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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.

Politics

Yes, Virginia, There Is No Political Santa Claus

At a time of the year when gift giving and charitable good spirit fills the air, please allow me to be the one who rains on the parade: “Yes, Virginia, there is no Santa Claus!”

I don’t mean the Santa who comes down the chimney with toys for every girl and boy. This is the Santa who really is Mom or Dad, Grandparent or other family members or close friends who out of their own earned income choose to purchase, wrap and give gifts to those little ones on Christmas morning.

The small child may have been told the fairy story about an jolly, fat man in a red suit who lives in the far north, working with his elves all year long so the toys and other presents are ready to be miraculously delivered to every “good boy and girl” around the world in one night.

But we “adults” all know that is all just a story for the children at an early and gullible age when the fantasy of it all seems possibly real. And many of us cherish those early years of wonder and make-believe, before the reality breaks through that it just does not and cannot happen that way.

The Redistributing and Regulating Political Santa

I mean the Uncle Sam “Santa” that, not just at Christmas time, but year-round, is believed by many people to have the ability to bring them many of the good things they want from a mythical North Pole called Washington, D.C., or any governmental capital around the world.

This is the political Santa who delivers subsidies of various sorts to farmers or “alternative energy” manufacturers. The Santa who redistributes vast sums of money for educational expenditures, or public housing, welfare and food stamps, or government defense contracts, and even “bridges to nowhere.”

This is also the political Santa who can magically fill the global skies with unmanned drones for surveillance and death, or fund decade-long trillion-dollar wars in far-off lands, or bankroll “friendly” governments in other places around the world while punishing “bad” countries for what Uncle Sam defines as “misbehavior.”

This is the Santa who claims the power and ability remake human nature, control human thought, and redesign some or even all of human society into various preferred shapes and forms.

This political Santa works hard to create the illusion that prosperity and improvement in the human condition cannot happen if not for the guiding, regulating, and manipulating hand of “benevolent” government.

The Political Myth of Something for Nothing

But while almost all children grow out of their belief in a Santa Claus with his home at the North Pole who “somehow” succeeds in manufacturing all those “goodies” that he carries on his sleigh on Christmas Eve, many people go through their entire life convinced of the Santa-like abilities of a paternalistic government that can “somehow” assure many, if not all, of the desired good things of life.

However, just as “Santa” is really Mom and Dad who buy the presents, and wrap them to put under the Christmas tree, governmental “Santa” are those in political office who have no ability to bestow desired benefits on “all” without, in fact, first taking from some to give to others.

Mom and Dad work. They assist in producing goods or in performing services for others in the marketplace, which earns them a salary or nets them a profit. They have had to first produce to, then, through the income they earned, have the ability to consume, including on the goods that their children find on Christmas morning.

The governmental Santa must, first, tax away the income and wealth of some to, then, redistribute it in one form or another to others in the country over which those in political power assert fiscal and regulatory authority.

For the mythical Santa at the North Pole there are no costs for anything he does. The resources, raw materials and tools with which his Christmas goodies are made just appear. The elves work, apparently, for nothing and their food and clothes do not need to be produced, either.

For our political Santa Claus to rain redistributive “gifts” on those he considers deserving and “nice,” he must take from those found to be “naughty” and not nice.

Santa vs. Government Giveaway cartoon

Political Santa’s “Gifts” Carry High Costs

Our political Santa Claus imposes real and meaningful costs on many in society to do his magical “social work.” First, he must appropriate part of the material wealth produced by those productive members of society. People who, in a free market, only earn what they have by peacefully offering to others things those others desire and value enough to pay an agreed-upon price to acquire.

A portion of the intellectual and material effort of real men and women are seized from them through compulsory taxation. The government classifies these net taxpayers in society as having more than they “really” need, and usually don’t ethically “deserve.”

They get “sack of coal” for being “bad” in the form of being left with less than the full value of their creative and hardworking effort. They are denied the opportunity and the right to enjoy the complete fruits of their mental and physical labors. Their choices to spend what they have honestly earned are narrowed to what the political Santa decides they should have available to spend.

The “good” little political citizens who are given the redistributive benefits, therefore, are the net recipients of what others have produced, and which they have received due the ideological and pressure group power they can bring to bear in collaboration with the political Santa in the municipal, state, and national halls of governmental control.

But the costs of political Santa’s generosity do not come just in the form of direct redistributions. They also come in the form of regulations, restrictions, and licensing requirements that determine who may allowed to compete, work, and earn a living in a particular line of enterprise, production, and trade.

This “sack of coal” for the “bad” citizens also comes in the form in the inability to start a business or expand and successfully run an enterprise as the result of the regulatory hand of political Santa. The costs also take the form of closed opportunities for those with little or no skills to find work or be hired at a starting wage that would give them a chance at improving their own lives through honest employment in the free marketplace.

It also costs the consumers who find their choices and options are more limited or nonexistent than the free market would have provided, if only the government had not imposed these barriers, walls, and hurtles in the way of those who merely wish to be left alone to go about their private and personal affairs of life by offering new, better, and less expense goods and services to their fellow men through honest, peaceful, and mutually agreed terms of trade.

The “good little citizens” in this case are those on the supply-side of the market who are sheltered from the competition of real or potentially more efficient and productive rivals. Their larger market shares, greater profit margins, and costly inefficiencies are protected by the political Santa’s regulatory power; he, in turn, receives the campaign contributions and implicitly bought votes on election days that keep him in office.

The Myth of Needing a Political Santa for Life

For political Santa to pursue his mythical game in governmental plunderland, he must do all in his power to persuade and convince his citizen “children” that they do not have a right to their own life and to live it in their own chosen way. They must be indoctrinated to either passively accept the role of life-long dependent upon the political Santa, or to serve as the self-sacrificing elves who must do the work to produce all the goods and services in the world that will be redistributed out of the political Santa’s sack of taxed and regulated benefits.

Santa will educate you; he will see that you have a job and that you receive a “fair” wage. He will make sure that you are safe and satisfied by controlling what is produced, how it produced, and the terms under which the “bad” business children under his regulatory supervision market and sell many of those “goodies” to you.

When sick or disabled, political Santa will give you medical care; and he will guarantee you a retirement free from the need for planning for these things yourself.

All you need to do is accept your status as a lifetime adolescent needing supervision, care, and oversight in everything and in all things that you do. The spirit and psychology of being political Santa’s dependent was captured in that government website cartoon during the first Obama Administration called “The Life of Julia.”

“Julia” needed government to supply the hospital in which she was born; to provide the pre-school education with which her political indoctrination began; too see that Julia was given not only a government high school diploma, but got taxpayer subsidies and special quotas to make it into a preferred college or university; to see that gender affirmative action laws guaranteed a “fair chance” to a good paying job and career that she otherwise could never get on her own; and to see that in later years Julia has the safety-net of government Social Security, without having to bear the responsibility of carrying for this herself.

