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.
Within the framework of our econometric model the key variable that drives a currency rate of exchange is the relative money supply rate of growth between respective economies. On this score our analysis shows that since October 2011 the money growth differential is currently favourable for the US$ against major currencies. Various key US data continue to display strength. We hold that on account of a downtrend in the growth momentum of AMS since October 2011 economic activity is likely to come under pressure in the months ahead. Meanwhile the growth momentum of the Euro-zone consumer price index has likely bottomed in May. We hold that a fall in the lagged growth momentum of German AMS is behind the weakening in some of the recent key German data. The S&P500 index could weaken for a few months before bouncing back. By next year our model expects the S&P500 to follow a declining path. According to our model the yield on the 10-year US T-Note is forecast to follow a declining path during 2015.
Prospects for US$ against the Euro
At the end of June the price of the Euro in US$ terms closed at 1.369 versus 1.363 in May – an increase of 0.4%. The yearly rate of growth of the price of the Euro stood at 5.3% against 4.9% in May. After closing at 13.6% in October 2011, the money growth differential (expressed in terms of our AMS) between the US and the Euro-zone settled at 0.7% in April. On account of long time lags we suggest that for the time being the effect of a rising differential between June 2010 and October 2011 is likely to dominate the scene. As time goes by the effect from a fall since October 2011 is expected to assert itself. (The US$ should strengthen).
The simulation of the model against the actual data is on the chart on the left below. Based on our model we expect the price of the Euro in US$ terms to close at 1.37 by March before settling at 1.36 in December next year.
Prospects for the British pound (GBP) against the US$
The price of the GBP in US$ terms closed at the end of June at 1.71 versus 1.675 at the end of May – an increase of 2.1%. Year-on-year the rate of growth climbed to 12.4% in June from 10.2% in the month before. The money growth differential fell from 10.4% in October 2011 to 0.6% in April.
We have employed our model to assess the future trend of the rate of exchange. The model simulation against the actual is presented on the left below. We expect the effect from the declining growth differential of money supply to gain strength as time goes by. By December next year the £Sterling-USD rate of exchange could settle at 1.66.
Prospects for the A$ against the US$
At the end of June the price of the A$ in US$ terms closed at 0.943 – an increase of 1.3%. The yearly rate of growth jumped to 3.2% from minus 2.7% in May. After closing at 15.5% in April 2012 the money growth differential between the US and Australia fell to minus 8.1% in April this year. Note that between January 2011 and April 2012 the yearly rate of growth was trending up.
According to our model (see the simulation on the left below) based on a declining money growth differential the A$ could come under pressure as time goes by. By June next year the Australian $ could close at 0.896 before settling at 0.91 by December next year.
Prospects for the Yen against the US$
The price of the US$ in Yen terms closed at the end of June at 101.3 – a fall of 0.5% from May. Year-on-year the rate of growth of the price of US$ rose to 2.2% from 1.3% in May. The money growth differential between the US and Japan fell from 12.8% in August 2011 to 3.9% in January 2013. There after the yearly rate of growth followed a horizontal path closing at 4.6% in May this year.
The simulation of the model is presented on the left below (see chart). According to the model the price of the US$ could increase to 102.3 by March before falling to 101.5 by May. Afterwards the price is forecast to follow a sideways movement closing at 101.2 by December 2015.
Prospects for the CHF against the US$
The price of the US$ in CHF terms closed at 0.887 at the end of June – a fall of 0.9% from May when it increased by 1.7% from April. The yearly rate of growth of the price of the US$ in CHF terms stood at minus 6.2% against minus 6.3% in May. The money growth differential between the US and Switzerland climbed to 4.8% in April 2013 from minus 6% in August 2012. This strong increase in the differential is providing strong support to the CHF against the US$ – note also that the differential fell sharply to minus 2.8% in April from 3.1% in January this year.
The simulation of the model against the actual data is presented on the left below (see chart). According to our model the price of the US$ in CHF terms is forecast to settle at 0.890 by December this year. By September next year the price is forecast to fall to 0.83 before stabilizing at 0.834 by December 2015.
