There are strong indications that the remarkable run up of asset prices in the last few years is beginning to run out of steam and may be on the verge of collapse. We will leave aside the question of whether the asset inflation is symptomatic of a garden-variety inflationary boom or is a more virulent bubble phenomenon in which prices are rising today simply because buyers anticipate that they will rise tomorrow.
1. The dizzying climb of London real estate prices since the financial crisis, noted in a recent postby Dave Howden, may be fizzling out. Survey data from real-estate agents indicate London housing prices in September fell 0.1 percent from August, their first decline since November 2012. Meanwhile, an index of U.K. housing prices declined for the first time in 17 months. In explaining the “pronounced slowdown” in the London real estate market, the research director of Hometrack Ltd. commented, “Buyer uncertainty is growing in the face of a possible interest-rate rise, a general election on the horizon and recent warnings of a house-price bubble,” which is playing out “against a backdrop of tougher mortgage affordability checks and limits on high loan-to-income lending.”
2. Just released data from the Dow Jones S&P/Case Schiller Composite Home Price Indices through July 2014 shows a marked deceleration of U.S. housing prices. 17 of the 20 cities included in the 20-City Composite Index experienced lower price increases in July than in the previous month. Both the 10- and 20-City Index recorded a 6.7 percent year-over-year rate of increase, down sharply from the post-crisis peak of almost 14 percent less than a year ago.
3. More ominously, U.S. Total Household Net Worth (HNW), as recently reported by the Fed for the second quarter of 2014, reached a record high of $81.5 trillion, over $10 trillion higher than the level at the peak of the asset bubble in 2007. Furthermore, the 2014 figure was $20 trillion higher than the level of the post-crisis — and pre-QE — year of 2008, when asset prices and the real structure of production were just beginning to adjust to the massive capital consumption and malinvestment wreaked by the Great Asset Inflation of 1995-2005. The increase in household wealth has been driven mainly by the increase in prices of financial assets which was generated by the Fed’s zero interest rate policy and its force feeding of additional bank reserves into the financial system via its quantitative easing programs. (See chart below). These policies falsify profit and wealth calculations and give rise to unsustainable investments and overconsumption. Once interest rates begin to adjust to their natural levels, however, asset prices are revealed to be grossly inflated and collapse. The asset inflation may be reversed even without an increase of interest rates, if people lose confidence in the narratives fabricated and propagated by government policymakers, economists, and the financial commentators to promote the continuation of the inflation in asset markets. Furthermore it is risible to believe that real wealth in the US in terms of the factories and other capital goods to which financial assets are merely ownership claims, has increased by over one-third since 2008, especially in light of the additional malinvestment and overconsumption caused by monetary and fiscal policy “stimulus” since then.
4. If we look at HNW in historical perspective, we note that, in the chart below, the HNW/GDP (or wealth to income) ratio is now at an all-time high. From 1952 to the mid-1990s this ratio averaged a little more than 350 percent and never went above 400 percent until 1998 as the dot-com bubble was blowing up. It peaked at nearly 450 percent before the bubble collapsed causing the ratio to plummet to slightly below 400 percent, indicating the beginning of the purging of the illusory capital gains created during the asset inflation.
But just as the adjustment was beginning to take hold in 2002, the Greenspan Fed played the deflationphobia card, driving interest rates to postwar lows and pumping up the money supply (MZM) by $2 trillion from beginning of 2001 to the end of2005. During this second phase of the Great Asset Inflation, the HNW/GDP ratio again reached a new high before plunging below 400 percent during the financial crisis. And, tragically, the nascent readjustment of financial markets to the underlying reality of the economy’s shattered and shrunken production structure was yet again aborted by government intervention in the form of the heterodox monetary policies of Bernankeism combined with the outsized deficits of the Obama administration. These policies succeeded in driving the HNW/GDP ratio to yet another new high, but without having the expected stimulatory effect on consumption and investment spending.
In sum, I do not expect that the ratio will rise much above 500 percent — Americans have just not saved enough since 1995 to have increased their real wealth from 3.5 times to 5 times their annual income. Nor is there much reason to expect a plateau anywhere near the current level. Once interest rates begin to rise — and rise they must, whether as a result of Fed policy or not — the end of the asset price inflation will be at hand. The result will be another financial crisis and accompanying recession. The Fed and the Administration will no doubt attempt to bail and stimulate their way out but given the still dangerously enervated state of the financial system and the real economy, it will be like dosing a horse that has already been overdosed to death. Thus my forecast for the U.S. economy one year to two years out echoes that of Clubber Lang, the villain in the movie Rocky III. When questioned about his forecast for the forthcoming fight against Rocky, Lang replied, “Pain.”
In its latest edition, in a piece entitled ‘Monetary policy: Tight, loose, irrelevant’, the ineffably dire Ekonomista considers the work of three members of the Sloan School of Management who conducted a study of the factors which – according to their rendering of the testimony of the 60-odd years of data which they analysed in their paper, “The behaviour of aggregate corporate investment” – have historically exerted the most influence on the propensity for American businesses to ‘invest’.
The article itself starts by deploying that unfailingly patronising, ‘it’s economics 101′ cliché by which we should really have long ago learned to expect some weary truism will soon be rehashed as fresh journalistic wisdom.
It may be only partly an exaggeration to say that the weekly then adopts a breathless, teen-hysterical approach to a set of results which, with all due respect to the worthies who compiled them, should have been instantly apparent to anyone devoting a moment’s thought to the issue (and if that’s too big a task for the average Ekonomista writer, perhaps they could pause to ask one of those grubby-sleeved artisans who actually RUNS a business what it is exactly that they get up to, down there at the coalface of international capitalism). Far from being a Statement of the Bleedin’ Obvious, our fearless expositors of the Fourth Estate instead seem to regard what appears to be a tediously positivist exercise in data mining as some combination of the elucidation of the nature of the genetic code and the first exposition of the uncertainty principle. This in itself is a telling indictment of the mindset at work.
For can you even imagine what it was that our trio of geniuses ‘discovered’? Only that firms tend to invest more eagerly if they are profitable and if those profits (or their prospect) are being suitably rewarded with a rising share price – i.e. if their actions are contributing to capital formation, realised or expected, and hence to the credible promise of a maintained, increased, lengthened or accelerated schedule of income flows – that latter condition being one which also means the firms concerned can issue equity on advantageous terms, where necessary, in the furtherance of their aims.
[As an aside, do you remember when we used to ISSUE equity for purposes other than as a panic measure to keep the business afloat after some megalomaniac CEO disaster of over-leverage or as part of a soak-the-patsies cash-out for the latest batch of serial shell-gamers and their start-up sponsors?]
Shock, horror! Our pioneering profs then go on to share the revelation that firms have even been known to invest WHEN INTEREST RATES ARE RISING; i.e., when the specific real rate facing each firm (rather than the fairly meaningless, economy-wide aggregate rate observable in the capital market with which it is here being conflated) is therefore NOT estimated to constitute any impediment to the future attainment (or preservation) of profit. Whatever happened to the central bank mantra of the ‘wealth effect’ and its dogma about ‘channels’ of monetary transmission? How could those boorish mechanicals in industry not know they are only to invest when their pecuniary paramounts signal they should, by lowering official interest rates or hoovering up oodles of government securities?
