Wall Street Journal, where J.-B.Say reappeared like a phoenix. The Journal’s late-editor Robert Bartley recounts the centrality of Say in his book The Seven Fat Years: And How to Do It Again (1992) “I remember Art Laffer telling me I had to learn Say’s Law. ‘That’s what I believe in’, he professed. ‘That’s what you believe in.’”
It is worth mentioning that the onslaught by Keynes on Say was largely ignored by many economic practitioners who attempt to anticipate the course of the economy. For them,the supply side of the economy has always received their most careful and anxious attention. For example, the Conference Board’s index of leading indicators for the U.S. economy is predominantly made up of supply-side indicators. Bloomberg’s supply-chain analysis function (SPLC) is yet another tool that indicates what practitioners think about when they conduct economic and financial analyses.
But, when it comes to the public and the debate about public policies, there is nothing quite like official data. So, until now, demand-side GDP data produced by the government has dominated the discourse. With GO, GDP’s monopoly will be broken as the U.S. government will provide official data on the supply side of the economy and its structure. GO data will complement, not replace, traditional GDP data. That said, GO data will improve our understanding of the business cycle and also improve the quality of the economic policy discourse.
So, what makes up the conventional measure of GDP and the new GO measure? And what makes up the gross domestic expenditures (GDE)measure, a more comprehensive, close cousin of GO? The accompanying two tables answer those questions. And for readers who are more visually inclined,bar charts for the two new metrics — GO and GDE — are presented.
Now, it’s official. Supply-side (GO) and demand-side (GDP) data are both provided by the U.S. government. How did this counter revolution come about? There have been many counter revolutionaries, but one stands out: Mark Skousen of Chapman University. Skousen’s book The Structure of Production, which was first published in 1990, backed his advocacy with heavy artillery. Indeed, it is Skousen who is, in part, responsible for the government’s move to provide a clearer, more comprehensive picture of the economy, with GO. And it is Skousen who is solely responsible for calculating GDE.
These changes are big, not only conceptually, but also numerically. Indeed, in 2013 GO was 76.4% larger, and GDE was 120.4% larger, than GDP. Why? Because GDP only measures the value of all final goods and services in the economy. GDP ignores all the intermediate steps required to produce GDP. GO corrects for most of those omissions. GDE goes even further, and is more comprehensive than GO.
Even though the always clever Keynes temporarily buried J.-B. Say, the great Say is back. With that, the relative importance of consumption and government expenditures withers away (see the accompanying bar charts). And, yes, the alleged importance of fiscal policy withers away, too.
Contrary to what the standard textbooks have taught us and what that pundits repeat ad nauseam, consumption is not the big elephant in the room. The elephant is business expenditures.
“Individuals who cannot master their emotions are ill-suited to profit from the investment process.”
- Ben Graham.
“What really broke Germany was the constant taking of the soft political option in respect of money..
“Money is no more than a medium of exchange. Only when it has a value acknowledged by more than one person can it be so used. The more general the acknowledgement, the more useful it is. Once no one acknowledged it, the Germans learnt, their paper money had no value or use – save for papering walls or making darts. The discovery which shattered their society was that the traditional repository of purchasing power had disappeared, and that there was no means left of measuring the worth of anything. For many, life became an obsessional search for Sachverte, things of ‘real’, constant value: Stinnes bought his factories, mines, newspapers. The meanest railway worker bought gewgaws. For most, degree of necessity became the sole criterion of value, the basis of everything from barter to behaviour. Man’s values became animal values. Contrary to any philosophical assumption, it was not a salutary experience.
“What is precious is that which sustains life. When life is secure, society acknowledges the value of luxuries, those objects, materials, services or enjoyments, civilised or merely extravagant, without which life can proceed perfectly well but which make it much pleasanter notwithstanding. When life is insecure, or conditions are harsh, values change. Without warmth, without a roof, without adequate clothes, it may be difficult to sustain life for more than a few weeks. Without food, life can be shorter still. At the top of the scale, the most valuable commodities are perhaps water and, most precious of all, air, in whose absence life will last only a matter of minutes. For the destitute in Germany and Austria whose money had no exchange value left existence came very near these metaphysical conceptions. It had been so in the war. In ‘All Quiet on the Western Front’, Müller died “and bequeathed me his boots – the same that he once inherited from Kemmerick. I wear them, for they fit me quite well. After me Tjaden will get them: I have promised them to him.”