President Santa Claus cartoon

Self-Sacrificing “Elves” to Serve Political Santa

The other side of political Santa’s plunderland is the indoctrination of the productive and producer “elves” who are needed to do the work that supplies all that government can give away. This requires convincing everyone that “society” comes before the individual; that anything that the individual has is not due to his own effort and his peaceful and voluntary associations with others, or as President Obama asserted, “You did not built it.”

Instead, what you have is due to the collective efforts of all, so that you cannot claim a right to anything or any more than what the collective deems you to deserve. And it is political Santa who represents and acts for the social collective in determining what shall be expected from you and in what form, and what you shall be allowed to have from “society” (or that you are allowed to keep) as bestowed by the government’s redistributive and regulatory activities.

But just as there is no Santa at the North Pole, there is no political Santa in society. Political Santa is really those who run for political office to gain and retain governmental control and power over other people’s lives. Political Santa is really all the special interest groups who wish to use the halls of governmental power to obtain through regulation and taxation what they cannot honestly earn in the open competition of the free marketplace.

Ethical Benevolence vs. Political Immorality

Benevolence and voluntary charity, and a properly understood spirit of “giving” to those you value and love at Christmas time are right and virtuous sentiments of free people in the open society.

But belief in and actions based upon the idea of a “political Santa” only succeeds in weakening and finally destroying the spirit and ethical health of a free and prosperous society.

So, yes, Virginia, there is no Santa Claus. Neither a North Pole Santa who comes down the chimney in a red suit, nor a political Santa who can give people “something for nothing” in a world in which all that people want and desire must be creatively produced by someone before it may used to satisfy those wants and desires.

What makes the mythical belief in a political Santa far worse than the short-lived childhood belief in the North Pole Santa, is that the idea of a political Santa challenges and destroys the spirit of individualism upon which the good, free and prosperous society ultimately rests.

Economics

The Real Fed Tug Of War: the Yellen Doctrine vs. the Volcker Doctrine

The financial markets are on a hair trigger as to when, and how quickly, the Fed will tighten and raise interest rates.  Billions of dollars will be won or lost by investors on this wager.

For the rest of us, getting it right — as did Chairman Volcker and (during his first two terms), Greenspan is crucial to the creation of a climate of equitable prosperity in which jobs are created in abundance.  39 million jobs were created during the “Great Moderation.” We haven’t seen anything remotely like that since.

Getting it right is crucial to economic mobility — raises, bonuses, and promotions — to let us workers climb the ladder to decent affluence. Thus, just when to raise rates is much less important than the bedrock issue.

For over a decade now job creation has been poor. Poor, too, has been economic mobility.  The left is very much on record as calling for extended ease — keeping interest rates down.  The right has been critical over the Fed’s “zero interest rate policy.” Yet the real tug of war is over whether the Fed should follow a monetary rule or exercise discretion; and, if a rule is preferable, what rule?

Yellen has been on a campaign to demonstrate her empathy with workers.  Less well known: this empathy is shared by many conservatives and libertarians. I, among others, find Yellen’s new openness to rank and file workers and activists a refreshing change of tone from that of the formerly hermetically sealed “Temple.” There are few matters on which I agree on with Sen. Sherrod Brown. This is one of them. As Sen. Brown told Politico:

“I love that Chair Yellen and three Fed governors actually had public meetings,” said Sen. Sherrod Brown of Ohio, an outspoken member of the Senate Democrats’ liberal wing, commending Yellen and her colleagues for recently meeting with progressive activists. “She wants to set a different tone there where they’re listening to the public and listening to people who have lost jobs, listening to people who have seen their life savings evaporate….

Yellen’s descent from Temple Mount to we plain people of the plane is a notable shift. It well accords, at least in style and possibly in substance, with the new populist spirit abroad in the land.  It is imperative, however, that it prove substantive and not merely cosmetic.  And substantive means an intellectual openness to a diversity of views.

The right is not the party of Ebenezer Scrooge.  The right is all for job creation and a rising tide lifting all boats. Yet Yellen has been connecting, so far exclusively, with the left. In her first year, Yellen visited a trade school and donned a welding mask (a terrific photo op, truly); toured a low income neighborhood before speaking, to wide note, at a Boston Fed conference where she advocated for the social safety net and social services (notably, mysteriously, not speaking about monetary policy); met with President Obama on the eve of the 2014 election; and recently took an unprecedented meeting with what Bloomberg.com called “labor and community organizers.”

It is my guess that Janet Yellen reaches out to the social-democratic left because it represents her native intellectual milieu. They speak her language.  Many progressives simply find the right foreign, our language alien. (Memo to Yellen: If all I knew about my team was what I read from Paul Krugman I, too, would disdain me. The mainstream media portrayal of the right is a grotesque caricature.  We’re not the way we are portrayed.  We are, however, skeptical of the efficacy of central planning.  For good reason. And, Dr. Yellen? America is a center right nation.)

Soon we shall stop guessing and find out if Janet Yellen truly is open to hearing a diversity of views … or whether this really is merely a “charm campaign.” One of the leading monetary integrity advocacy groups (and the lead gold standard advocacy group) on the center right, American Principles in Action, which I professionally advise, recently hand-delivered to the Fed a request to Madam Yellen that she meet with representatives of the right.

The letter, signed by 20 high profile figures on the right, stated:

This is to endorse the pending request by American Principles in Action’s Steve Lonegan for a meeting with you, Vice Chair Fischer, and others of your selection, to gather and exchange views with a delegation of monetary policy thought leaders from the center-right.

The left by no means has a monopoly on concern for unemployment and wage stagnation.  To balance a meeting with a group composed of, as described by Bloomberg News, “labor and community organizers” with one of the leading representatives of the center right experts would honor that principle of “a diversity of views”. An evenhanded insight on achieving our shared goal of job creation and economic mobility would facilitate steps toward realization of this mutual objective.

The letter is noteworthy and may portend a significant shift in the discourse. The “money quote:”The left by no means has a monopoly on concern for unemployment and wage stagnation.” This is a thematic development that Yellen would do well to encourage. The difference between members of the humanitarian left and humanitarian right is one of means, not ends.

All agree that money matters, and that the Fed is the fulcrum of the world’s monetary system.  The left believes that discretion is the recipe for more equitable prosperity. The right believes that a monetary rule will yield greater equitable prosperity. Both cannot be right.  Yet this is, and should be treated as, an empirical, not doctrinal, matter. It is not, at heart, a “left vs. right” issue.

In a way, it’s “Yellen vs. Volcker.”  Contrast a statement by Madam Yellen with one made by former (and iconic author of the Great Moderation) Fed Chairman Paul Volcker, reprised in an earlier column:

Madame Yellen [at hearing of the House Financial Services Committee chaired by Chairman Jeb Hensarling earlier this year] stated that “It would be a grave mistake for the Fed to commit to conduct monetary policy according to a mathematical rule.”  Contrast Madame Yellen’s protest with a recent speech by Paul Volcker in which he forthrightly stated: “By now I think we can agree that the absence of an official, rules-based cooperatively managed, monetary system has not been a great success.  In fact, international financial crises seem at least as frequent and more destructive in impeding economic stability and growth. … Not a pretty picture.”

