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Economics

Swiss National Bank abandons franc’s cap against the euro

On January 15th 2015 the Swiss National Bank (SNB) has announced an end to its three year old cap of 1.20 franc per euro. (The SNB introduced the cap in September 2011). The SNB has also reduced its policy interest rate to minus 0.75% from minus 0.25%. The Swiss franc appreciated as much as 41% to 0.8517 per euro following the announcement, the strongest level on record – it settled during the day at around 0.98 per euro.

EuroCHF
We suggest that the key factor in determining a currency rate of exchange is relative monetary pumping. Over time, if the rate of growth of money supply in country A exceeds the rate of growth of money supply in country B then that country’s currency rate of exchange will come under pressure versus the currency of B, all other things being equal.
Whilst other variables such as the interest rate differential or economic activity also drive the currency rate of exchange, they are of a transitory and not of a fundamental nature. Their influence sets in motion an arbitrage that brings the rate of exchange in line with the influence of the money growth differential.
We hold that until now the rise in the money growth differential between Switzerland and the EMU during July 2011 and April 2012 was dominating the currency rate of exchange scene. (It was pushing the franc down versus the euro).The setting of a cap of 1.20 to the euro to supposedly defend exports was an unnecessary move since the franc was in any case going to weaken. The introduction of the cap however prevented the arbitrage to properly manifest itself thereby setting in motions various distortions. (Note again the money growth differential was weakening the franc versus the euro).
A fall in the money growth differential between April 2012 and April 2013 is starting to dominate the currency scene at present i.e. it strengthens the franc against the euro. So from this perspective it is valid to remove the cap and allow the arbitrage to establish the “true” value of the franc. (This reduces the need to pump domestic money in order to defend the cap of 1.20). Observe that as opposed to 2011, this time around, by allowing the franc to find its “correct” level the SNB it would appear has decided to trust the free market.
Note that since April 2013 the money growth differential has been rising – working towards the weakening of the franc versus the euro – and this raises the likelihood that the SNB might decide again some time in the future on a new shock treatment.

 

AMSSwissVsEuroGrowth

We hold that by tampering with the foreign exchange market the SNB sets in motion fluctuations in the growth momentum of money supply (AMS) and this in turn generates the menace of the boom/bust cycles. (Note the close correlation between the fluctuations in the growth momentum of foreign exchange reserves, the SNB’s balance sheet and AMS).

 

SNBAssetsVsForeignReserves

Also, observe that by introducing the cap and then removing it the SNB, contrary to its own intentions, has severely shocked various activities such as exports. Note that the SNB is supposedly meant to generate a stable economic environment.

Economics

Should a Bank in Difficulties Receive Assistance?

This was the question put to me by Treasury Committee Chairman Andrew Tyrie MP when I appeared before the Committee on January 6th to give evidence on the Bank of England’s latest Financial Stability Report.

This is a question to which many of us on our side have given much thought and I believe it to be the single most important question in the whole field of bank regulatory policy.

I was nonetheless caught off-guard when Mr. Tyrie asked it at the beginning of the session – I was expecting questions on the Bank’s latest nonsense, the results of its new stress tests – and my initial response was less than it should have been. But no excuse: it was a perfectly reasonable and entirely foreseeable question – the obvious question, even – and I still didn’t see it coming. Reminds me of the blunders I would occasionally make when I played competitive chess: I obviously haven’t improved much.

Thankfully, he asked me the same question again at the close of the session, and his doing so allowed me to give the correct answer clearly, an emphatic ‘No’. However, by this point there was no time to elaborate on the reasons why a bank in difficulties should be denied assistance.

These reasons go straight to the whole can of worms and my follow-up letter to Mr. Tyrie should, I hope, help to set the record straight.

My message to other advocates of free markets is that leaving aside the usual bailouts-are-bad stuff, we really should give more thought to what an Armageddon Plan B might look like: Yes, no bailouts would be best, even in our intervention-infested system, but in that case why do we humour lender-of-last-resort and, more to the point, if the government is even considering intervention in what it (rightly or wrongly) sees as an emergency in which something-really-ought-to-be-done-NOW, then what should we advise it to do – other than ‘Don’t’?

Mark my words: if we don’t give the government constructive advice, it will do what it always does when a crisis breaks out: it will panic and the chances of any sensible policy response will be zero.

So here is the text of the letter, dated January 12th:

“Dear Mr. Tyrie,

I would like to thank you for the opportunity to give evidence to the Treasury Committee at its meeting on January 6th.

At that meeting you asked me if the authorities should assist a bank that gets into difficulties.

My answer is ‘No’ but I should like to elaborate.

Consider first a free or laissez-faire banking system in which there is no central bank, no financial regulation and no other state interventions such as deposit insurance. In such a system, competitive pressures would force the banks to be financially strong; bankers who ran down their banks’ capital ratios or took excessive risks would eventually lose their depositors’ confidence and be run out of business, so losing their market share to more conservative and better-run competitors. Bankers themselves would have serious skin in the game and therefore have strong incentives to keep their banks sound: for them, bank failure would be personally costly. Banks would then be tightly governed and conservatively risk-managed, and the banking system as a whole would be highly stable.

There would still be occasional failures due to the incompetence of individual bankers, but these would be few and far between, and not pose systemic threats.

These claims from free-banking theory are broadly confirmed by the historical experiences of the many free or loosely regulated banking systems of the past, most notably the experiences of Scotland pre-1845 and 19th century Canada.

In such a system, there is no good case for official assistance to any bank in difficulties. A bank failure would be painful to those involved, but the possibility of bankruptcy is unavoidable in any industry in a healthy capitalist economy, and this includes the banking industry. Letting a badly run bank fail also sends out the right signals – it encourages other bankers to avoid the same mistakes, it encourages depositors to be careful with the banks they choose and it avoids the moral hazards inevitably created by any policy of assistance.

Modern banking systems differ from these systems because of the presence of extensive systems of state intervention, including a central bank, a central bank lender of last resort function, deposit insurance, capital adequacy regulation and other forms of financial regulation. In different ways, each of these interventions makes the banking system less stable: central banks through erratic and usually loose monetary policies, which create inflation and fuel asset price cycles, and generally destabilise the macroeconomy; the lender of last resort and deposit insurance by creating moral hazards that lead to excessive risk-taking by bankers; capital regulation by creating short-termist incentives for banks to reduce their capital (e.g., by playing games with risk models and risk weights); and financial regulation generally by its large compliance costs and its stifling of innovation. Over time, these interventions have made the banking system weaker and weaker, even though their usual stated intention was to strengthen the banking system rather than to weaken it.

However, even with the banking system already seriously weakened by a long history of misguided government interventions, the best policy response is still to refuse assistance to banks in difficulties. I say this for two main reasons:

  • the systemic effects of bank difficulties tend to be exaggerated even in a systemic crisis, sometimes grossly so; and

  • interventionist policy responses tend to make matters even worse.

The ideal response by policymakers is to refuse assistance point-blank – and to announce such a policy in advance so the bankers know where they stand.

Policymakers should follow the advice of Lord Liverpool, who was PM at the time of the last systemic banking crisis pre-2007, that of December 1825. In May that year, he foresaw the looming crisis and warned the House of Lords about the “general spirit of speculation, which was going beyond all bounds and was likely to bring about the greatest mischief on numerous individuals.” He wished it to be “clearly understood” that those involved “entered on their speculations at their own peril and risk” and he thought it his duty to declare that he would “never advise the introduction of any bill for their relief; on the contrary, if any such measure were proposed, he would oppose it” and he hoped Parliament would reject it.

In our current system such a response would require political leadership with uncommon vision and nerves of steel. When the next crisis occurs, it will explode unexpectedly, taking policymakers off guard. They will be under extreme pressure to respond quickly – probably within hours – on the basis of inadequate information, whilst bankers lobby intensely for immediate assistance: if we don’t get bailed out, the world will end, etc., the usual scare mongering. Under such circumstances, it would be extremely difficult for even the best political leadership to avoid being dragged into making the same mistakes made repeatedly in previous crises.

These mistakes include:

  • panicky rescues, which are later shown to be unnecessary, ill-judged and in some cases illegal;

  • the abandonment of previous ‘commitments’ to let badly run institutions fail;

  • bankers being rewarded for their failures by being made personally better off than they would have been had their banks been allowed to fail; and

  • more regulation or regulatory reshuffles accompanied by the usual empty promises that ‘it’ won’t happen again, made by the very people who had no idea what they were doing when they were in charge the last time round.

So how can we avert such outcomes? A good start would be an Act to prohibit future assistance: as much as possible within the confines of our constitution, we should seek to tie the government to the mast. “Much as I would like to help you”, the PM can say, “my hands are tied.”

But even with this Act in place, there is still the difficult question: if the government does respond to the next crisis, then what should it do?

To that question I would propose a publicly disclosed Plan B, whose main features would include:

  • a programme to keep the banking system as a whole operating at a basic level to prevent widespread economic collapse;

  • fast-track bankruptcy processes to resolve problem banks and, where possible, return them to operation as quickly as possible;

  • a prohibition of cronyist sweetheart deals for individual banks or bankers;

  • provisions to ensure that senior managers of any failed banks are made strictly liable to severe personal financial penalties;

  • a holding-to-account of senior bankers, regulators and policymakers, including the opening of criminal investigations into the activities of any banks that fail;

  • the establishment of a legal regime that imposes high standards of personal liability on senior bankers;

  • the restoration of sound accountancy standards; and

  • a radical programme to deregulate the banking industry.

This programme would include the abolition of the current regulatory structure including the PRA and FCA, the ending of deposit insurance, the UK’s withdrawal from the Basel system of capital regulation, and the reform (and preferably, abolition) of the Bank of England. These reforms would rein-in the out-of-control moral hazards that permeate our current banking system and restore the personal responsibility, tight governance and conservative risk-taking that are the keys to a sound banking system.

Contingency planning for the next crisis should also provide for only two possible responses by the authorities: either Plan A (i.e., do nothing) or Plan B as just set out. Any intermediate response should be prohibited, as that would merely open the door to the usual mistakes that the authorities are prone to make in such circumstances.

In short, in response to your question about whether a bank should receive assistance, my answer would be ‘No’, but if we are to avoid another bungled policy response when the next crisis occurs it would be wise to have a credible Plan B in place to address upfront the Armegeddon scenario of a possible systemic collapse. And if it does intervene, the government should use the opportunity to clean up banksterism once and for all and restore a sound banking system based on the principles of personal responsibility and laissez-faire.