Focus on US economic indicators
Manufacturing activity in terms of the ISM index eased slightly in June from May. The index closed at 55.3 versus 55.4 in May. Based on the lagged growth momentum of real AMS we suggest that the ISM index is likely to follow a declining path. The growth momentum of light vehicle sales has eased in June from May. The yearly rate of growth stood at 6.9% in June against 8.3% in the previous month. Our monetary analysis points to a likely further softening ahead in light vehicle sales.
The growth momentum of manufacturing orders eased in May from April. Year-on-year the rate of growth fell to 2.4% from 5.1%. Based on the lagged growth momentum of AMS we can suggest that the growth momentum of manufacturing orders is likely to follow a declining trend. Also, the growth momentum of expenditure on construction eased in May from April with the yearly rate of growth softening to 6.6% from 7.9%. Using the lagged yearly rate of growth of AMS we hold that the growth momentum of construction expenditure is likely to come under pressure ahead.
US employment up strongly above expectations in June
Seasonally adjusted non-farm employment increased by 288,000 in June after rising by 224,000 in the month before. That was above analysts’ expectations for an increase of 215,000. The growth momentum of employment has strengthened last month. Year-on-year 2.495 million jobs were generated in June after 2.408 million in the prior month. Using the lagged manufacturing ISM index we can suggest that from July the growth momentum of US employment is likely to visibly weaken (see chart). The diffusion index of employment in the private sector one month span, which increased to 64.8 in June from 62.9 in May is forecast to follow a declining trend in the months to come (see chart).
Manufacturing employment increased by 16,000 last month after rising by 11,000 in May. Based on the lagged growth momentum of real AMS we expect the growth momentum of manufacturing employment to come under pressure in the months to come. In the meantime, the unemployment rate stood at 6.1% in June against 6.3% in May, while the number of unemployed declined by 325,000 last month to 9.474 million.
Focus on non US economic indicators
Manufacturing activity has eased slightly in Australia in June from May. The manufacturing purchasing managers index (PMI) fell to 48.91 from 49.22 in May. Based on the lagged growth momentum of Australian real AMS we suggest that the Australian PMI is likely to be well supported ahead. The yearly rate of growth of the EMU consumer price index (CPI) stood at 0.5% in June the same as in May. Using the lagged growth momentum of EMU AMS we hold that the yearly rate of growth of the EU CPI is likely to strengthen ahead.
Year-on-year the rate of growth of German factory orders in real terms fell to 5.8% in May from 6.6% in April. Using the lagged growth momentum of German real AMS we can suggest that the yearly rate of growth of German factory orders is likely to weaken further in the months ahead. Meanwhile, the Swiss manufacturing PMI rose to 53.96 in June from 52.54 in the month before. According to the lagged growth momentum of Swiss real AMS the Swiss PMI is likely to display volatility (see chart).
Prospects for the CRB commodity price index
At the end of June the CRB commodity price index closed at 308.22 – an increase of 0.9% from May when it fell by 1.3%. The growth momentum of the index has strengthened with the yearly rate of growth rising to 11.8% in June from 8.4% in May.
The CRB index to its 12-month moving average ratio eased to 1.0546 in June from 1.055 in the month before.
We have employed our model to assess the future course of the CRB index (see chart). The model is driven by the state of US and Chinese economic activity and by US monetary liquidity.
According to our large scale econometric model the CRB index is forecast to close at 303 by November before jumping to 316 in February. There after the index is forecast to follow a slightly declining path closing by December at 312.
S&P500 up on the week
The S&P500 added 0.55% on Thursday to close at 1,985.43. For the week the index climbed 1.25%. The stock price index rallied after strong employment report for June with the employment rising by 288,000 against the consensus for an increase by 215,000. Against the end of June the stock price index advanced 1.3% whilst year-on-year the rate of growth eased to 17.8% from 22% in June. The S&P500 to its 12 month moving average ratio has eased to 1.0833 from 1.0843 in June.
We have employed our large scale econometric model to assess the future course of the stock price index. Within the model’s framework the S&P500 is driven by our measure of monetary liquidity and by the state of US industrial production. (See the actual versus the model data on the left below). According to our model the S&P500 index could weaken for a few months before bouncing back. By next year our model “expects” the S&P500 to follow a declining path.