Not all rules are mathematical.  There may be room for agreement implicit in Yellen’s statement.

There is no generic rule. And a bad rule, or a rule badly implemented, could be worse than no rule at all. If a rule is to be preferred, which rule?

There are contending schools of thought. These prominently include the Taylor Rule, NGDP targeting, inflation targeting, commodity price targeting, and the gold standard. Of the latter, Paul Volcker, not himself a proponent of the gold standard, once had this to say in his Foreword to Marjorie Deane and Robert Pringle’s The Central Banks (Hamish Hamilton, 1994):

It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less. By and large, if the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with ‘free banking.’

Which rule would most likely be optimal for fomenting equitable prosperity as well as price stability? Each regime has eloquent advocates.

It is, in fact, an open question.

Thus the safest path forward out of the uncharted territory in which we find ourselves appears to be the proposed Brady-Cornyn monetary commission introduced in the 113th Congress. It reportedly is certain to be re-introduced in the 114th.

The proposed commission, widely praised in the financial media, is designed to be strictly bipartisan and meticulously empirical.  It is chartered to make an objective assessment of the real outcomes of the various rules now being propounded. While many commissions are designed to derail an issue, a monetary commission would be very much in order. Monetary policy is intricate and potent, not amenable to political towel-snapping-as-usual.

This proposed commission is not in at all inimical to the Fed. The Fed Chair gets an appointment of an ex-officio Commissioner to ensure that the monetary authorities have a dignified voice in the review process.  The Treasury Secretary gets to appoint an ex-officio commissioner as well.

Politico has termed Yellen’s the “Toughest job in Washington.” This surely is apt.   In taking a step away from her crystal ball and connecting with the rank and file Janet Yellen may have unleashed a healthy dynamic that could prove beneficial to making progress.  But only if she listens to all sides.  Moreover, the Commission would provide a civil buffer from the sobering reality that, as Politico reported, “Republican leaders and staff said in interviews that they plan to use their new dominance on both sides of Capitol Hill next year to target the Fed for much greater scrutiny, including aggressive hearings ….”

On the surface it’s a tug of war between raising and lowering interest rates.  At root, it’s an argument about whether the Fed should be following a rule or making one up as it goes along.  If Yellen proves open to a diversity of viewpoints, and if the Fed puts its benediction on the Brady-Cornyn monetary commission legislation, 2015 well could see the beginning of a move in the direction of credit both affordable and abundant that could rival for job creation the Great Moderation.

Originating at http://www.forbes.com/sites/ralphbenko/2014/12/15/the-yellen-tug-of-war/

Economics

Total Output grew by 2.17% in 2012

October 31st saw the belated release of the 2014 Input-Output Supply and Use Data. This is important because it incorporates a larger amount of economic activity than GDP data, but comes at the cost of only appearing as an annual series, and with an 18 month (or longer) lag. The diagram below shows the breakdown of the measure for 1997:

I’ve previously mentioned that Gross Output data is now an official BEA statistic, and I am interested in seeing equivelent figures for the UK. Here they are.

Firstly, in terms of absolute numbers, we can see that Total Output dwarfs Nominal GDP.

In fact Total Output is around twice as large as Nominal GDP:

The reduction in the ratio that occured in 2002-2005 is a result of Nominal GDP growth running ahead of Total Output growth. But notice the dramatic increase in the ratio in 2006. This was because Nominal GDP was growing at 5.81%, whilst Total Output grew at 8.73%. This reveals that economic activity was running at a significantly higher pace than a focus on GDP data was telling us:

One of the main reasons why the September revisions to GDP had such an impact was because of a reclassification of R&D spending. This rests on a conceptual problem with distinguishing between investment and intermediate consumption. As more and more economic activity becomes service based we might expect this problem to grow over time. One of the chief benefits of using a broader measure of national income is that it captures all intermediate consumption, and therefore the boundary between intermediate and final consumption/investment becomes less relevent.

These figures reveal that in 2010 and 2011 the wider economy was growing at a higher rate than that being measured by GDP, and in 2012 they were effectively the same. It is very difficult to read much into these annual growth rates, given that there is likely to be a lot of quarterly volatility. But in the same way that the US have started releasing this as a quarterly series, there would be much to gain from the ONS doing likewise.

Economics

Are major economies suffering from the deficiency of demand?

In his article “The curse of weak global demand”, Financial Times November 18, 2014, the economics columnist Martin Wolf wrote that today’s most important economic illness is chronic demand deficiency syndrome. Martin Wolf argues that despite massive monetary pumping by the central banks of US and EMU and the lowering policy interest rates to around zero both the US and the EMU economies have continued to struggle.

After reaching 1.0526 in Q1 2006 the US real GDP to its trend ratio fell to 0.966 by Q3 2011. By Q3 2014 the ratio stood at 0.98. The ratio of EMU real GDP to its trend after closing at 1.061 in Q1 2008 fell to 0.954 by Q3 2014.

Real GDP Ratios

Martin Wolf is of the view that what is needed is to raise the overall demand for goods and services in order to revive economies. He also holds that there is a need to revive consumer confidence that was weakened by the severe weakening of the financial system.

He is also of the view that there is a need for the banks to lift their lending in order to revive demand, which in turn, he suggests, will revive the economies in question. He also blames massive debt for the economic difficulties that the US and the EMU economies are currently experiencing.

Martin Wolf views the current economic illness as some mysterious and complex phenomena, which requires complex and non-conventional remedies.

We suggest that the essence of Wolf’s argument is erroneous. Here is why.

There is no such thing as deficiency of demand that causes economic difficulties. The heart of economic growth is the process of real wealth generation.

The stronger this process is the more real wealth can be generated and the stronger so-called economic growth becomes. What drives this process is infrastructure, or tools and machinery. With better infrastructure more and a better quality of goods and services i.e. real wealth, can be generated.

Take for instance a baker who has produced ten loaves of bread. Out of this he consumes one loaf and the other nine he saves.

He can exchange the saved bread for the services of a technician who will enhance the oven. With an improved oven the baker can now produce twenty loaves of bread. Now he can save more and use the larger savings pool to further invest in his infrastructure such as buying other tools that will lift the production and the quality of the bread.

Observe that the key for wealth generation is the ability to generate real wealth. This in turn is dependent on the allocation of the part of wealth towards the buildup and the enhancement of the infrastructure.

Also, note that if the baker were to decide to consume his entire production i.e. keeping his demand strong, then he would not be able to expand the production of bread (real wealth).

As time goes by his infrastructure would have likely deteriorated and his production would have actually declined.

The belief that an increase in the demand for bread without a corresponding increase in the infrastructure will do the trick is wishful thinking.