Yours Sincerely

Kevin Dowd,

Durham University/Cobden Partners [etc.]”

There is a lot more to say on this subject, but one of the points that emerges most clearly for me is the pressing need for free-market narratives of the financial crisis, blow-by-blow accounts of how it should and might have been. In this context – and off the top of my head – I would particularly recommend the following (with apologies to those whose work I have overlooked):

John A. Allison, The Financial Crisis and the Free Market Cure, McGraw-Hill 2013, esp. chapters 14-17.

Richard Kovacevich, “The Financial Crisis: Why the Conventional Wisdom has it All Wrong”, Cato Journal Vol. 34, No. 3 (Fall 2014): 541-556.

Vern McKinley, “Run, Run, Run: Was the Financial Crisis Panic over Institution Runs Justified?Cato Policy Analysis 747, April 10, 2014

George A. Selgin, “Operation Twist-the-Truth: How the Federal Reserve Misrepresents its History and Performance”, Cato Journal Vol. 34, No. 2 (Spring/Summer 2014): 229-263.

These are all US-oriented of course and we badly need to work on similar narratives for the UK, Ireland and Europe.

But going back to the Treasury Committee, most of the discussion was on the regulatory risk models – or more precisely, on what is wrong with regulatory risk modelling and in particular, the Bank’s stress tests. I have to say, too, that I was greatly heartened to see the skepticism of the MPs towards the models and their openness towards our ideas, much of which is obviously down to the pathbreaking work that Steve Baker is doing on the Committee. But let me come to all that in another posting.

Economics

Greece, Germany and the ECB: and what it means for Bonds, Stocks and the Euro

Greece is back in the spotlight amid renewed fears of a break-up of the Euro as the Syriza party show a 3.1% lead over the incumbent New Democracy in the latest Rass opinion poll – 4thJanuary. The average of the last 20 polls – dating back to 15th December shows Syriza with a lead of 4.74% capturing 31.9% of the vote.

These election concerns have become elevated since the publication of an article in Der Spiegel Grexit Grumblings: Germany Open to Possible Greek Euro Zone Exit -suggesting that German Chancellor Merkel is now of the opinion that the Eurozone (EZ) can survive without Greece. Whilst Steffen Seibert – Merkle’s press spokesman – has since stated that the “political leadership” isn’t working on blueprints for a Greek exit, the idea that Greece might be “let go” has captured the imagination of the markets.

A very different view, of the potential damage a Greek exit might cause to the EZ, is expressed by Market Watch – Greek euro exit would be ‘Lehman Brothers squared’: economistquoting Barry Eichengreen, speaking at the American Economic Association conference, who described a Greek exit from the Euro:-

In the short run, it would be Lehman Brothers squared.

Writing at the end of last month the Economist – The euro’s next crisis described the expectation of a Syriza win in the forthcoming elections:-

In its policies Syriza represents, at best, uncertainty and contradiction and at worst reckless populism. On the one hand Mr Tsipras has recanted from his one-time hostility to Greece’s euro membership and toned down his more extravagant promises. Yet, on the other, he still thinks he can tear up the conditions imposed by Greece’s creditors in exchange for two successive bail-outs. His reasoning is partly that the economy is at last recovering and Greece is now running a primary budget surplus (ie, before interest payments); and partly that the rest of the euro zone will simply give in as they have before. On both counts he is being reckless.

In theory a growing economy and a primary surplus may help a country repudiate its debts because it is no longer dependent on capital inflows.

The complexity of the political situation in Greece is such that the outcome of the election, scheduled for 25th January, will, almost certainly, be a coalition. Syriza might form an alliance with the ultra-right wing Golden Dawn who have polled an average of 6.49% in the last 20 opinion polls, who are also anti-Austerity, but they would be uncomfortable bedfellows in most other respects. Another option might be the Communist Party of Greece who have polled 5.8% during the same period. I believe the more important development for the financial markets during the last week has been the change of tone in Germany.

The European bond markets have taken heed, marking down Greek bonds whilst other peripheral countries have seen record low 10 year yields. 10 year Bunds have also marched inexorably upwards. European stock markets, by contrast, have been somewhat rattled by the Euro Break-up spectre’s return to the feast. It may be argued that they are also reacting to concerns about collapsing oil prices, the geo-political stand-off with Russia, the continued slow-down in China and other emerging markets and general expectations of lower global growth. In the last few sessions many stock markets have rallied strongly, mainly on hopes of aggressive ECB intervention.

Unlike the Economist, who are concerned about EZ contagion, Brookings – A Greek Crisis but not a Euro Crisis sees a Euro break-up as a low probability:-

A couple of years ago the prospect of a Syriza-led government caused serious tremors in European markets because of the fear that an extremely bad outcome in Greece was possible, such as its exit from the Euro system, and that this would create contagion effects in Portugal and other weaker nations. Fortunately, Europe is in a much better situation now to withstand problems in Greece and to avoid serious ramifications for other struggling member states. The worst of the crisis is over in the weak nations and the system as a whole is better geared to support those countries if another wave of market fears arise.

It is quite unlikely that Greece will end up falling out of the Euro system and no other outcome would have much of a contagion effect within Europe. Even if Greece did exit the Euro, there is now a strong possibility that the damage could be confined largely to Greece, since no other nation now appears likely to exit, even in a crisis.

Neither Syriza nor the Greek public (according to every poll) wants to pull out of the Euro system and they have massive economic incentives to avoid such an outcome, since the transition would almost certainly plunge Greece back into severe recession, if not outright depression. So, a withdrawal would have to be the result of a series of major miscalculations by Syriza and its European partners. This is not out of the question, but the probability is very low, since there would be multiple decision points at which the two sides could walk back from an impending exit.

I think The Guardian – Angela Merkel issues New Year’s warning over rightwing Pegida group – provides an insight into the subtle change in Germany’s stance:-

German chancellor Angela Merkel in a New Year’s address deplored the rise of a rightwing populist movement, saying its leaders have “prejudice, coldness, even hatred in their hearts”.

In her strongest comments yet on the so-called Patriotic Europeans Against the Islamisation of the West (Pegida), she spoke of demonstrators shouting “we are the people”, co-opting a slogan from the rallies that led up to the fall of the Berlin Wall 25 years ago.

“But what they really mean is: you are not one of us, because of your skin colour or your religion,” Merkel said, according to a pre-released copy of a televised speech she was to due to deliver to the nation on Wednesday evening.

“So I say to all those who go to such demonstrations: do not follow those who have called the rallies. Because all too often they have prejudice, coldness, even hatred in their hearts.”

Concern about domestic politics in Germany and rising support for the ultra right-wing Pegida party makes the prospect of allowing Greece to leave the Euro look like the lesser of two evils. Yet a Greek exit and default on its Euro denominated obligations would destabilise the European banking system leading to a spate of deleveraging across the continent. In order to avert this outcome, German law makers have already begun to soften their “hard-line” approach, extending the olive branch of a potential renegotiation of the terms and maturity of outstanding Greek debt with whoever wins the forthcoming election. I envisage a combination of debt forgiveness, maturity extension and restructuring of interest payments – perish the thought that there be a sovereign default.

Carry Concern

Last month the BIS – Financial stability risks: old and new caused alarm when it estimated non-domestic US$ denominated debt of non-banks to be in the region of $9trln:-

Total outstanding US dollar-denominated debt of non-banks located outside the United States now stands at more than $9 trillion, having grown from $6 trillion at the beginning of 2010. The largest increase has been in corporate bonds issued by emerging market firms responding to the surge in demand by yield-hungry fixed income investors.

Within the EZ the quest for yield has been no less rabid, added to which, risk models assume zero currency risk for EZ financial institutions that hold obligations issued in Euro’s. The preferred trade for many European banks has been to purchase their domestic sovereign bonds because of the low capital requirements under Basel II. Allowing banks to borrow short and lend long has been tacit government policy for alleviating bank balance sheet shortfalls, globally, in every crisis since the great moderation, if not before. The recent rise in Greek bond yields is therefore a concern.

An additional concern is that the Greek government bond yield curve has inverted dramatically in the past month. The three year yields have risen most precipitously. This is a problem for banks which borrowed in the medium maturity range in order to lend longer. Fortunately most banks borrow at very much shorter maturity, nonetheless the curve inversion represents a red flag : –

Date 3yr 10yr Yield curve
14-Oct 4.31 7.05 2.74
29-Dec 10.14 8.48 -1.66
06-Jan 13.81 9.7 -4.11

 

Source: Investing.com

Over the same period Portuguese government bonds have, so far, experienced little contagion:-

Date 3yr 10yr Yield curve
14-Oct 1.03 2.56 1.53
29-Dec 1.06 2.75 1.69
06-Jan 0.92 2.56 1.64

 

Source: Investing.com

EZ Contagion

Greece received Euro 245bln in bail-outs from the Troika; if they should default, the remaining EZ 17 governments will have to pick up the cost. Here is the breakdown of state guarantees under the European Financial Stability Facility:-

 

Country Guarantee Commitments Eur Mlns Percentage
Austria 21,639.19 2.78%
Belgium 27,031.99 3.47%
Cyprus 1,525.68 0.20%
Estonia 1,994.86 0.26%
Finland 13,974.03 1.79%
France 158,487.53 20.32%
Germany 211,045.90 27.06%
Greece 21,897.74 2.81%
Ireland 12,378.15 1.59%
Italy 139,267.81 17.86%
Luxembourg 1,946.94 0.25%
Malta 704.33 0.09%
Netherlands 44,446.32 5.70%
Portugal 19,507.26 2.50%
Slovakia 7,727.57 0.99%
Slovenia 3,664.30 0.47%
Spain 92,543.56 11.87%
EZ 17 779,783.14 100%

Assuming the worst case scenario of a complete default – which seems unlikely even given the par less state of Greek finances – this would put Italy on the hook for Eur 43bln, Spain for Eur 28.5bln, Portugal for Eur 6bln and Ireland for Eur 3.8bln.

The major European Financial Institutions may have learned their lesson, about over-investing in the highest yielding sovereign bonds, during the 2010/2011 crisis – according to an FTinterview with JP Morgan Cazenove, exposure is “limited” – but domestic Greek banks are exposed. The interconnectedness of European bank exposures are still difficult to gauge due to the lack of a full “Banking Union”. Added to which, where will these cash-strapped governments find the money needed to meet this magnitude of shortfall?