“In war, boots; in flight, a place in a boat or a seat on a lorry may be the most vital thing in the world, more desirable than untold millions. In hyperinflation, a kilo of potatoes was worth, to some, more than the family silver; a side of pork more than the grand piano. A prostitute in the family was better than an infant corpse; theft was preferable to starvation; warmth was finer than honour; clothing more essential than democracy; food more needed than freedom.”
- Adam Fergusson, ‘When Money Dies: the nightmare of the Weimar hyperinflation’.
“We are currently on a journey to the outer reaches of the monetary universe,” write Ronni Stoeferle and Mark Valek in their latest, magisterial ‘In Gold we Trust’. Their outstanding work is doubly valuable because, as George Orwell once wrote,
“In a time of universal deceit, telling the truth is a revolutionary act.”
Orwellian dystopia; Alice-Through-The-Looking-Glass World; state-sanctioned inflationist (deflationist?) nightmare; choose your preferred simile for these dismal times. The reality bears restating: as the good folk of Incrementum rightly point out,
“..the monetary experiments currently underway will have numerous unintended consequences, the extent of which is difficult to gauge today. Gold, as the antagonist of unbacked paper currencies, remains an excellent hedge against rising price inflation and worst case scenarios.”
For several years we have advocated gold as a (necessarily only partial) solution to an unprecedented, global experiment with money that can only end badly for money. The problem with money is that comparatively few people understand it, including, somewhat ironically, many who work in financial services. Rather than debate the merits of gold (we think we have done these to death, and we acknowledge the patience of those clients who have stayed the course with us) we merely allude to the perennial difficulty of investing, namely the psychology of the investor. In addition to being the godfather of value investing, Ben Graham was arguably one of the first behavioural economists. He wisely suggested that investors should
“Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it – even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”
Graham also observed,
“In the world of securities, courage becomes the supreme virtue after adequate knowledge and a tested judgment are at hand.”
Judgment has clearly been tested for anyone who has elected to hold gold during its recent savage sell-off. The beauty of gold, much as with a classic Ben Graham value stock, is that as it gets cheaper, it gets even more attractive. This should be self-evident, in that an ounce of gold remains an ounce of gold irrespective of its price. This puts gold (and value stocks) markedly at odds with momentum investing (which currently holds sway over most markets), where once a price uptrend in a given security breaks to the downside, it’s time to head for the hills.
A few highlights from the Incrementum research:
Since 1971, when President Nixon untethered the dollar from its last moorings to gold, “total credit market debt owed” in the US has risen by 35 times. GDP has risen by just 14 times. The monetary base, on the other hand, has risen by, drum roll please.. some 54 times.
If, like Incrementum and ourselves, you view gold primarily as a monetary asset and not as an industrial commodity, it has clearly made sense to have some exposure to gold during these past four decades of monetary debauchery.
They say a picture paints a thousand words. Consider the following chart of total US credit market debt and ask yourself: is this sustainable?
(Click image to view larger version)
To repeat, there are only three ways of trying to handle a mountain of unsustainable debt. The options are:
1) Maintain economic growth at a sufficient rate to service the debt. We believe this is grossly unlikely.
2) Repudiate the debt. Since we also operate within a debt-based monetary system (in which money is lent into being by banks), default broadly equates to Armageddon.
3) Inflate the debt away.
At the risk of pointing out the obvious, which path do we consider the most likely? Which path does it suit grotesquely over-indebted governments and their client central banks to pursue?
But it does not suit central banks to be caught with their fingers in the inflationary cookie jar, so they now have to pretend that deflation is Public Enemy Number One. Well, deflation is certainly a problem if you have to service unserviceable debts. So it should come as no surprise if this predicament is ultimately resolved through an uncontrollable and perhaps inevitable inflationary or stagflationary mess.