US long – term Treasuries yields up against the end of June
On Thursday US Treasuries fell – pushing 10-year note yields to the highest in two months in response to a strong June employment report. This lifted bets that the US central bank may consider raising interest rates sooner than previously thought. The yield on the 10-year T-Note rose one basis point to close at 2.64% against 2.53% at the end of June. Two-year note yield rose three basis points to 0.51%. Traders pushed up their bets for a June rate increase to 49% from 44% and 33% at the end of May. The yield spread between the 10 year and the 2 year T-note stood at 2.13% versus 2.08% in June.
The “TED” spread stood at 0.222% against 0.205% in June. We have employed our econometric model to establish the future direction of the yield on the 10-year T-Note. In the model’s framework the yield on the 10-year T-note is driven by monetary liquidity, by the state of US economic activity and by price inflation (see chart on the left below). According to our model the 10-year yield is forecast to follow a declining path during 2015.
[Editor's note: The Cato Institute will be publishing Cobden Senior Fellow Kevin Dowd's work "Competition and Finance" for free in ebook format. The following outlines the contributions of this important work.]
Originally published in 1996, Cato is proud to make available in digital format, Professor Kevin Dowd’s groundbreaking unification of financial and monetary economics, Competition and Finance: A Reinterpretation of Financial and Monetary Economics.
Dowd begins his analysis with a microeconomic examination of which financial contracts and instruments economic actors use, after which he extends this analysis to how these instruments impact a firm’s financial structure, as well as how firms manage that financial structure. After bringing the reader from individual agent to the foundations of corporate financial policy, Dowd then builds a theory of financial intermediation, or a theory of “banking”, based upon these micro-foundations. He uses these foundations to explain the role and existence of various forms of intermediaries found in financial markets, including brokers, mutual funds and of course, commercial banks.
Most scholarship in financial economics ends there, or rather examines in ever deeper detail the workings of financial intermediaries. Dowd, after having developed a theory of financial intermediation from micro-foundations, derives a theory of monetary standards, based upon his developed media of exchange and its relation to the payments system. While much of Competition and Finance breaks new theoretical ground, it is this bridge from micro-finance to macro-economics and monetary policy that constitutes the work’s most significant contribution. In doing so, Dowd also lays the theoretical groundwork for a laissez-faire system of banking and money, demonstrating how such would improve consumer welfare and financial stability.
As Competition and Finance has been out-of-print in the United States, our hope is to make this important work available to a new generation of scholars working in the fields of financial and monetary economics. If the recent financial crisis demonstrated anything, it is the need for a more unified treatment of financial and monetary economics. Competition and Finance provides such a treatment.
“I am definitely concerned. When was [the cyclically adjusted P/E ratio or CAPE] higher than it is now? I can tell you: 1929, 2000 and 2007. Very low interest rates help to explain the high CAPE. That doesn’t mean that the high CAPE isn’t a forecast of bad performance. When I look at interest rates in a forecasting regression with the CAPE, I don’t get much additional benefit from looking at interest rates… We don’t know what it’s going to do. There could be a massive crash, like we saw in 2000 and 2007, the last two times it looked like this. But I don’t know. I think, realistically, stocks should be in someone’s portfolio. Maybe lighten up… One thing though, I don’t know how many people look at plots of the market. If you just look at a plot of one of the major averages in the U.S., you’ll see what look like three peaks – 2000, 2007 and now – it just looks to me like a peak. I’m not saying it is. I would think that there are people thinking – way – it’s gone way up since 2009. It’s likely to turn down again, just like it did the last two times.”
“Paid promoters have helped push CYNK [CYNK Technology Corp] market cap to $655 million after a 3,650% increase in the share price on Tuesday.
“CYNK had assets of just $39 (no zeroes omitted) as of March 31, 2014 and a cumulative net loss of $1.5 million. The “company” has no revenue.
“CYNK claims that it is “a development stage company focused on social media.” However, the “company” does not even have a website and has just one employee [who acts as President, Chief Executive Officer, Chief Financial Officer, Treasurer and Company Secretary].