The ECBs response

ECB Balance Sheet - Bloomberg

Source: Bloomberg

In an interview with Handelsblatt last week, ECB president Mario Draghi reiterated the bank’s commitment to expand their balance sheet from Eur2 trln to Eur3 trln if conditions require it. Given that Eurostat published a flash estimate of Euro area inflation for December this week at -0.2% vs +0.3% in November, I expect the ECB to find conditions requiring a balance sheet expansion sooner rather than later. Reuters – ECB considering three approaches to QE – quotes the Dutch newspaper Het Financieele Dagbad expecting one of three actions:-

…one option officials are considering is to pump liquidity into the financial system by having the ECB itself buy government bonds in a quantity proportionate to the given member state’s shareholding in the central bank.

A second option is for the ECB to buy only triple-A rated government bonds, driving their yields down to zero or into negative territory. The hope is that this would push investors into buying riskier sovereign and corporate debt.

The third option is similar to the first, but national central banks would do the buying, meaning that the risk would “in principle” remain with the country in question, the paper said.

The issue of “monetary financing” – forbidden under Article 123 of the Lisbon Treaty – has still to be resolved, so Outright Monetary Transactions (OMT) in respect of EZ government bonds are still not a viable policy option. That leaves Covered bonds – a market of Eur 2.6trln of which only around Eur 600bln are eligible for the ECB to purchase – and Asset Backed Securities (ABS) with around Eur 400bln of eligible securities. These markets are simply not sufficiently liquid for the ECB to expand its balance sheet by Eur 1trln. In 2009 they managed to purchase Eur 60bln of Covered bonds but only succeeded in purchasing Eur 16.9bln of the second tranche – the bank had committed to purchase up to Eur 40bln.

Since its inception in July 2009 the ECB have purchased just shy of Eur 108bln of Covered bonds and ABS: –

Security Primary Secondary Total Eur Mlns Inception Date
ABS N/A N/A 1,744 21/11/2014
Covered Bonds 1 N/A N/A 28,817 02/07/2009 *
Covered Bonds 2 6015 10375 16,390 03/11/2011
Covered Bonds 3 5245 24387 29,632 20/10/2014
Total 76,583
* Original purchase Eur 60bln

Source: ECB

These amounts are a drop in the ocean. If the ECB is not permitted to purchase government bonds what other options does it have? I believe the alternative is to follow the lead set by the Bank of Japan (BoJ) in purchasing corporate bonds and common stocks. To date the BoJ has only indulged in relatively minor “qualitative” easing; the ECB has an opportunity to by-pass the fragmented European banking system and provide finance and permanent capital directly to the European corporate sector.

Over the past year German stocks has been relatively stable whilst Greek equities, since the end of Q2, have declined. Assuming Greece does not vote to leave the Euro, Greek and other peripheral European stocks will benefit if the ECB should embark on its own brand of Qualitative and Quantitative Easing (QQE):-

Athens_vs_DAX_one_year bloomberg

Source: Bloomberg               Note:      Blue = Athens SE Composite               Purple = DAX

It is important to make a caveat at this juncture. The qualitative component of the BoJ QQE programme has been derisory in comparison to their buying of JGBs; added to which, whilst the socialisation of the European corporate sector is hardly political anathema to many European politicians it is a long way from “lending at a penal rate in exchange for good collateral” – the traditional function of a central bank in times of crisis.

Conclusion and investment opportunities

European Government Bonds

Whilst the most likely political outcome is a relaxation of Article 123 of the Lisbon Treaty, allowing the ECB, or the national Central Bank’s to purchase EZ sovereign bonds, much of the favourable impact on government bond yields is already reflected in the price. 10 year JGBs – after decades of BoJ buying – yield 30bp, German Bunds – without the support of the ECB – yield 46bp. Aside from Greek bonds, peripheral members of the EZ have seen their bond yields decline over the past month. If the ECB announce OMT I believe the bond rally will be short-lived.

European Stocks

Given the high correlation between stocks markets in general and developed country stock markets in particular, it is dangerous to view Europe in isolation. The US market is struggling with a rising US$ and collapsing oil price. These factors have undermined confidence in the short-term. The US market is also looking to the Europe, since a further slowdown in Europe, combined with weakness in emerging markets act as a drag on US growth prospects. On a relative value basis European stocks are moderately expensive. The driver of performance, as it has been since 2008, will be central bank policy. A 50% increase in the size of the ECB balance sheet will be supportive for European stocks, as I have mentioned in previous posts, Ireland is my preferred investment, with a bias towards the real-estate sector.

The Euro

Whilst the EUR/USD rate continues to decline the Nominal Effective Exchange Rate as calculated by the ECB, currently at 98, is around the middle of its range (81 – 114) since the inception of the currency and still some way above the recent lows seen in July 2012 when it reached 94. The October 2000 low of 81 is far away.

If a currency war is about to break-out between the major trading nations, the Euro doesn’t look like the principal culprit. I expect the Euro to continue to decline, except, perhaps against the JPY. Against the GBP a short EUR exposure will be less volatile but it will exhibit a more political dimension since the UK is a natural safe haven when an EZ crisis is brewing.

Money

The present monetary system the key cause for boom-bust cycles

Originally, paper money was not regarded as money but merely as a representation of gold. Various paper certificates represented claims on gold stored with the banks. Holders of paper certificates could convert them into gold whenever they deemed necessary. Because people found it more convenient to use paper certificates to exchange for goods and services, these certificates came to be regarded as money.

 

Paper certificates that are accepted as the medium of exchange open the scope for fraudulent practice. Banks could now be tempted to boost their profits by lending certificates that were not covered by gold. In a free-market economy, a bank that over-issues paper certificates will quickly find out that the exchange value of its certificates in terms of goods and services will fall. To protect their purchasing power, holders of the over-issued certificates naturally attempt to convert them back to gold. If all of them were to demand gold back at the same time, this would bankrupt the bank. In a free market then, the threat of bankruptcy would restrain banks from issuing paper certificates unbacked by gold. On this Mises wrote,

 

People often refer to the dictum of an anonymous American quoted by Tooke: “Free trade in banking is free trade in swindling.” However, freedom in the issuance of banknotes would have narrowed down the use of banknotes considerably if it had not entirely suppressed it. It was this idea which Cernuschi advanced in the hearings of the French Banking Inquiry on October 24, 1865: “I believe that what is called freedom of banking would result in a total suppression of banknotes in France. I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.”1

This means that in a free-market economy, paper money cannot assume a “life of its own” and become independent of commodity money.
The government can, however, bypass the free-market discipline. It can issue a decree that makes it legal for the over-issued bank not to redeem paper certificates into gold. Once banks are not obliged to redeem paper certificates into gold, opportunities for large profits are created that set incentive to pursue an unrestrained expansion of the supply of paper certificates. The uncurbed expansion of paper certificates raises the likelihood of setting off a galloping rise in the prices of goods and services that can lead to the breakdown of the market economy.

 
To prevent such a breakdown, the supply of the paper money must be managed. The main purpose of managing the supply is to prevent various competing banks from over-issuing paper certificates and from bankrupting each other. This can be achieved by establishing a monopoly bank-i.e., a central bank-that manages the expansion of paper money.
To assert its authority, the central bank introduces its paper certificates, which replace the certificates of various banks. (The central bank’s money purchasing power is established on account of the fact that various paper certificates, which carry purchasing power, are exchanged for the central bank money at a fixed rate. In short, the central bank paper certificates are fully backed by banks certificates, which have the historical link to gold.)

 

The central bank paper money, which is declared as the legal tender, also serves as a reserve asset for banks. This enables the central bank to set a limit on the credit expansion by the banking system. Note that through ongoing monetary management, i.e., monetary pumping, the central bank makes sure that all the banks can engage jointly in the expansion of credit out of “thin air” via the practice of fractional reserve banking. The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out, because the redemption of each will cancel the other redemption out. In short, by means of monetary injections, the central bank makes sure that the banking system is “liquid enough” so that banks will not bankrupt each other.
It would appear that the central bank can manage and stabilize the monetary system. The truth, however, is the exact opposite. To manage the system, the central bank must constantly create money “out of thin air” to prevent banks from bankrupting each other. This leads to persistent declines in money’s purchasing power, which destabilizes the entire monetary system.

 
Observe that while, in the free market, people will not accept a commodity as money if its purchasing power is subject to a persistent decline, in the present environment, central authorities are coercively imposing money that suffers from a steady decline in its purchasing power. Since the present monetary system is fundamentally unstable it is not possible to fix it. Even Milton Friedman’s scheme to fix the money rate growth at a given percentage won’t do the trick. After all a fixed percentage growth is still money growth, which leads to the exchange of nothing for something-i.e., economic impoverishment and the boom-bust cycle. Moreover, we can conclude that there cannot be a “correct” money supply rate of growth. Whether the central bank injects money in accordance with economic activity or fixes the rate of growth, it further destabilizes the economy.

 

The central bank can keep the present paper standard going as long as the pool of real wealth is still expanding. Once the pool begins to stagnate-or, worse, shrinks then no monetary pumping will be able to prevent the plunge of the system. A better solution is of course to have a true free market and allow the gold to assert its monetary role. As opposed to the present monetary system in the framework of a gold standard money cannot disappear and set in motion the menace of the boom-bust cycles. In fractional reserve banking, when money is repaid and the bank doesn’t renew the loan, money evaporates. Because the loan has originated out of nothing, it obviously couldn’t have had an owner. In a free market, in contrast, when money i.e. gold is repaid, it is passed back to the original lender; the money stock stays intact.

 

1.  Mises , Human Action p 446.

Economics

Crisis? What Crisis?

[The following is a shortened version of an original which first appeared on the author’s website, www.truesinews.com ]

As Britain fast approaches what is arguably the most intriguingly unpredictable election of the modern era, the question must be also asked, how well situated is the country – economically speaking – to endure such a vigorous test of its political institutions?

To this observer, the answer would be ‘not very well, at all.’ Britain, you see, is rapidly sliding back into its bad old ways of spending too much, saving too little, and all the while allowing the state to loom far too large in people’s affairs, bolstered by the fact that far too many members of the populace are loth to give up their long-accustomed habit of trying to live at their neighbours’ expense and of borrowing from abroad whatever dole transfers the state cannot raise in taxes at home.

Let us start with the latest economic round to see what we mean. Though hours worked in the UK, along with both overall and private sector GDP, are each enviably some 3-5% above the pre-Crash peak – a constellation of which many Eurozone countries can still only dream – this has come about only through a 7-year reduction in real wages of a cumulative 11%.