So we have the courage of our knowledge and experience. (In fact, of other people’s experience, too. As the title of Robert Schuettinger and Eamonn Butler’s book puts it, we have ‘Forty Centuries of Wage and Price Controls’ and their inevitable failure to draw upon. We know how this game ends, we just don’t know precisely when.) We have formed a conclusion based on facts and we know our judgment is sound. For the last two years, the crowd has disagreed with us on gold. We think we are right because we think our data and reasoning are right. Not that we don’t see value in other things, too: bonds of unimpeachable quality offering a positive real return; uncorrelated assets; value and ‘deep value’ stocks. And we ask a final question: if not gold, then what? Are we deceiving ourselves – or are our central bankers in the process of deceiving everyone?
[Editor's note: this article, by Brendon Brown, was first published by Mises.org.]
Just as Professor Bernanke exits center stage at the end of Act I of the monetary comedy he created, the scene shifts to Frankfurt. The star of Act II is European Central Bank (ECB) chief Mario Draghi. As we pick up the story, Mr. Draghi has been launching a defense against a phantom threat of deflation.
Meanwhile, our retired star is busy collecting top fees from appreciative “fans,” especially from Wall Street, an area where he once admitted “he had to hold his nose.” What are these fans hoping to gain from their fawning of ex-superstar Bernanke in this new world of monetary transparency, which he proudly claims to have created? Is it the privileged insights that come from networking and knowing how the replacement actor will handle the Fed’s machinery for manipulating long-term interest rates? It has been said that the new chief, rising star Janet Yellen, is “joined at the hip” to her predecessor.
Mario Draghi has yet to acknowledge how much the success of Act II depends on the quantitative easing from Act I, as written and choreographed by Professor Bernanke. The ECB illusionist scored his first big ovation from center stage by proclaiming he would do “whatever it takes to save the euro.” The global asset price inflation plague created by the Bernanke Fed turned those words into immediate virtual reality. Irrationally exuberant investors in their search for yield have been chasing any half-plausible story. Europe with its onetime array of high-yielding markets has been fertile ground for such speculative hypotheses, including Draghi’s boast.
The ECB president is impervious to the critics who say his new strategy of injecting an added strain of asset price inflation into the veins of the European economy, though bolstering the European Monetary Union (EMU) in the short-term, could be fatal in the longer term. That is no laughing matter, because the collapse of EMU in the next great asset price deflation in global markets could bring a monetary revolution.
The essence of comedy is inflexibility, not the volume of the laughter. Don Juan is comic because even when granted a last chance of repentance, or else face death by fire, he cannot change his ways. In the present Bernanke authored comedy, the central bank actors cannot stop trembling for fear of deflation. Yet there has been no actual or threatened monetary deflation during all the years of this long-running show (and well before then).
Under a hypothetical regime of monetary stability the invisible hand of market forces would cause there to be periods of falling and rising prices. The determination of the Federal Reserve to fight those natural down-waves in prices such as occur in business contractions, or under the influence of technological change, has been the source of outbreaks of asset price inflation culminating in great recession and in long-run diminution of economic dynamism.
The Bernanke-ite comedic characters, though, remain convinced that any episode of falling prices would mean economic catastrophe and they have conjured a whole folklore, spanning from the Great Depression to Japan’s Lost Decade, to demonstrate this misleading assertion. ECB chief Mario Draghi cites the fight against deflation as the principal reason for introducing negative interest rates on deposits at the ECB, and a further package of below market cost loans to weak banks.
Yes, prices, and even some wages have been falling in Spain and Italy. But this is simply a result of the unsustainable high levels that resulted from the asset and credit inflation of the last decade, and are now falling slowly in line with real equilibrium tendencies. In Germany, goods-and-services inflation is running at over 1 percent per annum and real estate price inflation is at 10 percent-plus in many cities.
Understandably the German media is voicing complaints by savers being penalized for the camouflaged purpose of aiding crony-capitalist bankers in southern Europe. Mario Draghi gives the standard response of the deflation phobic central banker: Non-conventional policy tools will stimulate a strong recovery which should ultimately benefit the rentier. Who is he kidding?
It appears he is kidding many. The boom in carry trade (the assumption of currency, credit, or maturity risk in the pursuit of higher yields), a key symptom of the asset price inflation disease which ECB and Fed deflation fighting created, now features 10-year yields on Spanish government bonds, below those on US bonds.