We suggest that there is no such thing as a scarce demand. Most individuals have unlimited desires for goods and services.

For instance, most individuals would prefer to live in nice houses rather than in small apartments.

Most people would like to have luxuries cars and be able to dine in good quality restaurants. What prevents them in achieving these various desires is the scarcity of means.

In fact as things stand most individuals have plenty of desires i.e. goals, but not enough means.

Unfortunately means cannot be generated by boosting demand. This will only increase goals but not means.

Contrary to the popular way of thinking we can conclude that demand doesn’t create supply but the other way around.

As we have seen by producing something useful i.e. bread, the baker can exchange it for the services of a technician and boost his infrastructure.

By means of the enhanced infrastructure the baker can generate more bread i.e. more means that will enable him to attain various other goals that previously were not reachable by him.

The current economic difficulties are the outcome of past and present reckless monetary and fiscal policies of central banks and governments.

It must be realized that neither central banks nor governments are wealth generating entities. All that they can set in motion is a process of real wealth redistribution by diverting real wealth from wealth generators towards non-wealth generating activities.

As long as the pool of real wealth is expanding the central bank and the government can get away with the myth that their policies can grow the economy.

Once however, the pool of wealth becomes stagnant or starts shrinking the illusion of the central bank and government policies are shattered.

It is not possible to expand real wealth whilst the pool of real wealth is shrinking. Again a shrinking pool of wealth over time can only support a shrinking infrastructure and hence a reduced production of goods and services that people require to maintain their life and well being – real wealth.

The way out of the current economic mess is to close all the loopholes of wealth destruction. This means to severely cut government involvement with the economy. It also, requires closing all the loopholes for the creation of money out of “thin air”.

By curtailing the central bank’s ability to boost money out of “thin air” the exchange of nothing for something will be arrested. This will leave more real wealth in the hands of wealth generators and will enable them to enhance and to expand the wealth generating infrastructure.

Contrary to Martin Wolf the expanding of bank loans as such is not going to revive the economy. As we have seen the key for the economic revival is the buildup of infrastructure that could support an expanding pool of real wealth.

Banks are just the facilitators in the channeling of real wealth. However, they do not generate real wealth as such.

The lending expansion that Martin Wolf suggests is associated with fractional reserve lending i.e. lending out of “thin air” and in this respect it is bad news for the economy – it sets in motion the diversion of real wealth from wealth generators to non wealth generating activities.

We can conclude that the sooner governments and central banks will start doing nothing the sooner economic revival will emerge. We agree with Martin Wolf that the economic situation currently seems to be difficult; however, it cannot be improved by artificially boosting the demand for goods and services.

Summary and conclusion

Some experts are of the view that today’s most important economic illness is chronic demand deficiency syndrome. It is because of this deficiency that world economies are still struggling despite massive monetary pumping by central banks, or so it is held. We suggest that this way of thinking is erroneous. The key problem today is a severe weakening in the wealth generation process. The main reason for this is reckless monetary and government policies. We hold that the sooner central banks and governments start doing nothing the sooner economic revival will occur.

Money

Understanding the Money Creation and Society Debate

Together with colleagues spanning four parties – Michael Meacher (Lab), Caroline Lucas (Green), Douglas Carswell (UKIP) and David Davis (Con) – I have secured a debate on Money Creation and Society for Thursday 20 November. Here’s a quick guide to understanding the debate.

First, we have a system of paper or “fiat” money: it exists due to legal mandate as opposed to being a physical commodity like gold. Reserves, notes and coins are created by the state but claims on money are created by the banks when they lend. Most of the money we have was created by banks lending.

This excellent video from Dominic Frisby is a great place to begin:

There was once a time when the literature about money creation was sufficiently off the mainstream to be dismissed. The Bank of England now explains:

I published a short paper on what is wrong with the current system and what to do about it, first inBanking 2020 and then Jesús Huerta de Soto kindly republished it in his journal Procesos De Mercado Vol.X nº2 2013. A further monetary economist privately reviewed the paper but errors and omissions remain my own. You can download it here:

Recent emergency monetary policy has been dominated by Quantitative Easing: the Bank of England has provided a report on The distributional effects of asset purchases (PDF). However, the financial system has been chronically inflationary throughout my lifetime, ever since the Bretton Woods currency system ended.

If QE has distributional effects, why not all money creation?

Here is a historic price index from the Office for National Statistics and House of Commons Library: Consumer Price Inflation since 1750 (PDF).

Price Index 1750-2003

And here is the growth of broad money from 1982 to date via the Bank of England (series LPMAUYM). Note that the money supply stopped accelerating in the course of the crisis, during the period of QE:

M4: 1982-2014

No one can argue prosperity has not increased over the period but if distributional effects matter at all, one must ask “Who benefits?” Via Positive Money, here’s where the new money went:

Sectoral lending

As I said in debate on 6 Dec 2011:

Why are we in this debt crisis? I have just checked the M4 money supply figures—I am sorry to return to aggregates, but needs must. When Labour came to power the money supply was about £700 billion and it is now about £2.1 trillion, so it has tripled over the past 14 years. Unfortunately, most economists talk about money flowing into the economy as if it were water poured into a tank that found its own level immediately, but what if it is like treacle or honey? What if it builds up in piles when poured into the economy and takes a while to spread out? What if that money was loaned into existence in response to individual choices led by the excessively low interest rates pushed by the central bank? What if it was loaned into existence in particular sectors, such as the housing sector, where prices have more than doubled over the same period, and what if it was the financial sector that received the benefit of that new money first? Would that not explain why financiers and bankers are so much wealthier than everyone else, and why economic activity and wealth has been reorientated towards the south-east?

This debate will explore the effects on society of long-term money creation by private banks’ lending in the context of the present financial system.

Further reading:

Economics

Macro economic data: an instrument for government intervention

It is generally held that for an economist to be able to assess the state of the economy he requires macro-economic indicators which will tell him what is going on. The question that arises is why is it necessary to know about the state of the overall economy? What purpose can such types of information serve?

Careful examination of these issues shows that in a free market environment it doesn’t make much sense to measure and publish various macro-economic indicators. This type of information is of little use to entrepreneurs. The only indicator that any entrepreneur pays attention to is whether he makes profit. The higher the profit, the more benefits a particular business activity bestows upon consumers.

Paying attention to consumers wishes means that entrepreneurs have to organise the most suitable production structure for that purpose. Following various macro-economic indicators will be of little assistance in this endeavour.

What possible use can an entrepreneur make out of information about the rate of growth in gross domestic product (GDP)? How can the information that GDP rose by 4% help an entrepreneur make a profit? Or what possible use can be made out of data showing that the national balance of payments has moved into a deficit? Or what use can an entrepreneur make out of information about the level of employment or the general price level?