Pricing people back into jobs this way is one thing – if decidedly more unfair on all the other innocent victims of the Bank of England’s inflationism than would have been a simple pay cut – but it is also significant that, having trended up at around 2.3% per annum for almost four decades, real GDP per hour worked has shown no improvement whatsoever since Northern Rock closed its doors, seven long years ago. If we add in the fact that the UK has officially seen net inward migration of 1.5 million people in that same period, we can perhaps see how much of that growth has been achieved – through the blunt instrument of adding a big slug of low wage, low output, imported labour to the mix.

Sadly, in its policies of determined monetary laxity, Fred Karney’s army have added two malign side-effects to the short term boost to growth for which they are so widely praised. Firstly, the combination of Gilt-enacted QE with near zero interest rates has loosened the constraints on a state sector which still routinely spends a sum equivalent to almost one half of private GDP, with around a sixth of that being borrowed, even now amid a recovery vigorous enough to elicit a full measure of George Osborne’s headline-hogging boastfulness. Alarmingly, too, the punishment of savers and the encouragement of borrowers has reached a point where households have become net debtors at the aggregate level for the first time since the GFC while, simultaneously, non-financial corporates have collectively swung into the red for the first time since they were borrowing to relieve Culpability Brown of his pricey mobile phone airwave licences, back at the height of the Tech Bubble.

Mortgage debt is rising by £20 billion a year, consumer credit by £10 billion (the most since late ’08), student loans by £7 billion. Disposable income grew £29 billion in that same time which means debt:income may be swelling once more, from a point still north of 130%.

As a result, while state prodigality has diminished from its peak deficit of 10.7% of GDP (seen between QI-09 and QI-10) to today’s 5.9%, the non-financial private sector has gone from a point where it was saving 8.8% (and so funding four-fifths of Leviathan’s excesses) to a point where it, too, is now looking for 0.5% of GDP for its own consumptive purposes (all figures 4Q moving averages).

No wonder then that the current account deficit has blown up to a six decade high of 6.0% of GDP, despite the co-existence of a record surplus of 5.1% on the service account (the arithmetically astute will quickly infer that this must entail a similarly swingeing deficit on visible trade – a shortfall which in fact stretches to a hefty 7.1%). For comparison, when Chancellor Dennis Healey suffered the ignominy of appealing to the IMF for help in 1976, the balance of payments was only 1.5% in the red (though the tally had briefly hit 4.3% a year or two before, in the immediate aftermath of the first oil shock).

In fact, if we only look at the latest reported data – those for QIII – there is a chance that the BOP number may be revised to yet a deeper nadir since, in the three months to September, the ONS presently estimates that the public deficit was 5.1% of GDP, while households borrowed a six-year high balance of 2.6% of GDP and corporates took up a 14-year high credit of 2.2%, making for an aggregate shortfall of no less than 9.9%. Subtracting a net positive contribution of 0.2% from the domestic financial sector, that still leaves 9.7% to be financed, in theory, from foreigners and thereby to determine the scale of the current account deficit.

Performing the calculation in a different manner, the UK government has borrowed £109 billion ($167 billion) in the twelve months to September, an overspend which has leaked almost entirely abroad and has thus required a £98 billion ($150 billion) contribution in goods sold on credit from the world beyond Albion’s shining seas.

So, let us forget for a moment the controversy over the gaping hole which persists in the government’s finances and the laughably misnamed policy of ‘austerity’ which the regime has adopted to try to deal with this. Instead, let us lift our eyes to a horizon beyond our shores and we can surely agree that the sum of £130 a month per capita is not at all an unimpressive pace at which to be adding to a net external deficit of £450 billion (25% of GDP) or to an ex-FDI gross liability of £8,840 billion (490% of GDP), against which mountain of potentially nervy obligations the Treasury disposes of a defence against a classic ‘sudden stop’ of a paltry £63 billion in FX reserves (equal to around two months’ worth of goods imports).

Thus, not only is a full-employment Britain a country which must run an unsustainably large external deficit (since it is already setting records with 6% of the workforce still out of a job), but it has again been seduced into being one where all sectors are borrowing, not saving, largely in order to finance present consumption, meaning it is prey to a rather nasty, Hayekian ‘intertemporal’ disequilibrium – the cardinal economic sin of enjoying overmuch jam today at the cost of jam foregone tomorrow.

One day the piper to whose shrill accompaniment we are now dancing our merry jig (our Chuck Prince Charleston?) will present us with a bill which we are unlikely to be able to meet absent a great deal of sacrifice and possibly not without suffering a veritable collapse in the value of the currency to boot.

Since this is the time of year when we pundits traditionally have to set out scenarios containing an element of surprise, allow us to posit a very pleasant one, amid all the foreboding outlined above. Imagine if you will that, shortly after the election is held, our migrant cuckoo of a central bank governor will be fluttering off and away, back to his native Canada to ready his own political promotion – either by reinforcing the governing team if Junior Trudeau’s Liberals triumph there in October or perhaps by taking over the leadership should the latter’s bid ends in failure. One thing of which we can be fairly sure is that Moralising Mark will not hang around long to see a political melt-down in Britain mutate into a full blown sterling crisis and so add a few unsightly blots to his heretofore Teflon-coated escutcheon.

Economics

Time Horizons And Time Preference

Recent dollar strength has been a surprise to many but a strong dollar was also a key component of the Asian currency crises of 1997-98. These contributed to sharply lower oil prices, which in turn helped to trigger the 1998 Russian debt default, European bond spread de-convergence and spectacular blowup of hedge-fund Long Term Capital Management (LTCM). It is worth recalling that, when LTCM failed, the dollar abruptly gave up a full year of gains. While history rhymes rather than repeats, I suspect something comparable is likely in 2015, although with US total economy debt much higher, the potential for a sharp decline in the dollar is that much greater.

Back when I managed macro strategy teams at investment banks, I had a simple set of guidelines that I required junior strategists to follow when making investment recommendations, that is, in addition to those required by the firm or the regulators. These included:

  • Recommendations must be supported by a broad range of fact-checked evidence, rather than one or two ‘cherry-picked’ pieces;
  • Recommendations must be ‘actionable’ in a practical way by the target clients and one or more of these must be specified;
  • Recommendations must not only provide a specific price (or return) target, but also an estimate of risk (or volatility) and reference to a specific time horizon;
  • Recommendations must include one or more conditions under which the particular investment would no longer be as attractive, if at all.

In practice, most analysts managed in their initial draft recommendations to follow the first two but struggled when it came to the third and fourth. The reason for this is most probably the inclination that many if not all quantitative-analytical types have for expecting that financial assets be priced ‘correctly’, according to whatever analytical framework is applied. If something is out of line, so the thinking goes, it should start correcting as soon as the analysis in question is complete and should completely correct over the short-to-medium term time horizon of primary importance to the bulk of those active in the investment management industry.

While that might seem reasonable, the problem is that, notwithstanding claims to the contrary, investors are not rational. Indeed, I would hold that no economic actors are rational in any meaningful, measurable way. This is due in part to my view of human nature and modern psychology seems to uncover new ways in which our minds are biased and irrational with each passing day. But if all investment opinions are biased and irrational to some degree, the sum of all such opinions—the financial markets—is most probably also biased and irrational.

So-called ‘behavioural investing’ tries to address these biases in a systematic way in order generate excess investment returns over time with acceptably low risk. However, the problem with any such ‘fight the irrational herd’ approach is, to paraphrase Keynes, “The herd can remain irrational longer than the rational investor can remain solvent.” On top of this there is the added complexity of the so-called ‘beauty contest’, also mentioned by Keynes, in which investors constantly try to out-guess each others’ intentions, irrational, behavioural or otherwise, so what in fact is ultimately decisive in price determination at any point in time arguably has little if anything to do with any underlying, fundamental, rational investment process.

Having been an active investor for many years, I have experienced a number of profit and loss events across a broad range of assets and strategies. In the end, while idea generation, however rudimentary, is necessary to active trading or investing, it is ultimately some aspect of risk management, of knowing when NOT to trade or invest, that often tips the balance between success and failure. Sure, anyone can be ‘smart’ or ‘lucky’ for a time but the irrational herd is far more dangerous to the unusually smart than to the lucky, even though many in the latter category no doubt consider themselves also (or perhaps exclusively) in the former camp.

The fight against irrationality, if one wishes to call it that, is thus one that is overwhelming more likely to be won in the longer-term, over which most investors have only little or no interest. In the economic jargon, investors have high ‘time preference’ to front-load investment returns, by implication taking irrationally large longer-term risks. For institutional investors managing other peoples’ money, it is often a losing business proposition to fight the herd so aggressively as to risk losing clients, even if the investment views implemented ultimately work out longer-term. Holding on to client money month after month, quarter after quarter, year after year, when an apparently irrational market chooses to become ever more irrational is a potentially career-limiting move in the extreme. Thus herd-following, rather than fighting, becomes the industry norm, and those who rise to the top of large asset management organisations do so not because they are great investors but because they are skilled at retaining client assets regardless of the direction in which the irrational herd is travelling.

This natural (if irrational) herding tendency is further exaggerated when economic or monetary officials intervene in order to ‘stabilise’ asset markets, which at least since 1987 has meant to prevent them from correcting violently to the downside. 1. When the herd believes that officials have their backs, they tend to ignore the risks closing in on their backsides for far longer than they ought to. And so the inevitable bubbles that form can continue to grow and grow, yet concern about them fades and fades, as normalcy bias and policy goals converge in a world of ever-rising or at least not falling asset prices.

In this world, biased by policy towards steadily rising asset prices, returns beget leverage, and leveraged returns beget greater leverage. Regulators pretend as if they can manage this and its probable future effects on the financial system and economy, but 2008 and many other manias, panics and crashes that have come and gone before inform us otherwise. Sure, a new regulatory effort is rolled out now and again, to much fanfare: Note the central bankers’ ‘macroprudential’ PR campaign over the past two years. The ivory-tower academic folk who originally propose such measures—or so they claim—applaud on the sidelines while taking implied, self-serving credit. (These academics are equally quick to blame the ‘private sector’ whenever anything goes wrong, as their ideas can’t possibly be at fault.)

I’ve been around long enough to see this dynamic play out on multiple occasions. I also witnessed first-hand the spectacular events of 1997-98, a period with strong parallels to today. Back then, the dollar rose on the false view that the US could decouple from crises abroad. When events abruptly proved otherwise, the dollar gave up a full year’s gains in just two weeks. The same could happen in 2015.