“With no assets, no revenue and no product, CYNK has no value. Author expects that CYNK shares are worthless.”
Lord Overstone said it best. “No warning can save people determined to grow suddenly rich.” But there is clearly a yawning chasm between the likes of those folk cheerfully bidding up the share price of CYNK, and prudent investors simply trying to keep their heads above water. What has effectively united these two otherwise disparate communities is today’s central banker. Andy Haldane, the chief economist for the Bank of England, speaking at an FT conference last week, conceded that ultra-accommodative monetary policy had “aided and abetted risk-taking” by investors and that policy makers had wanted to use higher asset prices to try and stimulate the wider economy (that is to say, the economy) into a more robust recovery: “That is how [monetary policy] is meant to work. That’s why we did it.” If the Bank of England had not slashed interest rates and created £375 billion out of thin air, “the UK economy would have been at least 6 per cent smaller than it is today.” A curiously precise figure, given the absence of any counterfactual. But regardless of the economic “benefits” of quantitative easing, Haldane did have the grace to admit that
“That will mean, on average, that financial market volatility will be somewhat greater than in the past. I think it will mean, on average, that those greed and fear cycles in financial markets will be somewhat more exaggerated than in the past. That, for me, is the corollary of the risk migration.”
Which is a bit like an arsonist torching a wooden building and then shrugging his shoulders and saying,
“Well, wood will burn.”
Our central bankers, of course, will not be held accountable when the crash finally hits, even if the accumulated dry tinder of the boom was almost entirely of their own creation. Last week the Bank for International Settlements, the central banker’s central bank, issued an altogether more circumspect analysis of the world’s current financial situation, in their annual report. It concluded, with an entirely welcome sense of caution, that
“The [monetary] policy response needs to carefully consider the nature and persistence of the forces at work as well as policy’s diminished effectiveness and side effects. Finally, looking forward, the issue of how best to calibrate the timing and pace of policy normalisation looms large. Navigating the transition is likely to be complex and bumpy, regardless of communication efforts. And the risk of normalising too late and too gradually should not be underestimated.” (Emphasis ours.)
Translation: ZIRP (Zero Interest Rate Policy – and in the case of the ECB, which has taken rates negative, NIRP) is no longer working – if it ever did. Hyper-aggressive monetary policy has side effects. Getting out of this mess is not going to be easy, and it’s going to be messy. Forward guidance, which was meant to simplify the message, has instead hopelessly confused it. And there are big risks that central banks will lose the requisite confidence to tighten policy when it is most urgently needed, and allow an inflationary genie entirely out of the bottle.
The impact of central banks’ unprecedented monetary stimulus on financial markets is so overwhelming that it utterly negates any sensible analysis of likely macro-economic developments. On the basis that sometimes it’s simply best not to play some games, we no longer try. What should inform investors’ preferences, however, is bottom-up asset allocation and stock selection. The US equity market is clearly poor value at present. That doesn’t mean that it can’t get even more expensive, and the rally might yet have some serious legs. But overvaluation at an index level doesn’t preclude the existence of undervalued stocks well away from the braying herd. (We think the most compelling macro value is in Asia and, if we had to single out any one country, Japan.)
“The central thesis among investors at present is that they have no other choice but to hold stocks, given the alternative of zero short-term interest rates and long-term interest rates well below the level of recent decades..”
“Investment decisions driven primarily by the question “What other choice do I have ?” are likely to prove regrettable. What we now have is a market that has been driven to one of the four most extreme points of overvaluation in history. We know how three of them ended.”
The conclusion seems clear to us. If one chooses to invest at all, invest on the basis of valuation and not on indexation (the world’s largest stock market, that of the US, is one of the most seemingly conspicuously overvalued). As an example of the sort of valuations currently available away from the herd, consider the following. You can buy the US S&P 500 index today with the following metrics:
Price / earnings: 18.2
Price / book: 2.76
Dividend yield: 1.89%
Meanwhile, Greg Fisher in his Halley Asian Prosperity Fund (albeit currently closed) is buying quality businesses throughout Asia on somewhat more attractive valuations. (By geography, the fund’s largest allocations are to Japan, Vietnam and Malaysia.) The fund’s current metrics are as follows:
Average price / earnings: 7
Average price / book: 0.8
Average dividend yield: 4.5%.