At this point we might stop to insist that the supercilious, wielders of the ‘Eco 101’ trope at the Ekonomista note that these firms’ own heightened appetite for a presumably finite pool of loanable funds should firmly be expected to nudge interest rates higher precisely in order to bring forth the necessary extra supply thereof, just as a similar shift in demand would do in any other well-functioning market (DOH!), so please could they take the time in future to ponder the workings of cause and effect before they dare to condescend to us.
They might also reflect upon the fact that when the banking system functions to supplement such hard-won funds with its own, purely ethereal emissions of unsaved credit – thereby keeping them too cheap for too long and so removing the intrinsically self-regulating and helpfully selective effect which their increasing scarcity would otherwise have had on proposedschemes of investment – they pervert, if not utterly vitiate, a most fundamental market process. Having a pronounced tendency to bring about a profound disco-ordination in the system to the point of precluding a holistic ordering of ends and means as well as of disrupting the timetable on which the one may be transformed into the other, we Austrians recognize this as theprimary cause of that needless and wasteful phenomenon which is the business cycle. It is therefore decidedly not a cause for perplexity that investment, quote: ‘…expands and contracts far more dramatically than the economy as a whole’ as the Ekonomista wonderingly remarks
Nigh on unbelievable as it may appear to the policy-obsessed, mainstream journos who reviewed the academics’ work, all of this further implies that the past two centuries-odd of absolutely unprecedented and near-universal material progress did NOT take place simply because the central banks and their precursors courageously and unswervingly spent the whole interval doing ‘whatever it took’ to progressively lower interest rates to (and in some cases, through) zero! Somewhere along the line, one supposes that the marvels of entrepreneurship must have intruded, as well as what Deidre McCloskey famously refers to as an upsurge in ‘bourgeois dignity’ – i.e., the ever greater social estimation which came to be accorded to such agents of wholesale advance. This truly must shake the pillars of the temple of the cult of top-down, macro-economic command of which the Ekonomista is the house journal.
Remarkably, the Ekonomista’s piece is also daringly heterodox in inferring that, given this highly singular insensitivity to market interest rates, we might therefore return more assuredly to the long-forsaken path of growth if Mario Draghi and his ilk were to treat themselves to a long, contemplative sojourn, taking the waters at one of Europe’s idyllic (German) spa townsinstead of constantly hogging the limelight by dreaming up (and occasionally implementing) ever more involved, Cunning Plans directed towards driving people to act in ways in which they would otherwise not choose to do, but in which Mario and Co. conceitedly deem that they should.
Rather, the hacks have the temerity to assert – and here, Keynes be spared! – it might do much more for the investment climate if the Big Government to which they so routinely and so obsequiously defer were to pause awhile in its unrelenting programme to destroy all private capital, to suppress all economic initiative, and to restrict the disposition of income to thecentralized mandates of its minions and not to trust them to the delocalized vagaries of the market – all crimes which it more readily may perpetrate under the camouflage provided by the central banks’ mindless and increasingly counter-productive, asset-bubble inflationism.
Having reached this pass, might we dare to push the deduction one step closer to its logical conclusion and suggest that the only reason we continue today to suffer a malaise which the self-exculpatory elite (of whom none is more representative than the staff of the Ekonomista itself) loves to refer to as ‘secular stagnation’ is because its own toxic brew of patent nostrums is making the unfortunate patient upon whom it inflicts them even more sick? That, pace Obama the Great, The One True Indispensable Chief of the NWO, the three principal threats we currently face are not Ebola, but QE-bola – a largely ineradicable pandemic of destruction far more virulent than even that dreadful fever; not the locally disruptive Islamic State but the globally detrimental Interventionist State – the perpetrator of a similarly backward and repressive ideology which the IMF imamate seeks to impose on us all; and definitely not the Kremlin’s alleged (though highly disputable) revanchism being played out on Europe’s ‘fringe’ but the Kafkaesque reality of stifling and undeniable regulationism at work throughout its length and breadth?
We might end by reminding the would-be wearer of the One Ring, as He lurks warily, watching the opinion polls from His lair in the White House, that in being so active in propagating each one of these genuinely existential threats to our common well-being, He (capitalization ironically intended) will not so much ‘help light the world’ – as He nauseatingly claimed in His purple-drenched, sophomore’s set-piece at the UN recently – as help extinguish what little light there still remains to us poor, downtrodden masses.
The offending article:
Tight, loose, irrelevant
Interest rates do not seem to affect investment as economists assume
IT IS Economics 101. If central bankers want to spur economic activity, they cut interest rates. If they want to dampen it, they raise them. The assumption is that, as it becomes cheaper or more expensive for businesses and households to borrow, they will adjust their spending accordingly. But for businesses in America, at least, a new study* suggests that the accepted wisdom on monetary policy is broadly (but not entirely) wrong.
Using data stretching back to 1952, the paper concludes that market interest rates, which central banks aim to influence when they set their policy rates, play some role in how much firms invest, but not much. Other factors—most notably how profitable a firm is and how well its shares do—are far more important (see chart). A government that wants to pep up the economy, says S.P. Kothari of the Sloan School of Management, one of the authors, would have more luck with other measures, such as lower taxes or less onerous regulation.
Establishing what drives business investment is difficult, not. These shifts were particularly manic in the late 1950s (both up and down), mid-1960s (up), and 2000s (down, up, then down again). Overall, investment has been in slight decline since the early 1980s.
Having sifted through decades of data, however, the authors conclude that neither volatility in the financial markets nor credit-default swaps, a measure of corporate credit risk that tends to influence the rates firms pay, has much impact. In fact, investment often rises when interest rates go up and volatility increases.
Investment grows most quickly, though, in response to a surge in profits and drops with bad news. These ups and downs suggest shifts in investment go too far and are often ill-timed. At any rate, they do little good: big cuts can substantially boost profits, but only briefly; big increases in investment slightly decrease profits.
Companies, Mr Kothari says, tend to dwell too much on recent experience when deciding how much to invest and too little on how changing circumstances may affect future returns. This is particularly true in difficult times. Appealing opportunities may exist, and they may be all the more attractive because of low interest rates. That should matter—but the data suggest it does not.
* “The behaviour of aggregate corporate investment”, S.P. Kothari, Jonathan Lewellen, Jerold Warner
“Sir, The next financial apocalypse is imminent. I know this to be true because the House & Home section in FT Weekend is now assuming the epic proportions last seen before the great crash. Twenty-four pages chock full of adverts for mansions and wicker tea-trays for $1,000. You’re all mad.
Sell everything and run for your lives.”
- Letter to the FT from Matt Long, Seilh, France, 3rd October 2014.
“Investors unfortunately face enormous pressure—both real pressure from their anxious clients and their consultants and imagined pressure emanating from their own adrenaline, ego and fear—to deliver strong near-term results. Even though this pressure greatly distracts investors from a long-term orientation and may, in fact, be anathema to good long-term performance, there is no easy way to reduce it. Human nature involves the extremes of investor emotion—both greed and fear—in the moment; it is hard for most people to overcome and act in opposition to their emotions. Also, most investors tend to project near-term trends—both favourable and adverse—indefinitely into the future. Ironically, it is this very short-term pressure to produce—this gun to the head of everyone—that encourages excessive risk taking which manifests itself in several ways: a fully invested posture at all times; for many, the use of significant and even extreme leverage; and a market-centric orientation that makes it difficult to stand apart from the crowd and take a long-term perspective.”
- Seth Klarman, Presentation to MIT, October 2007.