POOR-QUALITY GROWTH, RISING IMBALANCES

Following six years of zero interest rates and QE, the US economy has still failed to resume healthy, sustainable growth. Yes, the economy is growing at present and there have been some pockets of deleveraging. But this amounts to ‘cherry picking’ the range of available evidence and thus fails to adhere to even the first of my guidelines for investment recommendations. Looking behind the numbers in more detail, as I prefer to do, one sees an unbalanced economy that is re-leveraging amid the growth of yet another asset bubble.

Now my mainstream economic critics will scoff at this, pointing to the recently-released Q3 GDP report, for example, as demonstrating that healthy US growth has resumed. But when you look behind the numbers at the composition, the quality of the growth, it remains poor. One way to do this is to strip out the volatile inventory cycle and see what remains of ‘core’ GDP growth, referred to as ‘real final sales’. US real final sales growth has been positive over the past few years but, notwithstanding massive policy stimulus, has barely managed to rise above 2% year-over-year. Past recoveries have seen rates two to three times higher.

CORE’ GDP GROWTH STUCK AROUND 2% Y/Y

Core GDP

If you go one step further and strip out population growth, what remains is a per-capita core growth rate of little more than zero. And what has it taken to achieve this near zero rate of per-capita growth? Why, huge government deficits which have not been spent on long-term infrastructure investment but rather programmes designed to promote current consumption. Moreover, households have been re-leveraging following a period of sharp retrenchment in 2008-9. The savings rate, averaging about 4.5% over the past few years, is only marginally higher than it was in the bubble years of 2004-7.

HOUSEHOLD LEVERAGE HAS SOARED AGAIN…

Household Leverage

…AS THE SAVINGS RATE HAS DECLINED ANEW

Savings Rate

There was some material deleveraging of corporate balance sheets in 2009-12 but that has now given way to re-leveraging. Much of this is occurring via share buy-backs, which were all the rage in 2014, perhaps because without them, earnings per share would not have risen by much, if at all, given now-negative US corporate profit growth.

Now this may be the first you have heard about ‘negative’ US corporate profit growth. But if you look at profits not in the ‘pro-forma’ way that corporations present them to shareholders but in how they actually report them for official pourposes according to the methodology used in the national accounts, this is precisely what you see.

CORPORATE PROFIT GROWTH NOW NEGATIVE

Corporate Profit Growth

This is not to say that the huge monetary and fiscal stimulus in the wake of the GFC had no effect. No, it had a huge effect. But that effect was primarily to bring future consumption artificially forward and thereby to reduce the savings available to provide for investment and future consumption. Eminent Austrian Economist Ludwig von Mises famously claimed that this was akin to “burning the furniture to heat the home.” (The pernicious effects of capital consumption are discussed in greater detail here.)

The fact is that the US is not saving enough to provide for current much less future consumption and thus must continue to borrow from the rest of the world. While the US trade deficit is not as large today as it was back in the bubble years of 2004-7—in large part due to increased domestic energy production—it remains sizeable in a historical comparison and, of course, adds to the enormous cumulative deficit that already exists.

US STILL DEPENDENT ON FOREIGN CAPITAL

Foreign capital

So not only is US growth not on a sustainable path; to the extent there is growth, much of it is being financed with US-issued IOUs (ie dollars). The dollar may be strong at present due to flows out of various underperforming emerging markets. But this should not disguise the fact that the US economy cannot possibly decouple from the rest of the world when it is in fact highly dependent on the rest of the world as a source of financing.

DECLINING OIL PRICES ARE A KEY MECHANISM OF AN INEVITABLE RECOUPLING

Much us external financing is in the form of recycled ‘petrodollars’ from the larger oil-exporting countries such as Saudi Arabia, who take oil revenues and invest them in US assets such as Treasury bonds. This has two inter-related effects, supporting demand for the US dollar and helping to hold down US interest rates. As oil prices decline, however, so do oil revenues, in particular if global demand is declining, as it appears to be doing. This implies less recycling of petrodollars.

While in theory declining oil prices are supportive of growth, this is true only to the point that the financial system is not leveraged to oil revenues. Russia’s 1998 default on its external debt is a classic case in point. All of a sudden what appeared a benign development for the US economy was anything but, as through various financial linkages, the US financial system was in fact exposed to a sharp decline in global oil revenues.

Global liquidity, sloshing as it does from place to place, is much like the tides of the oceans. Local observers in different locations might not notice or care that a high tide in one place implies a low tide in another. But the global observer knows better: An extreme high tide in one part of the world will correspond to an extreme low tide elsewhere. But these need not occur simultaneously, as the flow from high to low between locations can take time.

Collapsing oil revenues were the proximate trigger for Russia’s 1998 decision to default on its external debt. European banks were among Russia’s primary creditors and thus they had to liquidate holdings of peripheral EU debt in order to raise capital. This pushed peripheral bond spreads sharply wider, reversing the trend in leveraged euro ‘convergence trades’ in the run-up to European monetary union. LTCM was one of the largest, most highly-leveraged followers of this strategy and found it suddenly faced huge losses potentially exceeding its capital. LTCMs creditors—primarily bulge-bracket Wall Street banks—demanded additional collateral be posted immediately. But there wasn’t enough high-quality collateral to go around and so the price of the highest-quality collateral—US Treasury bonds—soared to records in the scramble.

The Fed soon realised the scale of the potential danger: A default cascading through the heart of Wall Street. It thus placed pressure on all LTCM’s creditors to agree to a plan to ease off on collateral calls, allowing for an orderly unwind of positions. In return, the Fed would lower interest rates, to the benefit of all participants.

While these actions succeeded in containing the damage, they signalled to the world that the US financial system was in fact highly leveraged to the international financial markets and thus exposed indirectly to the serial crises elsewhere. Moreover, the Fed was willing to lower interest rates as required to bail out the US financial system. Hence the dollar was not the safe-haven it was previously thought to be and suddenly plunged in value, wiping out an entire year’s gains in a violent, two-week selloff.

A YEAR’S DOLLAR GAINS ERASED IN WEEKS

Dollar gains erased

The US stock market also took notice, falling sharply as the re-coupling of the US to global reality set in. It was not until the Fed announced the LTCM bail out and rate cuts that the stock market began to recover.

Over the next two years, it did more than merely recover. With Fed policy actions having stimulated aggressive herd buying of equities, the NASDAQ crack-up boom took place, followed by the inevitable bust of 2001-03.

…AND A MAJOR STOCK MARKET CORRECTION

Wiltshire total market cap

DE-CONVERGENCE HAS RUN A LONG WAY; RE-CONVERGENCE COULD OCCUR AT ANY TIME

The parallels with 1997-98 are increasingly clear. Currencies, asset markets and growth have slumped across Asia and Europe, yet US financial markets have been largely unaffected, happily continuing to climb. The dollar has strengthened steadily. Yet in the sharp decline in oil and other commodity prices we see a mechanism in motion that, in some way yet unseen, will eventually choke off the flow of liquidity into US financial markets. While I don’t anticipate that Russia will default this time round—Russia’s external government debt is tiny—there are a number of other countries out there highly dependent on commodity exports for external debt service.

Indonesia and Malaysia are two cases in point, the former being a relatively large emerging market economy. Sharp weakness in these countries’ currencies of late is an indication of growing stress eerily similar to 1997. Either or both of these countries could soon find they are unable to prevent large withdrawals of foreign capital. But devaluing a currency to deal with a balance-of-payments crisis doesn’t work as the problem is external debt denominated in a foreign currency, in this case dollars. The International Monetary Fund might try to come to the rescue, as it did in 1997-98, but the scale of the problem is far larger this time round.

Also worth mentioning here is something rather closer to home. The US shale industry is hugely dependent on leveraged financing from the US banking and shadow banking systems. (The latter uses structured financing vehicles of various kinds. By some estimates as much as a quarter of the entire US high yield debt market is related to the shale industry in some way.) With crude oil prices now plunging below $50/bbl, a huge portion of shale oil production has become unprofitable. Yet with debt to service, producers have no choice but to continue producing as much oil as they can. This will help to keep a lid on prices but will also bleed the most poorly financed producers to the point of insolvency and default, with potentially grave implications for the US financial system. (Some readers may recall the Texas oil, property and savings and loan collapse of the late 1980s, a key contributor to the eventual federal bail out of the entire US savings and loan industry.)

There are thus several ways in which today’s commodity price bust could turn into a more general financial crisis, as in 1997-98. It is impossible to know. But in my opinion, unless commodity prices soon recover, it is only a matter of time before a wave of balance-of-payment crises and/or corporate insolvences begin to dissolve the pillars of sand on which the strong dollar currently stands.

STRATEGIES FOR A DOLLAR REVERSAL

Those investors who agree that dollar strength is likely to reverse, perhaps abruptly, in 2015, should consider now those strategies that will perform well in that sort of environment.

There are various ways to speculate on a weaker dollar, the most straightforward of which is to short the dollar against other currencies in the foreign exchange markets. The difficultly with this, however, is that investors then need to take a view regarding which currencies are most likely to re-strengthen versus the dollar. Given that many countries would oppose currency strength at present, investors should take care. A diversified approach is probably best, and there are various vehicles that exist for this purpose, including the Merk currency funds. (Disclosure: Axel Merk is a personal friend I have known for many years. However I have no financial interest in his funds, nor do I receive commissions or compensation of any sort for recommending them.)

However, given that many countries might resist currency strength, the case can be made that gold has more upside potential in a dollar reversal. Moreover, if the environment turns decidedly risk-averse, as it did in 1998 for example, gold can benefit two-fold. Last year, Axel Merk launched the Merk Gold Trust (NYSE: OUNZ), a vehicle that allows for investors to take physical delivery of their gold, if desired, without this qualifying as a taxable event.

Gold’s poor sister silver is arguably better value at present, although in a risk-off environment it would be normal for gold to outperform silver. A simple diversification compromise would be to allocate 2/3 to gold and 1/3 to silver. This is because silver is normally about twice as volatile as gold. From a risk perspective, this implies an equal risk weighting in each of these two monetary metals. There are ETFs available that can be rebalanced periodically to keep holdings from drifting too far from the target 2/3 and 1/3 allocations.