But the realistic prospect of growth is also on the table. The fund’s average historic return on equity stands at 15%.
Pay money. Take choice.
[Editor's Note: this piece, by Steve H Hanke, Professor of Applied Economics and Co-Director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at The Johns Hopkins University in Baltimore, was previously published at Cato.org and Globe Asia. Please also see our earlier postings here at The Cobden Centre on Mark Skousen's intrepid work on GDE. As Lord Kelvin said, "To measure is to know". ]
In late April of this year, the Bureau of Economic Analysis (BEA) at the U.S. Department of Commerce announced that it would start reporting a new data series as part of the U.S. national income accounts. In addition to gross domestic product (GDP), the BEA will start reporting gross output (GO). This announcement went virtually unnoticed and unreported — an unfortunate, but not uncommon, oversight on the part of the financial press. Yes, GO represents a significant breakthrough.
A brief review of some history of economic thought will show just why GO is a big deal. The Classical School of economics prevailed roughly from Adam Smith’s Wealth of Nations time (1776) to the mid-19th century. It focused on the supply side of the economy. Production was the wellspring of prosperity.
The French economist J.-B. Say (1767-1832) was a highly regarded member of the Classical School. To this day, he is best known for Say’s Law of markets. In the popular lexicon — courtesy of John Maynard Keynes — this law simply states that “supply creates its own demand.” But, according to Steven Kates, one of the world’s leading experts on Say, Keynes’ rendition of Say’s Law distorts its true meaning and leaves its main message on the cutting room floor.
Say’s message was clear: a demand failure could not cause an economic slump. This message was accepted by virtually every major economist, prior to the publication of Keynes’ General Theory in 1936. So, before the General Theory, even though most economists thought business cycles were in the cards, demand failure was not listed as one of the causes of an economic downturn.
All this was overturned by Keynes. Kates argues convincingly that Keynes had to set Say up as a sort of straw man so that he could remove Say’s ideas from the economists’ discourse and the public’s thinking. Keynes had to do this because his entire theory was based on the analysis of demand failure, and his prescription for putting life back into aggregate demand — namely, a fiscal stimulus (read: lower taxes and/or higher government spending).
Keynes was wildly successful. With the publication of the General Theory, the supply side of the economy almost entirely vanished. It was replaced by aggregate demand, which was faithfully reported in the national income accounts. In consequence, aggregate demand has dominated economic discourse and policy ever since.
Among other things, Keynes threw economics into the sphere of macro economics. It is here where economic aggregates are treated as homogenous variables for purposes of analysis. But, with such innocent looking aggregates, there lurks a world of danger. Indeed, because of the demand-side aggregates that Keynes’ analysis limited us to, we were left with things like the aggregate sizeof consumption and government spending. The structure of the economy — the supply side — was nowhere to be found.
Yes, there were various rear-guard actions against this neglect of the supply side. Notable were economists from the Austrian School of Economics,such as Nobelist Friedrich Hayek. There were also devotees of input-out put analysis, like Nobelist Wassily Leontief. He and his followers stayed away from grand macroeconomic aggregates;they focused on the structure of the economy. There were also branches of economics — like agricultural economics– that were focused on production and the supply side of the economy. But,these fields never pretended to be part of macroeconomics.
Then came the supply-side revolution in the 1980s. It was associated with the likes of Nobelist Robert Mundell. This revolution was carried out, in large part, on the pagesof The Wall Street Journal, where J.-B.Say reappeared like a phoenix. The Journal’s late-editor Robert Bartley recounts the centrality of Say in his book The Seven Fat Years: And How to Do It Again (1992) “I remember Art Laffer telling me I had to learn Say’s Law. ‘That’s what I believe in’, he professed. ‘That’s what you believe in.’”