“At first, the pendulum was swinging towards infinite interest, threatening the dollar with hyperinflation. Right now the pendulum is swinging to the other extreme, to zero interest, spelling hyper-deflation. This is just as damaging to producers as the swing towards infinite interest was in the early 1980’s. It is impossible to predict whether one or the other extreme in the swinging of the wrecking ball will bring about the world economy’s collapse. Hyperinflation and hyper-deflation are just two different forms of the same phenomenon: credit collapse. Arguing which of the two forms will dominate is futile: it blurs the focus of inquiry and frustrates efforts to avoid disaster.”
- Professor Antal Fekete, ‘Monetary Economics 101: The real bills doctrine of Adam Smith. Lecture 10: The Revolt of Quality’.
“Low interest rate policy has the following grave consequences:
- Normally conservative investors are increasingly under duress and due to the outlook for interest rates remaining low for a long time, are taking on excessive risk. This leads to capital misallocation and the formation of bubbles.
- The sweet poison of low interest rates and easy money therefore leads to massive asset price inflation (stocks, art, real estate).
- Through carry trades, interest rates that are structurally too low in the industrialized nations lead to asset bubbles and contagion effects in emerging markets.
- A structural weakening of financial markets, as reckless behaviour of market participants is fostered (moral hazard).
- A change in human behaviour patterns, due to continually declining purchasing power. While thrift is slowly but surely transmogrified into a relic of the past, taking on debt becomes rational.
- The acquisition of personal wealth becomes gradually more difficult.
- The importance of money as a medium of exchange and a unit of account increases in importance relative to its role as a store of value.
- Incentives for fiscal probity decline. Central banks have bought time for governments. Large deficits appear less problematic, there is no incentive to implement reform, resp. consolidate public finances in a sustainable manner.
- The emergence of zombie-banks and zombie-companies. Very low interest rates prevent the healthy process of creative destruction. Zero interest rate policy makes it possible for companies with low profitability to survive, similar to Japan in the 1990s. Banks are enabled to nigh endlessly roll over potentially delinquent loans and consequently lower their write-offs.
- Unjust redistribution (Cantillon effect): the effect describes the fact that newly created money is neither uniformly nor simultaneously distributed in the population. Monetary expansion is therefore never neutral. There is a permanent transfer of wealth from later to earlier receivers of new money.”
- Ronald-Peter Stöferle, from ‘In Gold We Trust 2014 – Extended Version’, Incrementum AG.
The commentary will have its next outing on Monday 27th October.
“When sorrows come,” wrote Shakespeare, “they come not single spies, but in battalions.” Jeremy Warner for the Daily Telegraph identifies ten of them. His ‘ten biggest threats to the global economy’ comprise:
- Geopolitical risk;
- The threat of oil and gas price spikes;
- A hard landing in China;
- Normalisation of monetary policy in the Anglo-Saxon economies;
- Euro zone deflation;
- ‘Secular stagnation’;
- The size of the debt overhang;
- Complacent markets;
- House price bubbles;
- Ageing populations.
Other than making the fair observation that stock markets (for example) are not entirely correlated to economic performance – an observation for which euro zone equity investors must surely be hugely grateful – we offer the following response.
- Geopolitical risk, like the poor, will always be with us.
- Yes, the prices for oil and natural gas could spike, but as things stand WTI crude futures have fallen by over 15% from their June highs, in spite of the clear geopolitical problems. And the US fracking revolution, in combination with fast-improving fundamentals for solar power, may turn out to be a secular (and disinflationary) game-changer for energy prices.
- China, however, is tougher to dismiss. If we had any meaningful exposure to Chinese equity or debt we would be more concerned. But we don’t, so we aren’t.
- Five of Jeremy Warner’s ‘threats’ are inextricably linked. The pending normalisation of monetary policy in the UK and US clearly threatens the integrity of the credit markets. It’s worth asking whether either central bank could possibly afford to let interest rates rise. This begets a follow-on question: could the markets afford to let the central banks off the hook ? Could we, in other words, finally see the return of the long absent and much desired bond market vigilantes ? That monetary policy rates are so low is a function of the growing prospect of euro zone deflation (less of a threat to solvent consumers, but deadly for heavily indebted governments). Absent a capitulation by the Bundesbank to Draghi’s hopes or intentions for full-blown QE, it’s difficult to see how the policy log-jam gets resolved. But since all German government paper out to three years now offers a negative yield, it’s difficult to see why any euro zone debt is worth buying today for risk-conscious investors. Cash is probably preferable and gives optionality into the bargain. ‘Secular stagnation’ is now a fair definition of the euro zone’s economic prospects. But all things lead back to Warner’s point 7: the size of the debt overhang. Since this was never addressed in the immediate aftermath of the Global Financial Crisis, it’s hardly a surprise to see its poison continue to drip onto all things financial. And since the policy response has been to slash rates and keep them at multi-century lows, it’s hardly a surprise to see property prices in the ascendant.
- Complacent markets ? Check. But stocks have lost a lot of their nerve over the last week. Not before time.
- Ageing populations ? Yes, but this problem has been widely discussed in the investment community over the past two decades – it simply isn’t new news.
We saw one particularly eye-catching chart last week, via Grant Williams, comparing the leverage ratios of major US financial institutions over recent years (shown below).
Source: Grant Williams, ‘Things that make you go Hmmm…’
The Fed’s leverage ratio (total assets to capital) now stands at just under 80x. That compares with Lehman Brothers’ leverage ratio, just before it went bankrupt, of just under 30x. Sometimes a picture really does paint a thousand words. And this, again, brings us back to the defining problem of our time, as we see it: too much debt in the system, and simply not enough ideas about how to bring it down – other than through inflationism, and even that doesn’t seem to be working quite yet.
In a recent interview with Jim Grant, Sprott Global questioned the famed interest rate observer about the likely outlook for bonds:
“What would a bear market in bonds look like? Would it be accompanied by a bear market in the stocks?
“Well, we have a pretty good historical record of what a bear market in bonds would look like. We had one in modern history, from 1946 to 1981. We had 25 years’ worth of persistently – if not steadily – rising interest rates, and falling bond prices. It began with only around a quarter of a percent on long-dates US Treasuries, and ended with about 15% on long-dated US Treasuries. That’s one historical beacon. I think that the difference today might be that the movement up in yield, and down in price, might be more violent than it was during the first ten years of the bear market beginning in about 1946. Then, it took about ten years for yields to advance even 100 basis points, if I remember correctly. One difference today is the nature of the bond market. It is increasingly illiquid and it is a market in which investors – many investors – have the right to enter a sales ticket, and to expect their money within a day. So I’m not sure what a bear market would look like, but I think that it would be characterized at first by a lot of people rushing through a very narrow gate. I think problems with illiquidity would surface in the corporate debt markets. One of the unintended consequences of the financial reforms that followed the sorrows of 2007 to 2009 is that dealers who used to hold a lot of corporate debt in inventories no longer do so. If interest rates began to rise and people wanted out, I think that the corporate debt market would encounter a lot of ‘air pockets’ and a lot of very discontinuous action to the downside.”
We like that phrase “a lot of very discontinuous action to the downside”. Grant was also asked if it was possible for the Fed to lose control of the bond market:
“Absolutely, it could. The Fed does not control events for the most part. Events certainly will end up controlling the Fed. To answer your question – yeah. I think the Fed can and will lose control of the bond market.”