Finally, a quick word on oil. While I have written above about the potentially negative financial market consequences of the recent, sharp decline in oil prices, there is of course much underlying demand for oil that is not particularly cyclical in nature but will occur even in a weak or zero-growth environment. Here I note that, even in the depths of the 2008 crisis, the oil price (WTI) found support around $40/bbl before recovering. At just under $50/bbl at time of writing, that is still a 20% decline from here, but the eventual upside recovery potential is probably far greater than 20%. For investors willing to take a risk amid what admittedly appears to be a ‘blood on the streets’ environment for oil at present, I’d recommend building a position here, either through an ETF or just by buying shares of upstream oil producers.

In relative terms, oil looks even better value, for example relative to industrial metals such as copper or aluminium. Yes, the latter have also seen prices come off but not to anywhere near the same extent. Platinum group metals may be precious but they are used overwhelmingly in industrial applications, in particular autocatalysts, and in the event that automobile demand should slow, there is much potential for these to decline relative to the price of oil. Palladium is considerably more exposed than platinum to this scenario and is thus the better short.

The really brave might even take a look at the debt of distressed shale producers, although I have no particular expertise in that area. A distressed industry is one that will likely be restructured in some way, such as by private equity firms swooping in, taking viable companies private, and restructuring them for the longer-term, out of the public spotlight.

1. There is in fact a far longer history of such interventions. In the US these include the devaluation of the US dollar by executive fiat in 1934 and abrogation of Bretton-Woods treaty obligations in 1971.

Economics

The False Promises Of Two Percent Price Inflation

A specter is haunting the world, the specter of two percent inflationism. Whether pronounced by the U.S. Federal Reserve or the European Central Bank, or from the Bank of Japan, many monetary central planners have declared their determination to impose a certain minimum of rising prices on their societies and economies.

One of the oldest of economic fallacies continues to dominate and guide the thinking of monetary policy makers: that printing money is the magic elixir for the creating of sustainable prosperity.

In the eyes of those with their hands on the handle of the monetary printing press the economic system is like a balloon that, if not “fully inflated” at a desired level of output and employment, should be simply “pumped up” with the hot air of monetary “stimulus.”

The Fallacy of Keynesian Macro-Aggregates

The fallacy is the continuing legacy of the British economist, John Maynard Keynes, and his conception of “aggregate demand failures.” Keynes argued that the economy should be looked at in terms of series of macroeconomic aggregates: total demand for all output as a whole, total supply of all resources and goods as a whole, and the average general levels of all prices and wages for goods and services and resources potentially bought and sold on the overall market.

If at the prevailing general level of wages, there is not enough “aggregate demand” for output as a whole to profitably employ all those interested and willing to work, then it is the task of the government and its central bank to assure that sufficient money spending is injected into the economy. The idea being that at rising prices for final goods and services relative to the general wage level, it again becomes profitable for businesses employ the unemployed until “full employment” is restored.

Over the decades since Keynes first formulated this idea in his 1936 book, The General Theory of Employment, Interest, and Money, both his supporters and apparent critics have revised and reformulated parts of his argument and assumptions. But the general macro-aggregate framework and worldview used by economists in the context of which problems of less than full employment continue to be analyzed, nonetheless, still tends to focus on and formulate government policy in terms of the levels of and changes in output and employment for the economy as a whole.

In fact, however, there are no such things as “aggregate demand,” or “aggregate supply,” or output and employment “as a whole.” These are statistical creations constructed by economists and statisticians, out of what really exists: the demands and supplies of multitudes of individual and distinct goods and services produced, and bought and sold on the various distinct markets that comprise the economic system of society.

The Market’s Many Demands and Supplies

There are specific consumer demands for different kinds and types of hats, shoes, shirts, reading glasses, apples, and books or movies. But none of us just demands “output,” any more than there is just a creation of “employment.”

When we go into the marketplace we are interested in buying the specific goods and services for which we have particular and distinct demands. And businessmen and entrepreneurs find it profitable to hire and employ particular workers with specific skills to assist in the manufacture, production, marketing and sale of the distinct goods that we as individual consumers are interested in purchasing.

In turn, each of these individual and distinct goods and services has its own particular price in the market place, established by the interaction of the individual demanders with the individual suppliers offering them for sale.

The profitable opportunities to bring desired goods to market results in the demand for different resources and raw materials, specific types of machinery and equipment, and different categories of skilled and lesser skilled individual workers to participate in the production processes that bring those desired goods into existence.

The interactions between the individual businessmen and the individual suppliers of these factors of production generate the prices for their purchase, hire or employment on, again, multitudes of individual markets in the economic system.

The “macro” economist and his statistician collaborator then proceed to add up, sum and averages all these different individual outputs, employments and specific prices and wages into a series of economy-wide measured aggregates.

But it should be fairly clear that in doing so all the real economic relationships in the market, the actual structure of relative prices and wages, and all the multitude of distinct and interconnected patterns of actual demands and supplies are submerged and lost in the macro-economic aggregates and totals.

Balanced Markets Assure Full Employment

Balanced production and sustainable employments in the economy as a whole clearly requires coordination and balance between the demands and supplies of all the particular goods and services in each of the specific markets on which they are bought and sold. And parallel to this there must be comparable coordination and balance between the businessmen’s demands for resources, capital equipment and different types of labor in each production sector of the market and those supplying them.

Such coordination, balance, and sustainable employment requires adaptation to the every-changing circumstance of market conditions through adjustment of prices and wages, and to shifts in supplies and demands in and between the various parts and sectors of the economy.

In other words, it is these rightly balanced and coordinated patterns between supplies and demands and their accompanying structures of relative prices and wages that assure “full employment” and efficient and effective use of available resources and capital, so entrepreneurs and businessmen are constantly and continuously tending to produce the goods we, the consumers, want and desire, and at prices that are covering competitive costs of production.

All this is lost from view when reduced to that handful of macro-aggregates of “total demand” and “total supply” and a statistical average price level for all goods relative to a statistical average wage level for all workers in the economy.

The Keynesian Government “Big Spender”

In this simplified and, indeed, simplistic view Keynesian-type view of things all that needs to be done from the government’s policy perspective is to run budget deficits or create money through the banking system to push up “aggregate demand” to assure a targeted rise in the general price level so profit-margins “in general” are widened relative to the general wage level so employment “in general” will be expanded.

We can think of government as a “big spender” who comes into a town and proceeds to increase “aggregate demand” in this community by buying goods. Prices for final output rise, profit margins are widened relative to the general wage level and other general cost-prices. Private businesses, in general, employ more workers, purchase or hire other inputs, and “aggregate supply” expands to a point of desired “full employment.”

The presumption on the part of the center bankers in targeting a rate of an average annual price inflation of two percent is that while selling prices are to be pushed up at this average annual rate through monetary expansion, the average level of cost prices (including money wages in general) will not rise or not by the same percentage increase as the average increase in the “price level.”

If cost prices in general (including money wages) were to rise at the same rate as the price level, there would be no margin of additional profits to stimulate greater aggregate output and employment.

Market Anticipations Undermine Keynes’ Assumptions

The fallacy in thinking that cost-prices in general will permanently lag behind the rate of increase in the price level of final goods and services was pointed out long ago, in 1898, by the famous Swedish economist, Knut Wicksell:

“If a gradual rise in prices, in accordance with an approximately known schedule, could be reckoned on with certainty, it would be taken into account in all current business contracts; with the result that its supposed beneficial influence would necessarily be reduced to a minimum.

“Those people who prefer a continually upward moving to a stationary price level forcibly remind one of those who purposely keep their watches a little fast so as to be more certain of catching their train. But to achieve their purpose they must not be conscious or remain conscious of the fact that their watches are fast; otherwise they become accustomed to take the extra few minutes into account, and so after all, in spite of their artfulness, arrive too late . . .”

Yellen and the Fed goes wrong cartoon

The Government “Big Spender” Unbalances Markets

But the more fundamental error and misconception in the macro-aggregate approach is its failure to appreciate and focus on the real impact of changes in the money supply that by necessity result in an unsustainable deviation of prices, profits, and resources and labor uses from a properly balanced coordination, the end result of which is more of the very unemployment that the monetary “stimulus” was meant to cure.

Let’s revert to our example of the “big spender” who comes into a town. The townspeople discover that our big spender introduces a greater demand into the community, but not for “goods in general.” Instead, he announces his intention of building a new factory on the outskirts of the town.

He leases a particular piece of land and pays for the first few months rent. He hires a particular construction company to build the factory, and the construction company in turn increases its demand not only for workers to do the work, but orders new equipment, that, in turn, results in the equipment manufacturers adding to their workforce to fulfill the new demand for construction machinery.

Our big spender, trumpeting the wonders for the community from his new spending, starts hiring clerical staff and sales personal in anticipation of fulfilling orders once the factory is completed and producing its new output.

The new and higher incomes earned by the construction and machinery workers, as well as the newly employed clerical and sales workers raise the demand for various and specific consumer and other goods upon which these people want to spend their new and increased wages.

The businesses in the town catering to these particular increased consumer demands now attempt to expand their supplies and, perhaps, hire more retail store employees.

Over time the prices of all of these goods and services will start to rise, but not at the same time or to the same degree. They will go up in a temporal sequence that more or less tends to match the pattern and sequence of the changed demands for those goods and services resulting from the new money injected by the “big spender” into this community.

Inflationary Spending Has to Continue and Increase

Now, whether some of the individual workers drawn into this specific pattern of new employments were previously unemployed or whether they had to be attracted away from existing jobs they already held in other parts of the market, the fact remains that their continued employments in these particular jobs is dependent on the “big spender” continuing to inject and spend his new money, period-after-period of time, in the same way and in sufficient amounts of dollar spending to assure that the workers he has drawn into his factory project are not attracted to other employments due to the rise in all of these alternative or other demands, as well.

If the interdependent patterns of demands and supplies, and the structure of interconnected relative prices and wages generated by the big spender’s spending are to be maintained, his injection of new money into the community must continue, and at an increasing rate of spending if they are not be fall apart.

An alternative imagery might be the dropping of a pebble or stone into a pond of water. From the epicenter where the stone has hit the surface of the water a sequence of ripples will be sent out which will be reversed when the ripples finally hit the surrounding shore, and will then finally come to rest when there is no longer any new disturbances affecting the surface of the pond.

But if the pattern of ripples created are to be sustained, new pebbles or stones must be continuously dropped into the pond and with increasing force if the resulting counter-waves coming back from the shore are not to disrupt and overwhelm the ripple pattern moving out from the original epicenter.