What an entrepreneur requires is not general macro-information but rather specific information about consumers demands for a product or a range of products. Government lumped macro-indicators will not be of much help to entrepreneurs. The entrepreneur himself will have to establish his own network of information concerning a particular venture. Only an entrepreneur will know what type of information he requires in order to succeed in the venture. In this regard no one can replace the entrepreneur.

Thus if a businessman assessment of consumers demand is correct then he will make profits. Wrong assessment will result in a loss. The profit and loss framework penalizes, so to speak, those businesses that have misjudged consumer priorities and rewards those who have exercised a correct appraisal. The profit and loss framework makes sure that resources are withdrawn from those entrepreneurs who do not pay attention to consumer priorities to those who do.

In a free market environment free of government interference the “economy” doesn’t exist as such. A free market environment is populated by individuals, who are engaged in the production of goods and services required to sustain their life and well being i.e. the production of real wealth. Also, in a free market economy every producer is also a consumer. For convenience sake we can label the interaction between producers and consumers (to be more precise between producers) as the economy. However, it must be realised that at no stage does the so called “economy” have a life of its own or have independence from individuals.

While in a free market environment the “economy” is just a metaphor and doesn’t exist as such, all of a sudden the government gives birth to a creature called the “economy” via its constant statistical reference to it, for example using language such as the “economy” grew by such and such percentage, or the widening in the trade deficit threatens the “economy”. The “economy” is presented as a living entity apart from individuals.

According to the mainstream way of thinking one must differentiate between the activities of individuals and the economy as a whole, i.e. between micro and macro-economics. It is also held that what is good for individuals might not be good for the economy and vice-versa. Within this framework of thinking the “economy” is assigned a paramount importance while individuals are barely mentioned.

In fact one gets the impression that it is the “economy” that produces goods and services. Once the output is produced by the “economy” what is then required is its distribution among individuals in the fairest way. Also, the “economy” is expected to follow the growth path outlined by government planners. Thus whenever the rate of growth slips below the outlined growth path, the government is expected to give the “economy” a suitable push.

In order to validate the success or failure of government interference various statistical indicators have been devised. A strong indicator is interpreted as a success while a weak indicator a failure. Periodically though, government officials also warn people that the “economy” has become overheated i.e. it is “growing” too fast.

At other times officials warn that the “economy” has weakened. Thus whenever the “economy” is growing too fast government officials declare that it is the role of the government and the central bank to prevent inflation. Alternatively, when the “economy” appears to be weak the same officials declare that it is the duty of the government and central bank to maintain a high level of employment.

By lumping into one statistic many activities, government statisticians create a non-existent entity called the “economy” to which government and central bank officials react. (In reality however, goods and services are not produced in totality and supervised by one supremo. Every individual is pre-occupied with his own production of goods and services).

We can thus conclude that so called macro-economic indicators are fictitious devices that are used by governments to justify intervention with businesses. These indicators can tell us very little about wealth formation in the economy and thus individuals’ well-being.

Economics

A market reset due

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.

Total World Money 2013

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.

Prices

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.

Gold

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.

Economics

The state of Austrian Economics and classical liberalism in Latin America

[Editor’s Note: The following piece was written exclusively for The Cobden Centre by Axel Kaiser, the Executive Director of think tank Fundacion para el Progresso, based in Santiago. It gives a good outline of how Austrian/free market ideas are developing in South America. Many young people globally are now embracing the ideas of Mises and Hayek, but we are also currently seeing undesirable reactions among many people, who now tragically associate free market ideas with crony capitalism and bailouts for the wealthy in society.] 

The Austrian school of economics has gained increasing attention since the 2008 financial crisis and Latin America has not been an exception in this trend. It is mostly young people who have been captivated by the ideas of Hayek, Mises, Rothbard and Huerta de Soto. The most powerful proponents of these ideas in the Spanish-speaking world presently are the Juan de Mariana Institute and the Universidad Rey Juan Carlos in Spain. The first actively participates in the public debate while the second has introduced both a Masters degree and a PhD in Austrian Economics under the leadership of Austrian economist Jesús Huerta de Soto. Many Latin Americans have been trained in the Universidad Rey Juan Carlos and returned to their countries to teach and influence in the public debate.

But there are also several institutions supported by private sponsors that actively promote Austrian economics and classical liberalism in Latin America itself. A remarkable case is Caminos de la Libertad in Mexico. Financed by Ricardo Salinas Pliego, head of the Salinas Group, Caminos de la libertad focuses on educating students in the ideas of liberty. It also organizes the most competitive classical liberal essay contest for scholars in the Spanish-speaking world. Fundación Libertad in Rosario, Argentina is another think tank that advances the Austrian school with great success among young people. Perhaps the most notable case of an institutional effort made to spread classical liberalism and the Austrian school is the Universidad Francisco Marroquín in Guatemala, which was founded entirely on a classical liberal philosophy. Its contributions to the cause of liberty have been considerable in a region dominated by socialist and populist worldviews.

Other important think tanks are CEDICE that does an extraordinary complex work in Venezuela, CREES in the Dominican Republic, IEEP in Ecuador and Fundación para el Progreso in Chile. This last one emerged as a classical liberal reaction against the dramatic rise that socialism and populism experienced over the last years. The Cato Institute has also a special concern with Latin America and permanently finds in these institutions support for organizing the “Cato University”, which brings together students from all over Latin America to learn classical liberalism and fee market economics from leading Latin American scholars.

Despite all these efforts, Latin America at large seems to be moving in the direction of populism and statism. The best and most alarming example is Chile. Long considered a bastion of free market reforms, the country has started a violent departure from the path of progress that followed the last three decades. The hegemony of left-wing and populist ideas has overwhelmed public opinion and caught pro market opinion leaders off guard. If the new statist trend is not stopped on time, the now most prosperous country in the region could follow an Argentinian type of institutional evolution in the next decades that would leave Latin America without a role model on sound economic policy.

Like in Europe and the United States, one of the central causes for the hegemony of statism in Latin America is the fact that most intellectuals and especially university professor are strong supporters of government intervention. This is extremely problematic in countries that are developing and require a wide consensus on policies needed for overcoming poverty. The free market movement in Latin America is still too weak to counterbalance this hegemony and achieve the shift in the intellectual climate of opinion necessary to move towards sound economic policies. It remains to be seen if in the long run the failure of statist ideas will allow once again for change that is desperately needed in the region. It that comes to happen, current pro market think tanks and intellectuals will play a decisive role in shaping the new institutional arrangements and in creating the public support for ensuring their survival.

Axel Kaiser is a Chilean public intellectual, financial columnist and writer dedicated to spreading classical liberalism in Latin America. He is also executive director of the think tank Fundación para el Progreso based in Santiago.