As we have written on innumerable prior occasions, we wholeheartedly agree. Geopolitics, energy prices, demographics – all interesting ‘what if’ parlour games. But what will drive pretty much all asset markets over the near, medium and longer term is almost entirely down to how credit markets behave. The fundamentals, clearly, are utterly shocking. The implications for investors are, in our view, clear. And as a wise investor once observed, if you’re going to panic, panic early.
Recent evidence points increasingly towards global economic contraction.
Parts of the Eurozone are in great difficulty, and only last weekend S&P the rating agency warned that Greece will default on its debts “at some point in the next fifteen months”. Japan is collapsing under the wealth-destruction of Abenomics. China is juggling with a debt bubble that threatens to implode. The US tells us through government statistics that their outlook is promising, but the reality is very different with one-third of employable adults not working; furthermore the GDP deflator is significantly greater than officially admitted. And the UK is financially over-geared and over-dependent on a failing Eurozone.
This is hardly surprising, because the monetary inflation of recent years has transferred wealth from the majority of the saving and working population to a financial minority. A stealth tax through monetary inflation has been imposed on the majority of people trying to earn an honest living on a fixed salary. It has been under-recorded in consumer price statistics but has occurred nonetheless. Six years of this wealth transfer may have enriched Wall Street, but it has also impoverished Main Street.
The developed world is now in deep financial trouble. This is a situation which may be coming to a debt-laden conclusion. Those in charge of our money know that monetary expansion has failed to stimulate recovery. They also know that their management of financial markets, always with the objective of fostering confidence, has left them with market distortions that now threaten to derail bonds, equities and derivatives.
Today, central banking’s greatest worry is falling prices. The early signs are now upon us, reflected in dollar strength, as well as falling commodity and energy prices. In an economic contraction exposure to foreign currencies is the primary risk faced by international businesses and investors. The world’s financial system is based on the dollar as reserve currency for all the others: it is the back-to-base option for international exposure. The trouble is that leverage between foreign currencies and the US dollar has grown to highly dangerous levels, as shown below.
Plainly, there is great potential for currency instability, compounded by over-priced bond markets. Greece, facing another default, borrows ten-year money in euros at about 6.5%, while Spain and Italy at 2.1% and 2.3% respectively. Investors accepting these low returns should be asking themselves what will be the marginal cost of financing a large increase in government deficits brought on by an economic slump.
A slump will obviously escalate risk for owners of government bonds. The principal holders are banks whose asset-to-equity ratios can be as much as 40-50 times excluding goodwill, particularly when derivative exposure is taken into account. The stark reality is that banks risk failure not because of Irving Fisher’s debt-deflation theory, but because they are exposed to a government debt bubble that will inevitably burst: only a two per cent rise in Eurozone bond yields may be sufficient to trigger a global banking crisis. Fisher’s nightmare of bad debts from failing businesses and falling loan collateral values will merely be an additional burden.
Macro-economists refer to a slump as deflation, but we face something far more complex worth taking the trouble to understand.
The weakness of modern macro-economics is it is not based on a credible theory of prices. Instead of a mechanical relationship between changes in the quantity of money and prices, the purchasing power of a fiat currency is mainly dependent on the confidence its users have in it. This is expressed in preferences for money compared with goods, and these preferences can change for any number of reasons.
When an indebted individual is unable to access further credit, he may be forced to raise cash by selling marketable assets and by reducing consumption. In a normal economy, there are always some people doing this, but when they are outnumbered by others in a happier position, overall the economy progresses. A slump occurs when those that need or want to reduce their financial commitments outnumber those that don’t. There arises an overall shift in preferences in favour of cash, so all other things being equal prices fall.
Shifts in these preferences are almost always the result of past and anticipated state intervention, which replaces the randomness of a free market with a behavioural bias. But this is just one factor that sets price relationships: confidence in the purchasing power of government-issued currency must also be considered and will be uppermost in the minds of those not facing financial difficulties. This is reflected by markets reacting, among other things, to the changing outlook for the issuing government’s finances. If it appears to enough people that the issuing government’s finances are likely to deteriorate significantly, there will be a run against the currency, usually in favour of the dollar upon which all currencies are based. And those holding dollars and aware of the increasing risk to the dollar’s own future purchasing power can only turn to gold and subsequently those goods that represent the necessities of life. And when that happens we have a crack-up boom and the final destruction of the dollar as money.
So the idea that the outlook is for either deflation or inflation is incorrect, and betrays a superficial analysis founded on the misconceptions of macro-economics. Nor does one lead to the other: what really happens is the overall preference between money and goods shifts, influenced not only by current events but by anticipated ones as well.
Recently a rising dollar has led to a falling gold price. This raises the question as to whether further dollar strength against other currencies will continue to undermine the gold price.
Let us assume that the central banks will at some time in the future try to prevent a financial crisis triggered by an economic slump. Their natural response is to expand money and credit. However, this policy-route will be closed off for non-dollar currencies already weakened by a flight into the dollar, leaving us with the bulk of the world’s monetary reflation the responsibility of the Fed.
With this background to the gold price, Asians in their domestic markets are likely to continue to accumulate physical gold, perhaps accelerating their purchases to reflect a renewed bout of scepticism over the local currency. Wealthy investors in Europe will also buy gold, partly through bullion banks, but on the margin demand for delivered physical seems likely to increase. Investment managers and hedge funds in North America will likely close their paper-gold shorts and go long when their computers (which do most of the trading) detect a change in trend.
It seems likely that a change in trend for the gold price in western capital markets will be a component part of a wider reset for all financial markets, because it will signal a change in perceptions of risk for bonds and currencies. With a growing realisation that the great welfare economies are all sliding into a slump, the moment for this reset has moved an important step closer.
Orders for US non-military capital goods excluding aircraft rose by 0.6% in August after a 0.2% decline in July to stand at $73.2 billion. Observe that after closing at $48 billion in May 2009 capital goods orders have been trending up.
Most commentators regard this strengthening as evidence that companies are investing both in the replacement of existing capital goods and in new capital goods in order to expand their growth.
There is no doubt that an increase in the quality and the quantity of tools and machinery i.e. capital goods, is the key for the expansion of goods and services. But is it always good for economic growth? Is it always good for the wealth generation process?
Consider the case when the central bank is engaging in loose monetary policy i.e. monetary pumping and an artificial lowering of the interest rate structure. Such type of policy sets the platform for various non-productive or bubble activities.
In order to survive these activities require real funding, which is diverted to them by means of loose monetary policy. (Once loose monetary policy is set in motion this allows the emergence of various bubble activities).
Note various individuals that are employed in these activities are the early recipients of money; they can now divert to themselves various goods and services from the pool of real wealth.
These individuals are now engaging in the exchange of nothing for something. (Individuals that are engage in bubble activities don’t produce any meaningful real wealth they however by means of the pumped money take a slice from the pool of real wealth. Again note that these individuals are contributing nothing to this pool).
Now bubble activities like any non-bubble activity also require tools and machinery i.e. capital goods. So various capital goods generated for these activities is in fact a waste of real wealth. Since the tools and machinery that are generated here are going to be employed in the production of goods and services that without the monetary pumping of the central bank would never emerge. (Wrong infrastructure has emerged).
These activities do not add to the pool of real wealth, they are in fact draining it. (This amounts to economic impoverishment). The more aggressive the central bank’s loose monetary stance is the more drainage of real wealth takes place and the less real wealth left at the disposal of true wealth generators. If such policy persists for too long this could slow or even shrink the pool of real wealth and set in motion a severe economic crisis.