Yellen and the Good Ship Fed cartoon

The “Austrian” Analysis of Inflation

It is no doubt that this way of analyzing and understanding the dynamics of how monetary expansion affects market activities is more complex and complicated than the simplistic Keynesian-style of macro-aggregate analysis. But as the famous Austrian-born economist, Joseph A. Schumpeter emphasized:

“The Austrian way of emphasizing the behavior or decisions of individuals and of defining the exchange value of money with respect to individual commodities rather than with respect to a price level of one kind or another has its merits, particularly in the analysis of an inflationary process; it tends to replace a simple but inadequate picture by one which is less clear-cut but more realistic and richer in results.”

And, indeed, it is this “Austrian” analysis of monetary expansion and its resulting impact on prices, employment and production, especially as developed in the 20th century by Ludwig von Mises and Friedrich A. Hayek, that explains why the Keynesian-originated macro-aggregate approach is fundamentally flawed.

As Hayek once explained the logic of the monetary inflationary process:

“The influx of the additional money into the [economic] system always takes place at some particular points. There will always be some people who have more money to spend before the others. Who these people are will depend on the particular manner in which the increase in the money stream is being brought about . . .

“It may be spent in the first instance by government on public works or increased salaries, or it may be first spent by investors mobilizing cash balances for borrowing for that purpose; it may be spent in the first instance on securities, or investment goods, on wages or on consumers’ goods . . .

“The process will take very different forms according to the initial source or sources of the additional money stream . . . But one thing all these different forms of the process will have in common: that the different prices will rise, not at the same time but in succession, and that so long as the process continues some prices will always be ahead of others and the whole structure of relative prices therefore will be very different from what the pure theorist describes as an equilibrium position.”

An inflationary process, in other words, brings about distortions, mismatches, and imbalanced relationships between different supplies and demands, and the relationships between the structure of relative prices and wages that only last for as long as the inflationary process continues, and often only at an accelerating rate.

Or as Hayek expressed it on a different occasion:

“Any attempt to create full employment by drawing labor into occupations where they will remain employed only so long as the [monetary and] credit expansion continues creates the dilemma that either credit expansion must continue indefinitely (which means inflation), or that, when it stops unemployment will be greater than it would be if the temporary increase in employment had never taken place.”

The Inflationary “Cure” Creates More Market Problems

Once the inflationary monetary expansion ends or is slowed down, it is discovered that the artificially created supply and demand patterns and relative price and wage structure are inconsistent with non-inflationary market conditions.

In our example of the “big spender,” one day the townsfolk discover that he was really a con artist who had only phony counterfeit money to spend, and whose deceptive promises and temporary spending drew them into in all of those specific and particular activities and employments. They now find out that the construction projects began cannot be completed, the employments created cannot be maintained, and the investments started in response to the phony money the big spender injected into this community cannot be completed or continued.

Many of the townspeople now have to stop what they had been doing, and try to discover other demanders, other employers and other possible investment opportunities in the face of the truth of the big spenders false incentives to do things they should not have been doing from the start.

The unemployment and under utilization of resources that “activist” monetary policy by governments are supposed to reduce, in fact, set the stage for an inescapable readjustment period of more unemployment and temporary idle resources, when many of the affected supplies and demands have to be rebalanced at newly established market-based prices if employments and productions are to be sustainable and consistent with actual consumer demands and the availability of scarce resources in the post-inflationary environment.

Thus, recessions are the inevitable result from prior and unsustainable inflationary booms. And even the claimed “modest” and “controlled” rate of two percent annual price inflation that has become the new panacea for economic stability and growth in the minds of central bankers, brings in its wake a “wrong twist” to many of the micro-economic supply and demand and price-wage relationships that are the substance of the real economy beneath the superficial macro-aggregates.

Governments and their monetary central planners, therefore, are the cause and not the solution to the instabilities and hardships of inflations and recessions. To end them, political control and manipulation of the money and banking systems will have to be abolished.

[This piece first appeared here: http://www.epictimes.com/richardebeling/2014/12/the-false-promises-of-two-percent-price-inflation/]

Economics

“We hate you guys but there is nothing much we can do”

“Except for US Treasuries, what can you hold ? US Treasuries are the safe haven. For everyone, including China, it is the only option.. Once you [Americans] start issuing $1 trillion – $2 trillion.. we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”

–       Luo Ping, official at the China Banking Regulatory Commission, addressing an audience in New York in early 2009.
“This is a big change and it cannot happen too quickly, but we want to use our reserves more constructively by investing in development projects around the world rather than just reflexively buying US Treasuries. In any case, we usually lose money on Treasuries, so we need to find ways to improve our return on investment.”

–       Unnamed senior Chinese official, cited in an FT article, ‘Turning away from the dollar’, 10th December 2014.

 

The Commentary will shortly be off for its winter break. We wish all clients and readers a merry Christmas and a peaceful and prosperous New Year. See you in 2015.

“Mutually assured destruction” was a doctrine that rose to prominence during the Cold War, when the US and the USSR faced each other with nuclear arsenals so populous that they ensured that any nuclear exchange between the two great military powers would quickly lead to mutual overkill in the most literal sense. Notwithstanding the newly dismal relations between the US and Russia, “mutually assured destruction” now best describes the uneasy stand-off between an increasingly indebted US government and an increasingly monetarily frustrated China, with several trillion dollars’ worth of foreign exchange reserves looking, it would now appear, for a more productive home than US Treasury bonds of questionable inherent value. Until now, the Chinese have had little choice where to park their trillions, because only markets like the US Treasury market (and to a certain extent, gold) have been deep and liquid enough to accommodate their reserves.

The FT article, by James Kynge and Josh Noble, points to three related policy developments on the part of the Chinese authorities:

1)    China’s appetite for US Treasury bonds is on the wane;

2)    China is ramping up its overseas development programme for both financial and geopolitical reasons;

3)    The promotion of the renminbi as a global currency “is gradually liberating Beijing from the dollar zone”.

The US has long enjoyed what Giscard d’Estaing called the “exorbitant privilege” of issuing a currency that happens to be the global reserve currency. The FT article would seem to suggest that the days of exorbitant privilege may be coming to an end – to be replaced, in time, with a bi-polar reserve currency world incorporating both the US dollar and the renminbi. (The euro might be involved, if that demonstrably dysfunctional currency bloc lasts long enough.) Here’s a quiz we often wheel out for prospective clients:

1)    Which country is the world’s largest sovereign miner of gold ?

2)    Which country doesn’t allow an ounce of that gold to be exported ?

3)    Which country has advised its citizenry to purchase gold ?

Three questions. One answer. In each case: China. Is it plausible that, at some point yet to be determined, a (largely gold-backed) renminbi will either dethrone the US dollar or co-exist alongside it in a new global currency regime ? We think the answer is yes, on both counts.

Meanwhile the US appears to be doing everything in its power to hasten the relative decline of its own currency. There is a new ‘big figure’ to account for the size of the US national debt, which now stands at some $18 trillion. That only accounts for the on-balance sheet stuff. Factor in the off-balance sheet liabilities of the US administration and pretty soon you get to a figure (un)comfortably north of $100 trillion. It will never be paid back, of course. It never can be. The only question is which poison extinguishes it: formal repudiation, or informal inflation. Perhaps we, or future generations, get both.

So the direction of travel of two colossal ‘macro’ themes is clear (the insolvency of the US administration, and its replacement on the geopolitical / currency stage by that of the Chinese). The one question neither we, nor anybody else, can answer precisely is: when ?

There are other statements that beg the response: when Government bond yields have already entered a ‘twilight zone’ of practical irrelevance to rational and unconstrained investors. But when do they go into reverse ? When will the world’s most frustrating trade (‘the widow-maker’, i.e. shorting the Japanese government bond market) start finally to work ? When will investors be able to enter or re-enter stock markets without having to worry about the malign impact of central bank price support mechanisms (a polite way of describing asset price boosterism and state-sanctioned inflationism) ?

Here’s another statement that begs the response: when ? The US stock market is already heavily overvalued by any objective historical measure. When is Jack Bogle, the founder of the world’s largest index-tracking business, Vanguard, going to acknowledge that advocating 100% market exposure to one of the world’s most expensive markets, at its all-time high, might amount to something akin to “overly concentrated investment risk” ? Barron’s Magazine asks broadly the same question.

Lots of questions, and not many definitive answers. Some suggestions, though:

  • At the asset class level, diversification – by geography, and underlying asset type – makes more sense than ever, unless you strongly believe you can anticipate the actions and intentions of central banking bureaucrats throughout the world. Warren Buffett once said that wide diversification was only required when investors do not understand what they are doing. We would revise that statement to take into account the unusual risks at play in the global macro-economic arena today: wide diversification is precisely required when central bankers do not understand what they are doing. 
  • Expanding on the diversification theme, explicit value (“cheapness”) today only exists meaningfully in the analytically less charted territories of the world. @RobustCap highlights the discrepancy between valuations in the US stock market versus those of Russia, China and emerging Europe. There are clearly ‘fundamental’ and corporate governance reasons that account for some of this discrepancy, but in our view certainly not the entirety of it. Some examples:

Country                                         C.A.P.E.                       P/E                              P/B

North America                                23.8                             20.2                             2.7x

Russia                                            5.2                               6.8                               0.7x

China                                             17.2                             6.9                               1.1x

Austria                                           6.8                               43.4                             0.9x

In emerging and ‘challenged’ markets, there are always reasons not to invest. Nevertheless, price is what you pay and value is what you get.

  • Some form of renminbi exposure makes total sense as part of a diversified currency portfolio.
  • US equities should be selected, if at all, with extreme care; ditto the shares of global mega-cap consumer brands, where valuations point strongly to the triumph of the herd.
  • And whatever their direction of travel in the short to medium term, US Treasuries at current levels make no sense whatsoever to the discerning investor. The same holds for Gilts, Bunds, JGBs, OATs.. Arguments about Treasury yields reverting to a much lower longer term mean completely ignore a) the overwhelming current and future oversupply, and b) the utter lack of endorsement from one of their largest foreign holders. Foreign holders of US Treasuries, you have been warned. The irony is that many of you are completely price-insensitive so you will not care.
  • There are other reasons to be fearful of stock market valuations, notably in pricey western markets, over and above concerns over the debt burden. As Russell Napier points out in his latest ‘The Solid Ground’ piece,

“In 1919-1921, 1929-1932, 2000-2003, 2007-2009 it was not a resurgence in wages, Fed-controlled interest rates or corporate taxes which produced a collapse in corporate profits and a bear market in equities. On those four occasions equity investors suffered losses of 32%, 85%, 41% and 51% respectively despite the continued dormancy of labour, creditors and the state. It was deflation, or the fear of deflation, which cost equity investors so much. There is a simple reason why deflation has always been so damaging to corporate profits and equity valuations: it brings a credit crisis..