It is worth mentioning that the onslaught by Keynes on Say was largely ignored by many economic practitioners who attempt to anticipate the course of the economy. For them,the supply side of the economy has always received their most careful and anxious attention. For example, the Conference Board’s index of leading indicators for the U.S. economy is predominantly made up of supply-side indicators. Bloomberg’s supply-chain analysis function (SPLC) is yet another tool that indicates what practitioners think about when they conduct economic and financial analyses.
But, when it comes to the public and the debate about public policies, there is nothing quite like official data. So, until now, demand-side GDP data produced by the government has dominated the discourse. With GO, GDP’s monopoly will be broken as the U.S. government will provide official data on the supply side of the economy and its structure. GO data will complement, not replace, traditional GDP data. That said, GO data will improve our understanding of the business cycle and also improve the quality of the economic policy discourse.
So, what makes up the conventional measure of GDP and the new GO measure? And what makes up the gross domestic expenditures (GDE)measure, a more comprehensive, close cousin of GO? The accompanying two tables answer those questions. And for readers who are more visually inclined,bar charts for the two new metrics — GO and GDE — are presented.
Now, it’s official. Supply-side (GO) and demand-side (GDP) data are both provided by the U.S. government. How did this counter revolution come about? There have been many counter revolutionaries, but one stands out: Mark Skousen of Chapman University. Skousen’s book The Structure of Production, which was first published in 1990, backed his advocacy with heavy artillery. Indeed, it is Skousen who is, in part, responsible for the government’s move to provide a clearer, more comprehensive picture of the economy, with GO. And it is Skousen who is solely responsible for calculating GDE.
These changes are big, not only conceptually, but also numerically. Indeed, in 2013 GO was 76.4% larger, and GDE was 120.4% larger, than GDP. Why? Because GDP only measures the value of all final goods and services in the economy. GDP ignores all the intermediate steps required to produce GDP. GO corrects for most of those omissions. GDE goes even further, and is more comprehensive than GO.
Even though the always clever Keynes temporarily buried J.-B. Say, the great Say is back. With that, the relative importance of consumption and government expenditures withers away (see the accompanying bar charts). And, yes, the alleged importance of fiscal policy withers away, too.
Contrary to what the standard textbooks have taught us and what that pundits repeat ad nauseam, consumption is not the big elephant in the room. The elephant is business expenditures.
“A balanced Input-Output framework…provides a more accurate and consistent picture of the U. S. economy.”
– Survey of Current Business
Starting in spring 2014, the Bureau of Economic Analysis will release a breakthrough new economic statistic on a quarterly basis. It’s called Gross Output, a measure of total sales volume at all stages of production. GO is almost twice the size of GDP, the standard yardstick for measuring final goods and services produced in a year.
This is the first new economic aggregate since Gross Domestic Product (GDP) was introduced over fifty years ago.
It’s about time. Starting with my work The Structure of Production in 1990 andEconomics on Trial in 1991, I have made the case that we needed a new statistic beyond GDP that measures spending throughout the entire production process, not just final output. GO is a move in that direction – a personal triumph 25 years in the making.
GO attempts to measure total sales from the production of raw materials through intermediate producers to final retail. Based on my research, GO is a better indicator of the business cycle, and most consistent with economic growth theory.
GO is a measure of the “make” economy, while GDP represents the “use” economy. Both are essential to understanding how the economy works.
While GDP is a good measure of national economic performance, it has a major flaw: In limiting itself to final output, GDP largely ignores or downplays the “make” economy, that is, the supply chain and intermediate stages of production needed to produce all those finished goods and services. This narrow focus of GDP has created much mischief in the media, government policy, and boardroom decision-making. For example, journalists are constantly overemphasizing consumer and government spending as the driving force behind the economy, rather than saving, business investment, and technological advances. Since consumer spending represents 70% or more of GDP, followed by 20% by government, the media naively concludes that any slowdown in retail sales or government stimulus is necessarily bad for the economy. (Private investment comes in a poor third at 13%.)