We suggest that the strong bounce in capital goods orders since May 2009 is on account of extremely loose monetary stance of the Fed. Note that the wild fluctuations in our monetary measure AMS after a time lag followed by sharp swings in capital goods orders.
An increase in the growth momentum of money followed by the increase in capital goods orders to support the increase in various bubble activities. Conversely, a decline in the growth momentum of money supply followed by a decline in capital goods orders.
We suggest that a down-trend in the growth momentum of money supply since October 2011 is currently on the verge of asserting its dominance. This means that various bubble activities are likely to come under pressure. Slower monetary growth is going to slow down the diversion of real wealth to them from wealth generating activities.
Consequently capital goods orders are going to come under pressure in the months ahead. (The build-up of a wrong infrastructure is going to slow down – a fewer pyramids will be built).
If there is one concept that illustrates the difference between a top-down macro-economic approach and the reality of everyday life it is the velocity of circulation of money. Compare the following statements:
“The collapse in velocity is testament to the substantial misallocation of capital brought about by the easy money regimes of the past 20 years.” Broker’s research note issued September 2014; and
“The mathematical economists refuse to start from the various individuals’ demand for and supply of money. They introduce instead the spurious notion of velocity of circulation according to the pattern of mechanics.” Ludwig von Mises, Human Action.
This article’s objective is not to disagree with the broker’s conclusion; rather it is to examine the basis upon which it is made.
The idea of velocity of circulation referred to arose from the quantity theory of money, which links changes in the quantity of money to changes in the general level of prices. This is set out in the equation of exchange. The basic elements are money, velocity and total spending, or GDP. The following is the simplest of a number of ways it has been expressed:
Amount of Money x Velocity of Circulation = Total Spending (or GDP)
Assuming we can quantify both money and total spending, we end up with velocity. But this does not tell us why velocity might vary: all we know is that it must vary in order to balance the equation. You could equally state that two completely unrelated quantities can be put into a mathematical equation, so long as a variable is included whose only function is to always make the equation balance. In other words the equation of exchange actually tells us nothing per se.
This gives analysts a problem, not resolved by the modern reliance on statistics and computer models. The dubious gift to us from statisticians is their so-called progress made in quantifying the economy, so much so that at the London School of Economics a machine called MONIAC (monetary national income analogue computer) used fluid mechanics to model the UK’s economy. This and other more recent computer models give unwarranted credence to the idea that the economy can be modelled, derivations such as velocity explained, and valid conclusions drawn.
Von Mises’s criticism is based on the philosopher’s logic that economics is a social and not a physical science. Therefore, mathematical relationships must be strictly confined to accounting and not be confused with economics, or as he put it human action. Unfortunately we now have the concept of velocity so ingrained in our thinking that this vital point usually escapes us. Indeed, the same is true of GDP, or the right hand side of the equation of exchange.
GDP is only an accounting identity: no more than that. It ranks gin with golf-balls by reducing them both to a monetary value. Statisticians select what’s included so it is biased in favour of consumer goods and against capital investment. Crucially it does not tell us about an ever-changing economy comprised of successes, failures, and hard-to-predict human needs and wants, which taken all together is economic progress. And because it is biased in its composition and says nothing about progress the value of this statistic is grossly exaggerated.
The only apparent certainty in the equation of exchange is the quantity of money, assuming it is all recorded. No one seems to allow for unrecorded money such as shadow banking, but we shall let that pass. If the money is sound, as it was when the quantity theory of money was devised, one could assume that an increase in its quantity would tend to raise prices. This was experienced following Spain’s importation of gold and silver from the new world in the sixteenth century, and following the gold mining booms in California and South Africa. But relating an increase in the quantity of gold to prices in general is at best a summary of a number of various factors that drive the price relationship between money and goods.
Today we no longer have sound money, whose purchasing power was regulated by human preferences across national boundaries. Instead we have fiat currencies whose purchasing power is formalised in foreign exchanges. When the Icelandic krona on 8th October 2008 halved in value, it had nothing to do with changes in the quantity of money or Iceland’s GDP. Yet if we try to interpret velocity in this case, we will find ourselves pleading a special case to explain its substantial increase as domestic prices absorbed the shock imparted through the foreign exchanges.
Iceland’s currency collapse is not an isolated event. The purchasing power of a fiat currency varies constantly, even to the point of losing it altogether. The truth of the matter is the utility of a fiat currency is entirely dependent on the subjective opinions of individuals expressed through markets, and has nothing to do with a mechanical quantity relationship. In this respect, merely the potential for unlimited currency issuance or a change in perceptions of the issuer’s financial stability, as Iceland discovered, can be enough to destabilise it.
According to the equation of exchange, this is not how things should work. The order of events is first you have an increase in the quantity of money and then prices rise, because monetarist logic states that prices rise as a result of the extra money being spent, not as a result of money yet to be spent. With a mechanical theory there can be no room for subjectivity.
It is therefore nonsense to conclude that velocity is a vital signal of some sort. Monetarism is at the very least still work-in-progress until monetarists finally discover velocity is no more than a factor to make their equation balance. The broker’s analyst quoted above would have been better to confine his statement to the easy money regimes of the past 20 years being responsible for the substantial misallocation of capital, and leaving out the bit about velocity entirely.
A small slip perhaps on the way to a sensible conclusion; but it is indicative of the false mechanisation of human behaviour by modern macro-economists. However it should also be noted that is impossible to square the concept of velocity of circulation with one simple fact of everyday life: we earn our salaries once and we dispose of it. That’s a constant velocity of roughly one.
“Sir, So Ed Miliband “forgot” to mention the deficit. This from a man who was a key member of the team that ran up a massive structural debt pile when the UK should have been enjoying a cyclical surplus. He was part of a Labour administration that took the UK economy to the brink of effective bankruptcy. Yet less than five years on, as we still struggle to deal with the toxic mess that he and his colleagues left behind, he “forgot” to mention it. This surely ranks alongside “the dog ate my homework” for feeble and unbelievable excuses for non-performance of basic required tasks.”
“Politicians and diapers have one thing in common. They should both be changed regularly, and for the same reason.”
It should be striking that government bonds, in nominal terms, have never been this expensive in history, even as there have never been so many of them. The laws of supply and demand would seem to have been repealed. How could this state of affairs have come about ? We think the answer is three-fold:
The bond market is clearly not perfectly efficient.
Bond yields are being manipulated by central banks through a deliberate policy of financial repression (and QE, of course).
Many bond fund managers may be unaware, or unconcerned, that the benchmarks against which they choose to be assessed are illogical and irrational.
What might substantiate our third claim ? It would be the festering intellectual plague that bedevils the fund management world known as indexation. Bond indices allocate their largest weights to the most indebted issuers. This is the precise opposite of what any rational bond investor would do – namely, to overweight their portfolio according to those issuers with the highest credit quality (or perhaps, all things being equal, with the highest yields). But bond indices do exactly the opposite. They force any manager witless enough to have fallen victim to them to load up on the most heavily indebted issuers, which currently also happen to offer amongst the puniest nominal yields. As evidence for the prosecution we cite the US Treasury bond market, the world’s largest. The US national debt currently stands at $17.7 trillion. With a ‘T’. Benchmark 10 year Treasuries currently offer a yield to maturity of 2.5%. US consumer price inflation currently stands at 1.7%. (We offer no opinion as to whether US CPI is a fair reflection of US inflation.) On the basis that US “inflation” doesn’t change meaningfully over the next 10 years, US bond investors are going to earn an annualised return just a smidgen above zero percent.