“Investors forget at their peril what can happen to the credit system in a highly leveraged world when cash-flows, whether of the corporate, the household or the state variety, decline. In a deflationary world credit is much more difficult to access, economic activity slows and often one very large institution or country fails and creates a systemic risk to the whole system. The collapse in commodity prices and Emerging Market currencies in conjunction with the general rise of the US$ suggests another credit crisis cannot be far away. With nominal interest rates already so low, monetary remedies to a credit seizure today would be much less effective. Such a shock, after five and a half years of QE, might suggest that the patient does not respond to this type of medicine.”

  • And since Christmas fast approaches, we can’t speak to the merits of frankincense and myrrh, but gold, that famous “6,000 year old bubble”, has always been popular, but rarely more relevant to the investor seeking a true safe haven from forced currency depreciation and an ever vaster mountain of unrepayable debt.

Happy holidays.

Economics

Budget deficit and economic growth

Some economists such as Nobel Laureate Paul Krugman hold that during an economic slump it is the duty of the government to run large budget deficits in order to keep the economy going.  On this score given that during 2011 to 2014 the rate of growth of real gross domestic product (GDP) hovered at around 2% many experts are of the view that the budget deficit, which stood at $483 billion in 2014, wasn’t large enough.

Budget Surplus

According to this way of thinking if overall demand in the economy weakens on account of a weakening in consumer outlays then the government must step in and boost its spending in order to prevent overall demand from declining. Note that government outlays in 2014 stood at $3.5 trillion against $1.788 trillion in 2000 – an increase of 96%.

US Govt Outlays

Nobel Laureate in economics Paul Krugman and other commentators are of the view that a widening of the budget deficit in response to larger government outlays can be great news for the economy.

Furthermore, they hold that there is very little empirical evidence that budget deficits are stifling economic growth as such. If anything, they hold it can only benefit an economy once it falls below its average growth path. In contrast the opponents of this view hold that a widening in the budget deficit tends to be monetized and subsequently leads to a higher inflation.

Also a widening in the budget deficit tends to crowd out the private sector and this stifles economic growth, so it is held. So from this perspective a government must avoid as much as possible a widening in the budget deficit. In fact the focus should always be on achieving a balanced budget.

We suggest that the goal of fixing the budget deficit as such, whether to keep it large or trying to eliminate it altogether, could be an erroneous policy. Ultimately what matters for the economy is not the size of the budget deficit but the size of government outlays – the amount of resources that government diverts to its own activities. Note that contrary to Krugman we hold that an increase in government outlays is bad news for the economy.

Observe that a government is not a wealth generating entity – the more it spends the more resources it has to take from wealth generators. This in turn undermines the wealth generating process of the economy. This means that the effective level of tax is the size of the government and nothing else. For instance, if the government plans to spend $3 trillion and funds these outlays by means of $2 trillion in taxes there is going to be a shortfall, labeled as a deficit, of $1 trillion. Since government outlays have to be funded it means that in addition to taxes the government has to secure some other means of funding such as borrowing or printing money, or new forms of taxes.

The government is going to employ all sorts of means to obtain resources from wealth generators to support its activities. Hence what matters here is that government outlays are $3 trillion, and not the deficit of $1 trillion.

For instance, if the government would have lifted taxes to $3 trillion and as a result would have a balanced budget, would this alter the fact that it still takes $3 trillion of resources from wealth generators? We hold that an increase in government outlays sets in motion an increase in the diversion of wealth from wealth generating activities to non-wealth generating activities. It leads to economic impoverishment. So in this sense an increase in government outlays to boost the overall economy’s demand should be regarded as bad news for the wealth generating process and hence to the economy.

Contrary to commentators such as Krugman, the IMF and various Fed officials, we suggest that a cut in government outlays should be seen as great news for wealth generators. It is of course bad news for various artificial forms of life that emerged on the back of increases in government outlays.

 

Money

Deflating the Inflation Myth

[Editor’s Note; this interview, with Cobden Centre contributor Jesus Huerta de Soto, was by Malte Fischer of Handelsblatt]

Professor Huerta de Soto, the inflation rate in the euro zone is now only 0.4 percent. Is deflation threatening us, as many experts maintain?

Deflation means that the money supply is shrinking. This is not the case in the euro zone. The M3, the broadly defined supply of money, is growing by about two percent, while the more narrowly defined money supply, M1, by more than six percent. Although the inflation rate in the euro zone is below the European Central Bank’s target of barely two percent, that’s no reason to stir up fears of deflation like some central bankers are doing.

By doing so, they are suggesting that lowering prices is something bad. That is wrong. Price deflation is not a catastrophe, but rather a blessing.

You’ll have to explain that.

Take my homeland, Spain. At the moment, the consumer prices there are decreasing. At the same time, the economy is growing by around two percent on a yearly basis. Some 275,000 new jobs were created in 2013 and unemployment fell from 26 to 23 percent. The facts contradict the horror scenarios of deflation.

Does that mean we should be happy about deflation?

Certainly. It is particularly beneficial when it results from an interplay of a stable money supply and increasing productivity. A fine example is the gold standard in the 19th century. Back then, the money supply only grew by one to two percent per year. At the same time, industrial societies generated the greatest increase in prosperity in history. That is why the ECB should use the gold standard as an example and lower the target for the growth of the M3 money supply from 4.5 to around 2.0 percent.

If the euro economy were to grow by about three percent – which it is capable of doing if it were freed from the shackles of state regulations – prices would decrease by about one percent per annum.

If deflation is so beneficial, why are people afraid of it?

I don’t believe that the average person is frightened by falling prices. It is the representatives of mainstream economics fomenting a deflation phobia. They argue that deflation allows the actual debt burden to increase, and thus strangles the overall economic demand. The deflation alarmists fail to mention that creditors benefit from deflation, which stimulates demand.

Isn’t there a danger consumers will roll back their spending if everything is cheaper tomorrow?

That is an abstruse argument you hear again and again. Look at how fast the latest smartphones sell, although consumers know that the phones will be sold at a lower cost a few months afterwards. America was dominated by deflation for decades after the Civil War. In spite of that, consumption increased. If people were to put off buying because of lower prices, they ultimately would starve to death.

But lowering prices drives down sales figures and lessens the willingness of companies to invest. Do you want to ignore that?

Sales figures are not crucial for companies, but rather their earnings, meaning the difference between revenues and costs. Sinking sales prices increase pressure to reduce costs. The companies, therefore, replace manpower with machines. That means more machines need to be produced, which increases the demand for manpower in the capital goods sector. In this way, workers who lost their jobs in the wake of price deflation find new work in the capital goods sector. The capital stock grows without resulting in mass unemployment.

Aren’t you making that too easy for yourself ? In reality, the gap between the qualifications of the unemployed and the needs of companies is, at times, quite large.

I’m not claiming the market is perfect. That means it’s crucial that the labor market is flexible enough to offer incentives for creative employers to hire new workers.

What role does politics play?

The problem is that politicians have a short time horizon. That is why we need a monetary policy framework that holds both politicians and unions in check. The euro has this job in Europe. The common currency has removed the option of governments to devalue the currency to cover for their misguided economic policies. Economic policy mistakes are seen directly in the affected country’s loss of competitiveness, which forces politicians to make harsh reforms. Two governments in Spain within one and half years have implemented reforms that I hadn’t even dared to dream of. Now, the economic situation is improving and Spain is reaping the harvest of the reforms.

You may be right in the matter of Spain, but there have been no signs of fundamental reforms in Italy and France…

Which is why conditions there will first have to get worse before reforms come. We have learned from experience that the more miserable the economic situation, the stronger the pressure to reform. The reform successes that Spain and other euro countries have achieved increase the pressure on Paris and Rome. High unemployment in Spain had pushed down labor costs. At an average of €20, or $24.90, per hour, they are now half the rate as in France. That is why the French cannot avoid a drastic economic policy cure, even if the people oppose it. Germany should hold to its budgetary consolidation to keep up pressure on France and Italy.

The ECB is coming under increasing pressure to open the monetary floodgates and devalue the euro. The pressure is coming from academics, financial markets and politicians.

The economic mainstream of Keynesianism and monetarism explains the Great Depression of the 1930s with a shortage of money, which allowed an anti-deflation mentality to develop among academics. Politicians use the academic sounding board to pressure the ECB to reinflate the economy. Governments love inflation because it gives them the opportunity to live beyond their means and pile up huge mountains of debt that the central bank devaluates through inflation. It is no wonder it just happens to be the opponents of austerity policies who warn about deflation and demonize the euro’s set of stability policy regulations. They are afraid of presenting the true costs of the welfare state to the electorate.

The head of the ECB, Mario Draghi, succumbed to the pressure with his promise to save the euro if needs be by firing up the money printing presses. A mistake?

Careful. Until now, Mr. Draghi has been mainly making promises, but has barely acted. Although the ECB has initiated generous money lending transactions, and lowered the prime lending rate, the actual yield for 10-year government bonds of ailing euro zone members is above those in America. Measured on the balance sheet totals, the ECB has done less than other Western central banks. As long as the guardians of the euro are only talking but not acting, the pressure will remain on Italy and France to reform. That is why it is crucial the ECB resists the pressure of the governments and the Anglo-Saxon financial world and buys no state bonds.

What role do the Anglo-Saxon financial markets play?

The Anglo-Saxon press and the financial markets are ostentatiously conducting a crusade against the euro and the austerity policy in continental Europe necessitated by it. I am really no believer in conspiracy theories, but the out-and-out attacks against the euro by Washington and London suggest a hidden agenda. The Americans are afraid that the days of the dollar as a global currency are numbered if the euro survives as a hard currency.

Can the euro survive without political union?

A political union will not draw majority support in the population. It also isn’t desirable because it reduces the pressure for fiscal austerity. The best monetary regime for a free society is the gold standard, with all deposits covered by full reserves and without state central banks. As long as we don’t have that, we should defend the euro because it deprives governments of access to the money printing presses and forces them to consolidate their budgets and make reforms. In a certain way, it has the effect of the gold standard.