Many in the marketplace now question whether there ever really was a crisis in the European Monetary Union. The David Low cartoon comes to mind, John Bull rubs his eyes on March 13, 1939, asking whether the Munich crisis of the previous November was just a bad dream. No wonder the euro stays at high levels.
Back on stage, the Bernanke-ite comedians are now puppeteers, pulling the strings of their puppets, donning their Emperor’s new clothes (in the form of rate manipulation machinery the effectiveness of which depends on market irrationality), and waving their wands. The question of whether the comedians are themselves puppets does not cloud the minds of those in the audience mesmerized by the show, and expecting to cash their profits before speculative temperatures drop. The retired actor and author, in the twilight of his career, knows his appearance fees depend on the show’s continued power to mesmerize the crowd.
Brendan Brown is an associated scholar of the Mises Institute and is author of Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations and The Global Curse of the Federal Reserve: Manifesto for a Second Monetarist Revolution.
Free-market economist Dr. Brian P. Simpson, author of Markets Don’t Fail! (Lanham, Maryland [USA]: Lexington Books, 2005) and a professor at National University in San Diego, CA (USA), has written a new book you might be interested in. The book shows how government interference—particularly in the monetary and banking system—causes the business cycle, including the recessions, depressions, and financial crises that are a part of it. The book also shows how establishing a free market in money and banking would lead to a much more stable monetary and banking environment.
This book should be read by everyone interested in free-market ideas. It is a major contribution to the monetary, banking, and business cycle literature. It builds on the business cycle theory developed by Ludwig von Mises and Friedrich Hayek. The two-volume book is published by Palgrave Macmillan and is titled Money, Banking, and the Business Cycle, with subtitles of Integrating Theory and Practice for volume one and Remedies and Alternative Theories for volume two. Volume one was published in April. Volume two is due out in July.
Part one of volume one shows how manipulations of the supply of money and credit by the government are the primary cause of the cycle. Part two applies the theory to over 100 years of U.S. history to illustrate the explanatory power of the theory. The author uses extensive amounts of data to make his case, including data for interest rates, the rate of profit in the economy, the money supply, the velocity of money, industrial production, GDP/GNP, gross national revenue (a more comprehensive measure of spending and output than GDP/GNP), and more. He shows how the theory explains the Great Depression, the Great Recession, the recession of the early 1980s, and all episodes of the cycle in the U.S. since 1900. In addition, he goes back to 18th century France and Great Britain and the Mississippi and South Sea Bubbles to demonstrate the explanatory power of the theory.
Part one of volume two critiques alternative theories of the cycle, including Keynes’s theories of depressions and fluctuations, Keynesian “sticky” price and wage theory, and real business cycle theory. Part two shows what a free market in money and banking would look like, provides an outline to transition to a free market in money and banking, and gives a detailed explanation of why it would lead to greater stability in the monetary and banking system and raise the rate of economic progress in an economy.
Here are links to the two volumes:
The book would be great for courses on “macroeconomics,” money and banking, or the business cycle. In addition, it would be excellent for collections of university libraries and libraries at other institutions. It is a must read for anyone interested in monetary, banking, and business cycle theory.
A recent report by the Official Monetary and Financial Institutions Forum (OMFIF) entitled Global Public Investor 2014 discussed the investment strategies of 400 government investors split into 157 central banks, 156 government pension funds and 87 sovereign wealth funds, with $29 trillion at their disposal. We normally assume that government pension and sovereign wealth funds are invested to maximise returns and are not used for political and economic purposes, but the same cannot be said of central banks.
According to the OMFIF report the principal reasons central banks are now investing in a wider range of assets include an appetite for higher returns in a low interest rate environment, and geopolitical reasons, whereby stakes in foreign corporations are acquired for strategic purposes. However, central banks are the conduit for a government’s financial management of an economy, and the function has been generally limited to setting interest rates, currency issuance and overseeing the expansion of bank credit. Foreign currency management and gold dealing have been grey areas, with these functions often managed by a government’s finance ministry in an exchange stabilisation fund. So a central bank investing in equities is clearly a case of mission-creep.
Perhaps we should not be surprised that the Peoples Bank of China through its $3.9 trillion State Administration of Foreign Exchange Fund is acquiring equity stakes in European and other companies, but we should note that central banks, such as the Swiss, Danish and Italians are also investing significant sums in equities. Other central banks yet to buy equities will be watching with interest, and analysing the potential benefits of equity investment as an ancillary tool for managing markets.