Economics

Money, Macro and Markets

It was something of an irony last week when the idiots savants who constitute the upper ranks of the ineffable current incarnation of the IMF decided briefly to forgo their penchant for the politics of the Montagnard – more inflation, higher wages, death to the speculators, les aristocrats à la lanterne, that sort of thing – in favour of those of the ancien régime. Specifically, this took the form of updated proposals for a ‘Visa’ of the kind twice instituted in early 18th century France; the first to try to clear up the fiscal mess which was the principle legacy of the military vainglory of the just departed Sun King and a second time to mop up after that QE disaster of its time, John Law’s infamous ‘System’.

 

Sorting the participants into five classes whose activities were deemed to have been increasingly speculative – and hence liable to more swingeing penalties – those in charge of the Visa saw to it that the bigger players (or at least those bigger players unable to use their royal connections to secure themselves an indemnity) suffered haircuts, retrospective tax assessments, forcible debt extensions, property confiscation – and, in one or two cases, a salutary trip to the Bastille.

 

Jump forward three centuries and in its latest position paper on sovereign debt ‘resolution’ the IMF is drooling about dipping, in a not wholly dissimilar fashion, into people’s pension funds and insurance policies – since these are seen to be easy targets – as well as about imposing arbitrary prolongations of tenor on outstanding securities should the state’s chronic mismanagement end up rendering it temporarily unable to entice sufficient new or repeat suckers into enabling the maintenance of its naked fiscal Ponzi scheme.

 

As the reader may be aware, we are all for adopting a stance of unsentimental realism when it comes to facing problems of over-indebtedness and, further, that we have long bemoaned the readiness of governments to swell their own commitments in the aftermath of financial crises, not just because of the inherent cronyism and inequity which riddles most TBTF assistance packages, but because sovereign debt is intractable in a way that private sector obligations generally are not. We are, therefore, more than happy to see all breaches of contract – which is what the unpayability of a debt involves – dealt with in as clinical and judicial way as possible, no matter whether these failures are misjudgements, examples of malfeasance, of ‘acts of god’. Moreover, we are exceedingly happy to see anything which reminds people that, despite the modern fiction of the ‘risk-free’ rate which attaches to them, Leviathan’s IOUs have always been among the least trustworthy of all pledges to pay.

 

However, that principal is not what is at issue here, but what does gall is the IMF’s glib reliance on the sneaky, archly legalistic, announce-it-once-the-banks-are-closed repudiation of existing agreements by a borrower which has not only promoted itself as the one true guardian of the people’s well-being, but which has frequently given its subjects precious little choice but to trust a goodly part of the surplus they have wrung from their already sorely-taxed income to those same instruments whose terms the state is now unilaterally amending in its favour.

 

As yet one more example of the sinister creed of ‘Gemeinnutz geht vor Eigennutz’, this betrays the classic statist proclivity to view all notionally private property as really belonging to the Collective, even if this is rarely expressed so clearly today as it was when last elevated into a central tenet of axe-and-bundle political theory in the 1920s and 30s.

 

‘What’s yours is only truly so to the extent that we, the functionaries of the Hive, do not decide that we have a better use for it and so do not exercise what we insist is our prior claim to it, ‘ they imply, though a little more disingenuously than heretofore. Having ignited an all too short-lived burst of outrage at last year’s more overt Visa proposal to go for a straight confiscation of 10% of ‘wealth’, this latest business of simply denying people an exit route has the poisonous virtue of being more subtle in its operation and therefore of being more likely to pass into effect all unremarked, even if the effect upon those being locked in would be broadly equivalent in many respects.

 

Moreover, for all the weasel words uttered in the Fund’s blueprint about limiting moral hazard, the plan explicitly endorses what it archly terms the ‘reprofiling’ measure on the grounds that it serves to deliver a ‘larger creditor base’ into the meat-grinder and hence helps limit damage to ‘longer-term creditors who would have otherwise had to shoulder the full burden of the debt reduction’ As an added bonus, stiffing one’s existing creditors in place of begging a payday loan from Uncle IMF ‘…increases the chances of a more rapid return to the market, as the debt stock will be less burdened by senior claims’ – i.e., those emanating from the IMF itself. A third, tacit advantage would be that since the IMF would not be not committing an actual monies, there need be no debate among its members about the implementation of such a programme, while the softening of the criteria calling for its use from one where the state’s finances are categorically ‘unsustainable’ to one where there is a mere inability to rule out the arrival of such a contingency drastically lowers the nuclear threshold.

 

One might object that the very knowledge that such steps could be taken would be enough to destroy any residual element of ‘sustainability’ with which a given sovereign’s budget might otherwise be imbued. If people became aware that in buying a 3-month T-bill (and buying it at vanishingly small rates of interest at that) they were also selling their overlords a 30-year put, or that the YTW calculation of their security really ought to include the chance of a 10% principal reduction, would they not try to incorporate this in its price, thereby pushing up yields and so aggravating any incipient funding difficulties? Might they, indeed, not halt their discretionary purchases altogether and so advance rather than retard the onset of the crisis?

 

Given that they are each, in their own way, subject to the compulsions of so-called ‘prudential’ regulations with regard to the assets they must hold to ensure their solvency and liquidity, would such ‘captives’ as the banks, pension funds, and insurers thus be left the only buyers outside of the ever-eager to oblige central bank? A moment’s consideration of what could happen to the most fragile of these – the already–impaired banks – if their assets were suddenly to suffer another sizeable mark down as a result of state defalcation shows why the IMF wants the universe of the afflicted to be as all-inclusive as possible. That way, however large the absolute loss might be, the percentage loss to each holder could be conveniently minimized as the poor individual innocent was once again mulcted to provide a subsidy for the rich, corporate players whose fate is so closely entwined with that of their overlords.

 

Thus, under the terms of this new wheeze, we might imagine a day when the following missive drops onto the doormat of the Forgotten Men and Women up and down the country

 

“Dear Grandma and Grandad, thank you for making the valiant effort over these past decades to achieve a measure of self-reliance in your dotage and for allowing us jacks-in-office full use of your savings in the meanwhile as both a means to fulfil our political ambitions and as a way to act out our own economically-illiterate and usually illiberal prejudices at the expense of you and yours.”

 

“Sadly, it transpires that we have not only wasted a goodly part of your savings, but we have greatly added to the host of irredeemable promises which we made to you, in the form of a mountain of even more pressing pledges issued to the Biggest of Big Fish in the financial markets. So that we do not entirely dissuade these latter sophisticates from again indulging our follies at the earliest opportunity, we shall now have to ask you to share – and thereby greatly to reduce – their pain.”

 

“Be assured, however, that the loss for which you have my heartfelt sympathy will patriotically ensure that we can continue to live well beyond our means. In this way your sacrifice will see to it that the least possible harm will come to any of us in the political classes (a.k.a. the agents of your misfortune), to our army of placemen, patronage-seekers, and dole-gatherers, or to our plutocratic enablers for – as the IMF puts it – ‘…resources that would otherwise have been paid out to creditors will have been retained [to] reduce [our] overall financing needs.’ Nor will we have to suffer the indignity of modifying our existing approach overmuch by actually only spending money on the things for which you, in true democratic fashion, have openly voted the taxes since – here let me cite those marvellous chaps in Washington, once again – ‘resources could be efficiently employed to allow for a less constraining adjustment path.’, i.e., to allow one demanding as little fundamental ‘adjustment’ as possible.”