For instance, the New York Times recently reported, “Consumer spending makes up more than 70% of the economy, and it usually drives growth during economic recoveries.” (“Consumers Give Boost to Economy,” New York Times, May 1, 2010, p. B1) Or as the Wall Street Journal stated a few years ago, “The housing bust has chilled consumer spending — the largest single driver of the U. S. economy…” (“Home Forecast Calls for Pain,” Wall Street Journal, September 21, 2011, p. A1.)
Or take this report during the economic recovery:
“Friday’s estimates of second-quarter gross domestic product [1.3%, well below consensus forecasts] provided a sobering look at how a decline in public spending and investment can restrain growth….The astonishingly slow growth rate from April through June was due in large part to sluggish consumer spending and an increase in imports, which subtract from growth numbers. But dwindling government spending also held back growth.” (“The Role of Government Spending,” New York Times, July 29, 2011.)
In short, by focusing only on final output, GDP underestimates the money spent and economic activity generated at earlier stages in the production process. It’s as though the manufacturers and shippers and designers aren’t fully acknowledged in their contribution to overall growth or decline.
Gross Output exposes these misconceptions. In my own research, I’ve discovered many benefits of GO statistics. First, Gross Output provides a more accurate picture of what drives the economy. Using GO as a more comprehensive measure of economic activity, spending by consumers turns out to represent around 40% of total yearly sales, not 70% as commonly reported. Spending by business (private investment plus intermediate inputs) is substantially bigger, representing over 50% of economic activity. That’s more consistent with economic growth theory, which emphasizes productive saving and investment in technology on the producer side as the drivers of economic growth. Consumer spending is largely the effect, not the cause, of prosperity.
Second, GO is significantly more sensitive to the business cycle. During the 2008-09 Great Recession, nominal GDP fell only 2% (due largely to countercyclical increases in government), but GO collapsed by over 7%, and intermediate inputs by 10%. Since 2009, nominal GDP has increased 3-4% a year, but GO has climbed more than 5% a year. GO acts like the end of a waving fan. (See chart below.)
I believe that Gross Output fills in a big piece of the macroeconomic puzzle. It establishes the proper balance between production and consumption, between the “make” and the “use” economy, and it is more consistent with growth theory. As Steve Landefeld, director of the BEA, and co-editors Dale Jorgenson and William Nordhaus state in their work, A New Architecture for the U. S. National Accounts (University of Chicago Press, 2006), “Gross output [GO] is the natural measure of the production sector, while net output [GDP] is appropriate as a measure of welfare. Both are required in a complete system of accounts.”
The history of these two economic statistics goes back to several pioneers. Two economists in particular had much in common — they were both Russian Americans who taught at Harvard University, and both won the Nobel Prize. Simon Kuznets did breakthrough work on GDP statistics in the 1930s. Following the Bretton Woods Agreement in 1946, GDP became the standard measure of economic growth. A few years later, Wassily Leontief developed the first input-output tables, which he regarded as a better measure of the whole economy. I-O accounts require examining the “intervening steps” between inputs and outputs in the production process, “a complex series of transactions…among real people.”
I-O data created the first estimates of Gross Output. However, GO was not emphasized as an important macroeconomic tool until my own work, The Structure of Production,was published in 1990 by New York University Press. In chapters 6 and 9, I created a universal four stage model of the economy (see the diagram below) demonstrating the relationship between total spending in the economy and final output.
In chapter 6, I made the point that GDP was not a complete picture of economic activity, and compared it to GO for the first time, contending that GO was more comprehensive and more accurately revealed that business investment was far bigger than consumption in the economy.
Since writing Structure, I discovered that the BEA’s Gross Output does not include all sales at the wholesale and retail level. The BEA only includes value-added data for commodities after they become finished products. Gross sales are ignored at the final two stages of production. David Wasshausen, a BEA staff researcher, offers this rationale: since “there is no further transformation of these goods…to the production process, they are excluded from wholesale/retail trade output.”
Therefore, in the 2nd edition of Structure, published in 2007, I created my own aggregate statistic, Gross Domestic Expenditures (GDE), which includes gross sales at the wholesale and retail level and is therefore significantly larger (more than double GDP). For a comparison between GDE, GO and GDP, see my working paper.