It will be far easier for the Fed, the ECB or the Bank of England to buy equities if the trail is already blazed by other smaller and respectable central banks. Perhaps an analyst at the Bank for International Settlements will open the door by writing paper on the subject. Given the abject failure of monetary policy to stimulate the major advanced economies, surely it is only a matter of time before our “animal spirits” are kept alive with this new tool.
Equity bulls are unlikely to complain. If the ECB can help recapitalise the eurozone’s banks by subscribing to capital issues, what’s not to like? If a failing industrial conglomerate is given a new lease of life by a share support scheme paid for by a central bank, think of all the jobs saved at no apparent cost! By issuing government currency to support industrial investment, Keynes’s dream explicitly stated in the conclusion to his General Theory can finally be realised, with the state replacing despised savers as the source of funding for industrial investment.
The acquisition of equities by central banks, government pension funds and sovereign wealth funds amounts to enormous power to sway markets the state’s way; all that’s required is a bit of inter-departmental cooperation and $29 trillion (and rising) can be fully utilised to this end. This intervention could increase until governments end up as significant shareholders in most major companies. Norway’s Government Pension fund alone is buying 5% of every major listed European company.
So do not under-estimate the potential scope for further government intervention. Politicians and crony-capitalists will relish this new state-sponsored capitalism, which promises to tame bear markets and enhance share options. Unfortunately such idealist thinking is in defiance of economic reality with all the eventual consequences that entails.
Seth Lipsky, the editor of the storied New York Sun
(a brand distinguished by the long residency of Henry Hazlitt), recently, in the Wall Street Journal
, brought to wider attention certain remarkable recent comments by Paul Volcker. Volcker spoke before the May 21st annual meeting of the Bretton Woods Committee at the World Bank Headquarters in Washington, DC. Volcker’s remarks did not present a departure in substance from his long-standing pro-rule position. They nonetheless were striking, newly emphatic both by tone and context.
Volcker, asked by the conference organizer for his preferred topic, declared that he had said:
“What About a New Bretton Woods???” – with three question marks. The two words, “Bretton Woods”, still seem to invoke a certain nostalgia – memories of a more orderly, rule-based world of financial stability, and close cooperation among nations. Following the two disasters of the Great Depression and World War II that at least was the hope for the new International Monetary Fund, and the related World Bank, the GATT and the OECD.
No one here was actually present at Bretton Woods, but that was the world that I entered as a junior official in the U.S. Treasury more than 50 years ago. Intellectually and operationally, the Bretton Woods ideals absolutely dominated Treasury thinking and policies. The recovery of trade, the opening of financial markets, and the lifting of controls on current accounts led in the 1950’s and 60’s to sustained growth and stability.
The importance, especially from a speaker of Volcker’s stature presenting among the current heads of the two leading Bretton Woods institutions, the IMF’s Christine Lagarde, and the World Bank Group’s Jim Yong Kim, among other luminaries, potentially has radical implications. Volcker provided a quick and precise summary of the monetary and financial anarchy which succeeded his dutiful dismantling of Bretton Woods:
Efforts to reconstruct the Bretton Woods system, either partially at the Smithsonian or more completely in the subsequent negotiations of the Committee of 20, ultimately failed. The practical consequence, and to many the ideological victory, was a regime of floating exchange rates. Somehow, the intellectual and convenient political argument went, differences among national financial and economic policies, shifts in competitiveness and in inflation rates, all could be and would be smoothly accommodated by orderly movements in exchange rates.
How’s that working out for us? Volcker played an instrumental role in dutifully midwifing, as Treasury undersecretary for monetary affairs under the direction of Treasury Secretary John Connally the “temporary” closing of the gold window announced to the world on August 15, 1971 by President Nixon. Volcker now unequivocally indicts the monetary regime he played a key role in helping to foster.
By now I think we can agree that the absence of an official, rules-based cooperatively managed, monetary system has not been a great success. In fact, international financial crises seem at least as frequent and more destructive in impeding economic stability and growth.