How do US Treasury yields stack up against the longer term trend in interest rates ? The following data are from @Macro_Tourist:
10 year US Treasury yields since 1791
The chart shows the direction of travel for US market rates since independence, given that the Continental Congress defaulted on its debts.
Now it may well be that US Treasury yields have further to fall. As SocGen’s Albert Edwards puts it,
“Our ‘Ice Age’ thesis has long called for sub-1% bond yields and I see this extending to the US and UK in due course.”
As things stand, the trend is with the polar bears. The German bond market has already broken down through the 1% level (10 year Bunds at the time of writing currently trade at 0.98%).
Deutsche Bank Research – specifically Jim Reid, Nick Burns and Seb Barker – recently published an extensive examination of global debt markets (“Bonds: the final bubble frontier ?” – hat tip to Arnaud Gandon of Heptagon Capital). Deutsche’s strategists ask whether bonds constitute the culminating financial bubble after almost two decades of them:
“After the Asian / Russian / LTCM crises of the late 1990s we entered a supercycle of very aggressive policy responses to major global problems. In turn this helped encourage the 2000 equity bubble, the 2007 housing / financial / debt bubble, the 2010-2012 Euro Sovereign crisis and arguably some recent signs of a China credit bubble (a theme we discussed in our 2014 Default Study). At no point have the imbalances been allowed a full free market conclusion. Aggressive intervention has merely pushed the bubble elsewhere. With no obvious areas left to inflate in the private sector, these bubbles have now arguably moved into government and central bank balance sheets with unparalleled intervention and low growth allowing it to coincide with ultra-low bond yields.” [Emphasis ours.]
The French statesman George Clemenceau once commented that war is too important to be left to generals. At this stage in the game one might be tempted to add that monetary policy is far too important to be left to politicians and central bankers. We get by with free markets in all other walks of economic and financial life – why let the price of money itself be dictated by a handful of State-appointed bureaucrats ? We were once told by a fund manager (a Japanese equity manager, to be precise – rare breed that that is now), around the turn of the millennium, that Japan would be the dress rehearsal, and that the rest of the world would be the main event. Again, the volume of the mood music is rising in SocGen’s favour.
We nurse no particular view in relation to how the government bond bubble (for it surely is) plays out – whether yields grind relentlessly lower for some time yet, or whether they burst spectacularly on the back of the overdue return of bond market vigilantes or some other mystical manifestation of long-delayed economic common sense. But Warren Buffett himself once said that,
“If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”
The central bank bond market poker game has been in train for a good deal longer than half an hour, and the stakes have never been higher. Sometimes, if you simply can’t fathom the new rules of the game, it’s surely better not to play. So we’re not in the business of chasing US Treasury yields, or Gilt yields, or Bund yields, ever lower – we’ll keep our bond exposure limited to only the highest quality credits yielding the highest possible return. Even then, if Fed tapering does finally dissipate in favour of Fed hiking – stranger things have happened, though we can’t think of any off the top of our head – it will make sense at the appropriate time to eliminate conventional debt instruments from client portfolios almost entirely.
But indexation madness is not limited to the world of bonds. Its malign, unthinking mental slavery has fixed itself upon the equity markets, too. Equity indices, as is widely acknowledged, allocate their largest weights to the largest and most expensive stocks. What’s extraordinary is that even as stock markets have powered ahead, index trackers have enjoyed their highest ever inflows. The latest IMA data show that more UK retail money was put into tracker funds in July than in any other month since records began. We accept the ‘low cost’ aspect of tracker funds and ETFs; we take serious issue with the idea of buying stock markets close to or at their all-time high and being in for any downside ride on a 1:1 basis.
But there is a middle way between the Scylla of bonds at all-time low yields and the Charybdis of stocks at all-time high prices. Value. Seth Klarman of the Baupost Group once wrote as follows:
“Stock market efficiency is an elegant hypothesis that bears quite limited resemblance to the real world. For over half a century, disciples of Benjamin Graham, the intellectual father of value investing, have prospered buying bargains that efficient market theory says should not exist. They take advantage of the short-term, relative performance orientation of other investors. They employ an absolute (not relative) valuation compass, patiently exploiting mispricings while avoiding overpaying for what is popular and trendy. Many are willing to concentrate their exposures, knowing that their few best ideas are better than their hundredth best, and confident in their ability to tell which is which.
“Value investors thrive not by incurring high risk (as financial theory would suggest), but by deliberately avoiding or hedging the risks they identify. While efficient market theorists tell you to calculate the beta of a stock to determine its riskiness, most value investors have never calculated a beta. Efficient market theory advocates moving a portfolio of holdings closer to the efficient frontier. Most value investors have no idea what this is or how they might accomplish such a move. This is because financial market theory may be elegant, but it is not particularly useful in formulating a successful investment strategy.
“If academics espousing the efficient market theory had no influence, their flawed views would make little difference. But, in fact, their thinking is mainstream and millions of investors make their decisions based on the supposition that owning stocks, regardless of valuation and analysis, is safe and reasonable. Academics train hundreds of thousands of students each year, many of whom go to Wall Street and corporate suites espousing these beliefs. Because so many have been taught that outperforming the market is impossible and that stocks are always fairly and efficiently priced, investors have increasingly adopted strategies that eventually will prove both riskier and far less rewarding than they are currently able to comprehend.”
That sounds about right to us. Conventional investing, both in stocks and bonds on an indexed or benchmarked basis, “will prove both riskier and far less rewarding” than many investors are currently able to comprehend.
Today’s financial markets are built on the sand of unsound currencies. Consequently brokers, banks and investors are wedded to monetary inflation and have lost both the desire and ability to understand gold and properly value it.
Furthermore governments and central banks in welfare-driven states see markets themselves as the biggest threat to their successful management of the economy, a threat that needs to be tamed. This is the backdrop to the outlook for the price of gold today and of the forces an investor in gold is pitted against.
At the heart of market control is the substitution of unsound currency for sound money, which historically has been gold. Increasing the quantity of currency and encouraging banks to increase credit out of thin air is the principal means by which central banks operate. No matter that adulterating the currency impoverishes the majority of the population: central banks are working from the Keynesian and monetarist manual of how to manage markets.
In this environment an investor risks all he possesses if he insists on fighting the system; and nowhere is this truer than with gold. Gold is not about conventional investing in this world of fiat currencies, it is about insurance against the financial system collapsing under the weight of its own delusions. Regarded as an insurance premium against this risk, gold is common sense; and there are times when it is worth increasing your insurance. In taking that decision, an individual must be able to evaluate three things: the relative quantities of currency to gold, the likelihood of a systemic crisis and the true cost of insuring against it. We shall consider each of these in turn.
The relationship of currency to gold
Not only has the quantity of global currency and bank credit expanded dramatically since the Lehman crisis, it is clear that this is a trend that cannot now be reversed without triggering financial chaos. In other words we are already committed to monetary hyperinflation. Just look at the chart of the quantity of US dollar fiat money and note its dramatic growth since the Lehman crisis in 2008.
Meanwhile, the quantity of above-ground stocks of gold is growing at less than 2% annually. Gold is therefore getting cheaper relative to the dollar by the day. [Note: FMQ is the sum of all fiat money created both on the Fed’s balance sheet and in the commercial banks. [See here for a full description]
Increasing likelihood of a systemic crisis
Ask yourself a question: how much would interest rates have to rise before a systemic crisis is triggered? The clue to the answer is illustrated in the chart below which shows how lower interest rate peaks have triggered successive recessions (blue shaded areas are official recessions).