 

“I feel confident you will join me in looking forward with some enthusiasm to the next, inevitable ‘reprofiling’, just as soon as we can arrange to overspend enough to make one necessary once again. Should I have already laid down the heavy burden of selfless public service by the time this comes about and gone instead to my just reward as a highly-paid ‘consultant’ to a global investment bank, I would urge you to give your full support to my successor, of whatever political stripe he or she may be. In such an event, there will, of course, be precious little different in the treatment you receive at the hands of any of the mainstream parties as currently constituted”

 

Yours Insincerely, The Minister of Finance.

 

It is all too easy at present to make fun of the IMF, though in so doing we should bear in mind that such ridicule is perhaps the only weapon we have in our fight to prevent it from lending a spurious air of rationality to the worst predilections of our national nomenklatura.

 

A case in point is that, at the conclusion of its periodic, Article IV review of the economic condition of the homeland of so many of those in the upper reaches of the Fund, the website prominently carried the triumphant banner, “France: Policies on the Right Track.”!

 

Truly, you could not make this up. For a slightly less self-justificatory assessment, one only has to trawl briefly through the Bloomberg series or consult the most recent verdict of the official ‘auditor’ of the nation, the Cours de Comptes.

 

There it becomes readily apparent that while the two decades prior to the first oil shock saw Real GDP, ex-government trend upward at a 5.5% annualized rate, and the next three decades managed 2.3% compound, the last seven years have seen no progress made whatsoever. Similarly, real capital formation by non-financial business has decelerated from 7.5% to 2.9% to zero over those same divisions of time. Exports stand at close to a 6 ½ year low and two-way trade at the weakest in more than three years. Industrial output – a whisker off the worst since the rebound from the GFC – lies 13% below its peak and hence no higher than it first reached in 1988

 

Government expenditures, meanwhile, have swollen to a record 58% of overall GDP, 80% of private, with taxes some 4-5% behind. These are levels only exceeded in the EU by Finland, Denmark, Greece, and Slovenia. The EU-calibrated debt:GDP ratio has risen by 30% of GDP since the Crash and by 12% since 2010 alone (that latter a slippage of 15% compared to the German pathway from an almost identical starting point). Here, fast approaching €2 trillion outright, it stands at 94% of overall GDP and therefore at 120% of that of the private component out of whose income that debt must be ultimately serviced.

 

Yes, policies are indeed on the right track, assuming that track itself is an economic highway to hell.

 

Given the foregoing, it was of note that the Governor of the Banque de France, Christian Noyer, insisted over the weekend that it might be highly counter-productive to speculate publicly about any programme of even partial debt repudiation.

 

“This all corresponds to a somewhat contrived definition of sustainability and ignores the highly disruptive effects… besides, it relies on a very pessimistic growth outlook,” he argued. “Once one starts not to pay ones debts, borrowing becomes very expensive and the impact on growth greatly exceeds that of managing a gentle reduction in debt.”

 

The only problem with such a judgement is that M. Noyer’s preferred – if sometimes implicit – remedy is for a reinforcement of the policies which have so signally failed France over the past several years – viz., further extreme monetization of assets (to include equities, if need be) and a weaker currency.

 

As a result, we find ourselves ensnared in nest of Keynesian paradoxes and economic canards. We need more investment, we are told, but the only means we can imagine to stimulate it is to lower interest rates. We understand that debt levels are too high, but we are so terrified that they might actually begin to be reduced that we subsidize profligacy as the default option of policy. We fret that prices of assets are rising as a result, not the price of labour (which we implicitly want to increase so we can reduce debt ratios, rather than debt itself) and in order to offset a form of inequality we ourselves have engendered, we stultify an economy already overburdened with rules and regulations with that en vogue form of top-down, baby-with-the-bathwater interference we style ‘macroprudential’ policy.

 

We want to see more people in work, on the one hand we work manfully to introduce ingenious tax and benefit ‘wedges’ which act to discourage marginal job seekers and, on the other, we call for the cost of labour to be raised through higher minimum wage rates (and or plain-old monetary inflation). We decry the fact that businesses will not hire while lowering the prospective economic returns to such hiring by seeking to tax profits more heavily.

 

The reality is that it does not have to be like this. The curse of macroeconomics is that it takes what should be a crude metalanguage which merely attempts the convenient shorthand of describing an impossibly complex but largely self-organising whole using a few, hopefully representative general features and attempts to elevate it into a rigorous, cybernetic control system to be twiddled and fiddled by the fingers of Philosopher Kings. Given this assertion, let us try instead to work from the other – the microeconomic – end and see if we can shed a little light on this dark and dismal scene.

 

If Robinson Crusoe wishes to survive his enforced sojourn on his remote island, he must only engage in such activities as provide him with a flow of the needs – at their most elementary, sustenance and shelter – that is at minimum no smaller than their accomplishment costs him in the expenditure of time and effort. The more astute he is in doing this, the more alert and adaptable he is in going about it, the wider will be the margin of success he enjoys, the more rapidly his most essential requirements will be satisfied, and the sooner he can move on to meeting a broader range of desires and to building up a precautionary reserve against misfortune.

 

It should then be obvious that, when Friday washes up over the reef, Crusoe – unless driven by an inexhaustible fund of potentially-self-endangering altruism – will not be able to offer his new companion an ongoing share in his accomplishments, free access to his stock of implements, or the instant ability to draw upon his, Crusoe’s, hard-won skill and understanding if Friday does not at the very least act in a manner which exacts no net toll of Crusoe (including the unseen one of foregoing better opportunities for gain in their use elsewhere). In fact, he would be unlikely to take the risk of depleting his own scarce resources and of squandering his finite energies if Friday does not contribute something beyond such a bare material parity, the which surplus he, Crusoe, will be able to use to increase the future possibilities open for the two of them to exploit.

 

If we stop to think about it clearly, Crusoe’s surplus income – and let us not be shy to call this his profit – is what enables him firstly to improve his own standard of living (to invest) and eventually to afford Friday the means with which to leapfrog away from the perils and privation of shipwrecked destitution to the more secure and less impoverished existence he may lead if he contracts to work under the guidance of Crusoe’s entrepreneurial instincts while utilising some of Crusoe’s already-produced stock of capital. For this, Friday earns himself the right to avail himself of an agreed proportion of the goods (the income) they generate through their mutual collaboration. Once more, it is Crusoe who rightly accedes to and disposes of any subsequent excess which he by his craft, and they two by their sweat, can conjure out of the unforgiving surroundings of their savage little world.