The United States, in particular, had in the 1970’s an unhappy decade of inflation ending in stagflation. The major Latin American debt crisis followed in the 1980’s. There was a serious banking crisis late in that decade, followed by a new Mexican crisis, and then the really big and damaging Asian crisis. Less than a decade later, it was capped by the financial crisis of the 2007-2009 period and the great Recession. Not a pretty picture.
Volcker fully recognizes the difficulties in restoring a rule-based well functioning system both in his speech and in this private comment to Lipsky made thereafter. Lipsky: “It’s easy to say what’s wrong,” Mr. Volcker told me over the weekend, “but sensible reforms are a pretty tough thing.”
The devil, of course, is in the details. What rule should prevail? There is an almost superstitious truculence on the part of world monetary elites to consider the restoration of the gold standard. And yet, the Bank of England published a rigorous and influential study in December 2011, Financial Stability Paper No. 13, Reform of the International Monetary and Financial System. This paper contrasts the empirical track record of the fiduciary dollar standard directed by Secretary Connally and brought into being (and then later administered by) Volcker. It determines that the fiduciary dollar standard has significantly underperformed both the Bretton Woods gold exchange standard and the classical gold standard in every major category.
As summarized by Forbes.com
contributor Charles Kadlec, the Bank of England found
When compared to the Bretton Woods system, in which countries defined their currencies by a fixed rate of exchange to the dollar, and the U.S. in turn defined the dollar as 1/35 th of an ounce of gold:
- Economic growth is a full percentage point slower, with an average annual increase in real per-capita GDP of only 1.8%
- World inflation of 4.8% a year is 1.5 percentage point higher;
- Downturns for the median countries have more than tripled to 13% of the total period;
- The number of banking crises per year has soared to 2.6 per year, compared to only one every ten years under Bretton Woods;
That said, the Bank of England paper resolves by calling for a rules-based system, without specifying which rule. Volcker himself presents as oddly reticent about considering the restoration of the “golden rule.” Yet, as recently referenced in this column, in his Foreword to Marjorie Deane and Robert Pringle’s The Central Banks (Hamish Hamilton, 1994) he wrote:
It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less. By and large, if the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with ‘free banking.’ The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy.
There is an active dispute in Washington between Republicans, who predominantly favor a rule-based monetary policy, and Democrats, who predominantly favor a discretion-based monetary policy. The Republicans have not specified the rule they wish to be implemented. The specifics matter.
There is an abundance of purely empirical evidence for the gold standard’s effectiveness in creating a climate of equitable prosperity. The monetary elites still flinch at discussion the gold option. That said, the slow but sure rehabilitation of the legitimacy of the gold standard as a policy option was put into play by one of their own, no less than the then World Bank Group president Robert Zoellick, in an FT
op-ed, The G20 must look beyond Bretton Woods.
There he observed, in part, that “Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.”
There are many eminent and respectable elite proponents of the gold standard. Foremost among these Reagan Gold Commissioners Lewis E. Lehrman (with whose Institute this writer has a professional association) and Ron Paul, and Forbes Media CEO Steve Forbes, coauthor of a formidable new book, Money
, among them. There are many more, too many to list here.
In the penultimate paragraph of his remarks to the Bretton Woods Committee Volcker observes:
Walter Bagehot long ago set out succinctly a lesson from experience: “Money will not manage itself”. He then spoke from the platform of the Economist to the Bank of England. Today it is our mutual interdependence that requires a degree of cooperation and coordination that too often has been lacking on an international scale.
As the great Walter Layton, editor of the Economist, wrote in 1925, “the choice which presents itself is not one between a theoretical standard on the one hand and gold with all its imperfections on the other, but between the gold standard … and no control at all.” “No control at all” anticipates Volcker’s own critique.
If Chairman Volcker overcame his aversion to considering the gold standard as a respectable option for consideration he just might find that his his stated concern “We are long ways from (a new Bretton Woods conference)” may be exaggerated. A golden age of equitable prosperity and financial stability is closer than Mr. Volcker believes.
The corollary to Volcker’s dictum, “ultimately the power to create is the power to destroy” is that the power to destroy is the power to create. It is time, and past time, Mr. Volcker, to give full and respectful consideration to the gold standard which served the world very well indeed and would serve well again.
This article was previously published at Forbes.com