The reason is simple: it is the accumulating burden of debt. The sum of US federal and private sector debt stands at about$30 trillion, so a one per cent rise in interest rates and bond yields will simplistically cost $300bn annually. The increase in interest rates during the 2004-07 credit boom added annual interest rate costs of a little over double that, precipitating the Lehman crisis the following year. And while the US this time might possibly weather a two to three per cent rise in improving economic conditions, much less would be required to tip other G8 economies into financial and economic chaos.
The real cost of insurance
By this we mean the real price of gold, adjusted by the rapid expansion of fiat currency. One approach is to adjust the nominal price by the ratio of US dollars in circulation to US gold reserves. This raises two problems: which measure of money supply should be used, and given the Fed has never been audited, are the official gold reserves as reported to be trusted?
The best option is to adjust the gold price by the growth in the quantity of fiat money (FMQ) relative to the growth in above-ground stocks of gold. FMQ is constructed so as to capture the reversal of gold’s demonetisation. This is shown in the chart below of both the adjusted and nominal dollar price of gold.
Taken from the month before the Lehman collapse, the real price of gold adjusted in this way is $550 today, based on a nominal price of $1220. So in real terms, gold has fallen 40% from its pre-Lehman level of $920, and has roughly halved from its adjusted high in 2011.
So to summarise:
• We already have monetary hyperinflation, defined as an accelerating debasement of the dollar. And so for that matter all other currencies that are referenced to it are on a similar course, a condition which is unlikely to be halted except by a final systemic and currency crisis.
• Attempts to stabilise the purchasing power of currencies by raising interest rates will very quickly develop into financial and economic chaos.
• The insurance cost of owning gold is anomalously low, being considerably less than at the time of the Lehman crisis, which was the first inkling of systemic risk for many people.
So how is the global economy playing out?
If the economy starts to grow again a small rise in interest rates would collapse bond markets and bankrupt over-indebted businesses and over-geared banks. Alternatively a contracting economy will increase the debt burden in real terms, again threatening its implosion. So the last thing central banks will welcome is change in the global economic outlook.
Falling commodity prices and a flight from other currencies into the dollar appear to be signalling the greater risk is that we are sliding into a global slump. Even though large financial speculators appear to be driving commodity and energy prices lower, the fact remains that the global economy is being undermined by diminishing affordability for goods and services. In other words, the debt burden is already too large for the private sector to bear, despite a prolonged period of zero official interest rates.
A slump was halted when prices collapsed after Lehman went bust; that time it was the creation of unlimited money and credit by the Fed that saved the day. Preventing a slump is the central banker’s raison d’être. It is why Ben Bernanke wrote about distributing money by helicopter as the final solution. It is why we have had zero interest rates for six years.
In 2008 gold and oil prices fell heavily until it became clear that monetary stimulus would prevail. Equities also fell with the S&P 500 Index down 60% from its October 2007 high, but this index was already 24% down by the time Lehman failed.
The precedent for unlimited creation of cash and credit has been set and is undisputed. The markets are buoyed up by a sea of post-Lehman liquidity, are not discounting any trouble, and are ignoring the signals from commodity prices. If the economic downturn shows any further signs of accelerating the adjustment is likely to be brutal, involving a complete and sudden reassessment of financial risk.
This time gold has been in a bear market ahead of the event. This time the consensus is that insurance against financial and systemic risk is wholly unnecessary. This time China, Russia and the rest of Asia are buying out physical bullion liquidated by western investors.
We are being regularly advised by analysts working at investment banks to sell gold. But bear in mind that the investment industry is driven by trend-chasing recommendations, because that is what investors demand. Expecting analysts to value gold properly is as unlikely as farmers telling turkeys the truth about Thanksgiving.
[Editor's Note: This article, by Mateusz Machaj, first appeared at mises.org]
Various criticisms have been raised against the Fed, not only from the side favoring the abolition of central banking, but also from the side of those who argue that the Federal Reserve is indispensable for stability. One of those arguments came from respected economist John Taylor, who is the author of the often mentioned “Taylor Rule” on how to conduct monetary policy, with two House Republicans recently proposing to impose this “rule” on the Fed .
Like Taylor, politicians who advocate for such a rule blame huge credit expansion for the Great Recession. Unfortunately such policymakers are usually not convinced by the Austrian arguments in favor of abolition of the Federal Reserve. Instead they are convinced by John Taylor’s statistical demonstrations. According to Taylor, the Fed set the interest rates too low in the beginning of this century, which led to an unsustainable real estate boom. He adds nonetheless: if only the central bank followed his rule of proper interest rate levels, then monetary policy would work very well.
For Taylor, the Federal Funds rate in recent years should have looked something like this:
The first thing to note about the Taylor Rule is that, strictly speaking, there is no such thing as one universal Taylor Rule. There are many possible Taylor Rules, depending on a variety of factors, on which there is no agreement. Any version of the rule crucially depends on the usage of mathematical variables and their coefficients in the used equation, which is used for calculating the “right” level of interest rates set by the central bank. Those main variables are price inflation and the so called “output gap,” a difference between “actual output” and “potential output.”
Depending on which variables we exactly pick and how we use them, we can have different rules, and therefore different interest rate policy recommendations. It is all well documented in the mainstream literature. Economists disagree how to measure “potential output” (should we use trends, econometric models, or “production function models”?) and there is no agreement how much importance should be assigned to it. There are discussions about the nature of the data that is being used — should it be the one registered currently, or real-time data, or should it be somehow adjusted, since every data set will sooner or later become revised data? Or perhaps since monetary policy takes time we should focus more on the predicted data, rather than just look at the immediate past? We can add to this the Austrian flavor: there are problems with proper price inflation measurements (various indices can differ significantly), and even the actual output measurements can be questioned as proper indicators of economic activity.
It is in fact the case that one can come up with several versions of the Taylor Rule. For example, we could come up with one that would recommend lower interest rates than what we had at the beginning of this century or we could come up with a version of the rule that would recommendhigher interest rates. Or we could come up with one that suggests no change. Research does not give us any clear answer which version of the rule should be chosen.
One particular version which John Taylor is using for his criticism of Alan Greenspan, for example, serves as an ex post demonstration that interest rates should have been higher. Yet there is nothing really that special about this inference. After the fact, anyone can come up with an alternate version of any rule to demonstrate that interest rates should have been higher.
The crucial question to be answered is the following: can reliance on one particular version of the Taylor Rule pave the way for a bubble-proof economy? As described above, a Taylor Rule in any of its versions can at best target the balance between a chosen index for “price inflation” and a chosen way of measuring the invented concept of aggregate “potential output.”
The problem is that targeting either of those macroeconomic variables is not a recipe forintertemporal coordination understood in the Hayekian sense: as coordination between successive stages of production. In his major works Hayek proved that targeting one selected variable, such as price inflation, is not a proper formula for macroeconomic stability. Actually, stabilizing the index may ultimately cause macroeconomic destabilization. It is the same case with Taylor Rules, although in the rule the concept of “potential output” is hidden. Yet this potential output describes production in the aggregate, so it cannot capture the notion of intertemporal coordination among many acting individuals in countless industries.
Malinvestment bubbles are still possible when the central bank follows Taylor Rules, because by targeting potential output and price inflation the central bank triggers artificial credit expansions. For an example, we need only look to the dot-com bubble which happened even though the federal funds rates were actually significantly higher in the nineties than the most-used version of the Taylor Rule would recommend at that time.