 

Assuming Crusoe to be as diligent in his way as Friday is in his, the generation of each successive surplus will allow Crusoe progressively to improve the quality, quantity, and variety of means they each can employ, so that Friday, as well as he, can enjoy those better returns on his effort which accrue from the fact that his capital endowment has risen, those better returns being what we call a higher real wage.

 

It is all very well to bewail the fact that, in the modern world, the admirably rugged individual, Crusoe, has been transformed into that bête noire of the scribbling and scriptwriting classes – the faceless and vaguely sinister Crusoe Incorporated – and it may equally be a matter of unthinking dogma that ‘profit’ like ‘property’ is theft, but the truth remains that what applied to our pairing of Lost-prequel cast members still applies in the disembodied world of distributed shareholding and managerial agency: profit is both the sign of entrepreneurial success and the seedcorn of capital provision; labour will only be – can only be – hired if the value of its product exceeds the cost of its retention; and the more capital each worker has at his disposal (including the kind contained between his ears), the greater will be the likely worth of his product and hence the more lavish his reward.

 

There are no short cuts on offer. Or perhaps none which bear up to the test of self-sustainability. Thus, the would-be macro-puppeteers of the kind characterised by Deputy BOE Governor Jon Cunliffe when he waxed metaphorical in a recent speech about how the Old Lady’s duty was to ‘steer’ the economy ‘at the highest speed that can be achieved… down a winding road’ can be seen both to seriously overate their powers to do good and to vastly underestimate their proclivity to do harm.

 

Allow a man the scope both to make and keep a profit (to win receipts greater than costs, adjusted for the passage of time); place no restrictions on the terms of the mutually-beneficial, freely-contracted co-operation into which he enters with less adventurous, but no less assiduous, persons as he seeks to do so; do as little as possible to add to the costs of any such contract (monetary manipulation herein included) and thus to dissuade either party from entering into it; subject our man to no deterrent to ploughing the fruits of this cycle’s endeavours back into the attempt to make those of the next more succulent and more plentiful and, by and large, though failures will occur and frauds will not be unknown, all those involved will flourish – even if they happen to live in a France where, the last we heard, the laws of economics still applied and where it was not the people who were failing but those who ruled over them.

 

But let us not to be too unfair to the worthies who reside among the splendours of the Elysée, the Matignon, or Bercy: as the Cours de Comptes points out, the performance of their counterparts on the other side of the Channel has in many ways been just as unimpressive.

 

The UK, after all, still runs a deficit of around ₤100 billion a year, 6% of total and 8% of private sector GDP. Net debt of more than ₤1.4 trillion amounts to 85% of overall and 110% of private GDP (even without counting in the obligations pertaining to the bailed-out banks) and has doubled in five years, tripled in nine. Total spending has risen by a half since 2005, climbing 5% of pGDP in that time to reach a very lofty 52.5% – and this despite all the bleating about swingeing ‘austerity’. The ₤650 billion which comprises that churn amounts to around ₤200, or more than 31 hours of minimum wage pay, per week for every man, woman, and child in the country. Not entirely unrelated is the fact that the current account gap yawns as wide as ₤75 billion a year, equivalent to what is fast approaching a post-war record of 4.5% of total, 6% of private GDP.

 

Here, too, the optimists have been somewhat deceived by their hopes of undergoing a true economic revival. Though the series is bumpy, manufacturing output in May appears to have stalled, suffering its largest drop since the harsh winter of 2013 and leaving overall industrial production barely 3.5% off 2012’s 27-year lows and still having 80% of its GFC losses to make up.

 

Despite the glaringly obvious construction that the UK is once more undergoing a lax money, too-low interest rate, classic, Tory Chancellor pre-election boom – all about non-tradables, a housing mania, an excess of imports, and plagued with soft-budget government incontinence – the myopically GDP-fixated macromancers cannot resist becoming ecstatic at the results.

 

Jack Meaning, a research fellow at the highly-regarded National Institute of Economic and Social Research, for example, was quoted this week in the broadsheets in full Trumpet Voluntary mode:-

 

“The outlook is very positive,” he exulted. “Growth now is very much entrenched, and given all the positive data that has come out, it looks like growth is here to stay.”

 

Hmmmm! While it is true that the Carney-Osborne duumvirate will do nothing to restrict access to the punch bowl (a) before the Scottish Independence referendum; (b) before the UK General Election next spring ; and (c) if it can be managed, before our beloved Governor quits (in 2017?) to leave his palm print on the pavement of Grauman’s Chinese Theater en route to what is rumoured to be his apotheosis at the pinnacle of the Canadian Liberal Party hierarchy, the longer this particular locomotive of ‘growth’ progresses along its current track, the more certain we can be that it will terminate in the same, drear Vale of Tears where all its predecessors have hit the buffers.

 

As for the US – where policy has retrogressed through some sort of Phillips Curve warping of the space-time continuum to make un(der)employment the only real matter of concern – well, let’s not get too bogged down in the to and fro about Birth:Death adjustments, the household versus the establishment survey, competing explanations for a falling participation rate, part-time versus full-time job issues and all the rest of the minutiae.

 

Taking the data at face value, private sector jobs (adding agriculture and self-employed to the establishment total) seem to have risen over the whole of the last four years by a remarkably steady 180k a month, 1.8% a year, for a cumulative 870k gain which is pretty much in tune with the simultaneous official estimate of 910k in population growth. While similar to the pace mapped out in the 2003/07 expansion (then 210k and 1.6% off a higher base), this is one of the slower episodes in the last half century. If we calculate the real wage fund (2.1% outright and 1.4% per capita) or real private GDP (3.0% outright and 2.3% per capita) we get similar results: the US private sector has been expanding reasonably, if a little tardily, in real terms though it has also been more obviously lagging in nominal ones.

 

Why no faster rebound? Certainly not because interest rates are too high, or government outlays too parsimonious, or because the ‘low-hanging fruit’ of human progress has been well and truly plucked to leave us the unpalatable choice between ‘secular stagnation’ and an invigorating burst of warfare.

 

Read the Crusoe paragraphs again: incentives matter, especially at the margin. And among the many perverse incentives to limit hiring we have, just as in the 1930s, a whole host of programmatic and regulatory barriers to take into account – extended benefits, changes to health care, access to classification as ‘disabled’, unemployment insurance rules, and so on.

 

Though America is not as sorely afflicted with these hindrances as are many Western nations, it is not hard to see that the sort of work done by Richard Vedder and Lowell Galloway, by Lee Ohanian, by Robert Higgs, and lately by Casey Mulligan all come back to the same basic conclusion: that for the micro-economics of job-creation to take hold, the legal and institutional framework must not only be conducive to fostering the hope of gain among those seeking to employ both capital and labour (including their own), but it must be straightforward to negotiate and stable in its composition. Neither constant bureaucratic tampering, nor wrenching shifts in fiscal or monetary policy – with all the wilder swings they transmit via the financial markets through which they act – can contribute much that is positive, for all the arrogance of the Colossi who never cease to promulgate them.