The answer to the Taylor Rule is the Hayek Rule, which is the rule of balancing savings with investments in truly free financial markets. Meanwhile, we must endure the current situation of a market stimulated by the central bank with its pretense of knowledge about the “right” price for money and credit.
Low interest rates contribute to weak labour markets
In the latter part of August, the cream of the world’s central bankers convened at the annual Kansas City Fed gathering at Jackson Hole, Wyoming. Every year the Conference has a theme. Last year’s was Quantitative Easing (QE): when and how it would end. This year’s topic was unemployment, under the rather grandiose title “Re-Evaluating Labour Market Dynamics”.
Ms Yellen, chair of the Federal Reserve, seemed at last to acknowledge one of this Newsletter’s recurring concerns; namely, that official unemployment data mislead because they ignore the number of citizens so disaffected with prospects that they no longer register as looking for work. She is warming towards a new Fed Board developed Labour Market Conditions Index (LMCI) which takes account of workforce participation rates and various other measures. She considers LMCI a better indicator of employment market strength or weakness than the raw unemployment percentage number. By this measure, unemployment is still substantially above the pre-crisis level. Accordingly, Ms Yellen remains concerned about the present strength of the US recovery:
“the recent behavior of both nominal and real wages point to weaker labor market conditions than would be indicated by the current unemployment rate”;
Nonetheless, she indicated that interest rates would rise if future, stronger than expected, labour market data were reported.
Similar concerns are now paramount among UK central bankers. The Bank of England now overtly links its ‘forward guidance’ about the timing of interest rate increases to evidence of growth in wage levels.
The ECB’s President Mario Draghi had absorbed the summer’s deterioration in European data suggesting that another slowdown is underway. Only this time, it is impacting primarily the core, France and Italy, and even Germany. Finance Minister Schaeuble recently said that ‘the ECB have already done enough’ so Germany is firmly against more stimulus at this stage.
President Draghi’s speech put labour market worries at the forefront of Europe’s problems. In Europe there was a second surge in unemployment 3 years after the financial crisis. From early 2011, when it became apparent that a number of countries would, without bailouts, default or renege on sovereign debt, heavy job losses drove up the Eurozone average to levels that have only recently topped out. Draghi took the opportunity of the profile of this occasion once again to express doubts whether unleashing QE in the Eurozone would make any difference to labour market conditions, because national governments have failed to implement substantive structural reforms. Like a physical trainer addressing a group of failed slimmers after 3 years of group therapy, he berated that he has done all he could do in the group sessions, those dissatisfied with their progress should look to themselves.
Although these presentations reveal doubts among leading central bankers that near zero interest rate policies (ZIRP) may not result in economic stimulus, there is still a gulf between these doubts and the scepticism about ZIRP policies, doubt that have been strongly expressed by the Bank for International Settlements (see our July Newsletter).
An even stronger counter view is beginning to gather mainstream support; namely, that ZIRP is a primary cause of the continuing weak labour market conditions. The reasoning is as follows. By reducing the cost of borrowing money substantially below its ‘market’ level, capital goods for businesses have become disproportionately cheap compared with the cost of employing people. When weighing up the cost/ benefit of, say, installing a machine to sell tickets in train stations compared with employing staff to do the same job, low interest rates reduce the cost of the machine option. Businessmen make such decisions using discounted cash flow analysis, whereby future costs are assessed a present value using average market interest rates over the term. So ZIRP has a double whammy effect; not only is the borrowing cost of the machine lower, but by applying a discount rate of close to zero to the employee option, the present value cost of the stream of wages is increased. This may go some way towards explaining the trend of low to moderate-income jobs being replaced by machines in areas such as supermarket checkout services as well as transport ticketing.
This is a classic “misallocation” as per Austrian economics. It follows that, when rates rise, firms will find their overall operations burdened by excessive (now expensive) capital equipment. What they will then want are more productive employees. However, the lack of skilled workers–those out of the labour force for several years tend to be less productive–will make competition for skilled labour intense, wage pressures will rise, and the combination of excess capital capacity and rising wage pressures will intensify the stagflation we have already seen to date (see our July Newsletter).
Concerns about Repo Market Disruptions.
In August, concerns were reported that the US repo market, one of the largest engines of liquidity in global capital markets, was experiencing disruptions to its otherwise smooth functioning owing to a reduction in repo activity by banks. Banks explained this by citing increased capital costs under the recently introduced Leverage Ratio (see our February Newsletter).
Before considering this further, since repo transactions can be confusing, let us set out an example. A repo counterparty, say an investment fund, might hold a 5-year US Treasury bond. There has traditionally been a deep and liquid market enabling the fund to enter into a contract with, say, a bank to sell and buy back the bond, usually on a very short-term basis (overnight). However, medium term funding can be obtained by rolling the position every day. The sale and repurchase price are pre-agreed, the differential constitutes the return to the provider of cash. Banks have been encouraged to play the role of repo cash provider (otherwise known as Reverse repo Counterparty) as the market for derivatives, particularly interest rate swaps (IRS), has grown.
Thus it can be seen that not only have banks been lured to the repo market by the modest net interest income generated by being the repo cash provider against very low credit risk, but also because repos provide a steady source of government bonds that are useful for other hedging activities of the bank itself.
So why are they now pulling back? Even though the Basel Capital weighting applied to banks’ holdings of non-defaulted government bonds is zero, such holdings are indeed caught by the Leverage Ratio. Therefore, there will be a cost from the new rule’s effective date of 1 January 2015.
But is the pullback entirely attributable to new regulations, as claimed in the mainstream press? We are not so sure. There also appears to be a shortage of available collateral (Treasury bonds) in the maturities most popular with market participants. Perhaps this results from the Federal Reserve’s mopping up of so much of the US Treasury security market via its QE programme. The result is that banks providing cash into the transaction in which the underlying security is becoming scarce (e.g. 5 years), now expect to make a negative return on the loan of the cash. The loss would materialize if the price they will have to pay in the market to buy back the bond for delivery back to the counterparty has risen owing to scarcity. In these circumstances, it is hardly surprising that banks would prefer to deposit their cash with the Federal Reserve at a better rate of return and without the negative Leverage ratio consequences.
Under normal market conditions, repo provides a cheap and easy way to releverage an asset. If trend described in the previous paragraph persists, does it presage the start of wholesale reductions in systemic leverage? We doubt it. The thrust of ‘legal’ financial innovation, especially since the outbreak of the crisis, has been for banks to find new ways of leverage through collateral transformation, swapping collateral with each other in ways that either slip by, or are tacitly approved by regulators. One such example is asset rehypothecation, which we discussed in our January Newsletter.
Finally, is this repo market disruption an ‘unintended consequence’ of the new Leverage Ratio regulations? The prevailing view appears to be negative. A small number of senior US Reserve bank governors have long memories of the 2008 crisis, and fear a recurrence of the repo market seizure. Sceptics may take the view that those bank governors are overly focussed on the symptoms of that crisis rather than on its cause. As has been amply documented, at the peak of the crisis (before any talk of bailouts), repo and other markets froze up because a number of insolvent counterparties reneged on obligations to deliver cash or collateral, triggering a collapse in confidence upon which these interbank markets rely. Shrinking the repo market will not prevent a recurrence of system wide crisis when such insolvency worries resurface.
[Editor's note: Please find the IREF Newsletter here]