The BEA has been compiling GO statistics from input-output data for years, but the media have largely ignored these figures because they came out only every five years (known as benchmark I-O tables). Since the early 1990s, the BEA has been estimating industry accounts annually. Even so, the data was never up-to-date like GDP. (The latest input-output industry accounts are for 2011).
That has gradually changed. Under the leadership of BEA director Steve Landefeld, the BEA now has the budget to report the input-output data, including Gross Output, on a quarterly basis, and has already begun publishing quarterly data prior to 2012. This is a major breakthrough involving the cooperation of the Bureau of the Census, Bureau of Labor Statistics, the Federal Reserve Board, and other government agencies.
Controversies Over This New Statistic
Several objections have been made over the years to the use of GO and GDE. Economists are especially fixated over the perceived problem of “double counting” with GO and GDE. I am the first to note that GO and GDE involve double counting. A commodity is often sold repeatedly as it goes through the resource, production, wholesale and retail stages. Why not just measure the value added at each stage rather than double or triple count? they ask. GDP eliminates double counting and measures only the value added at each stage.
There are several reasons why double counting should not be ignored and is actually a necessary feature to understanding the overall economy. As accountants and financiers know, double counting is essential in business. No company can operate or expand on the basis of value added or profits only. They must raise the capital necessary to cover the gross expenses of the company — wages and salaries, rents, interest, capital tools and equipment, supplies and goods-in-process. GO and GDE reflect this vital business decision making at each stage of production. Can publicly-traded firms ignore sales/revenues and only focus on earnings when they release their quarterly reports? Wall Street would object. Aggregate sales/revenues are important to measure on an individual firm and national basis.
In my own research, I find it interesting that GO and GDE are far more volatile than GDP during the business cycle. As noted in the chart above, sales/revenues rise faster than GDP during an expansion, and collapse during a contraction (wholesale trade fell 20% in 2009; retail trade dropped over 7%).
Economists need to explore the meaning of this cyclical behavior in order to make accurate forecasts and policy recommendations. Double counting counts.
Another objection involves outsourcing and merger/acquisitions. Companies that start outsourcing their products will cause an increase in GO or GDE, while companies that merge with another company will show a sudden decrease, even though there is essentially no change in final output (GDP).
That’s a legitimate concern. Similar problems occur with GDP. When a homeowner marries the maid, the maid may no longer be paid and therefore her services may no longer be included in GDP. Black market activities often fail to show up in GDP data as well. Certainly if a significant trend develops in outsourcing or merger & acquisition activity, it will be reflected in GO or GDE statistics, but not necessarly in GDP. It bears further investigation to see how serious this issue is. No aggregate statistic is perfect, but GO and GDE offer forecasters an improved macro picture of the economy.
In conclusion, GO or GDE should be the starting point for measuring aggregate spending in the economy, as it measures both the “make” economy (intermediate production), and the “use” economy (final output). It complements GDP and can easily be incorporated in standard
national income accounting and macroeconomic analysis. To see how, take a look at the 4th edition of my textbook, Economic Logic (Capital Press, 2014), available in paperback and Kindle.
[Editor's note: this article was originally published by the IEA here]
I would like to thank the IEA for today publishing my monograph, New Private Monies, which examines three contemporary cases of private monetary systems.
The first is the Liberty Dollar, a private mint operated by Bernard von NotHaus, whose currency became the second most widely used in the United States. It was highly successful and its precious metallic basis ensured it rose in value over time against the inflating greenback. In 2007, however, Uncle Sam shut it down, successfully charging von NotHaus with counterfeiting and sundry other offences. In reality, the Liberty Dollar was nothing like the greenback dollar. Nor could it be, as its purpose was to provide a superior dollar in open competition, not to pass itself off as the inferior dollar it was competing against, which has lost over 95 per cent of its value since the Federal Reserve was founded a century ago. For this public service of providing superior currency, Mr. von NotHaus is now potentially facing life in the federal slammer. As he put it:
‘This is the United States government. It’s got all the guns, all the surveillance, all the tanks, it has nuclear weapons, and it’s worried about some ex-surfer guy making his own money? Give me a break!’
The second case is e-gold, a private digital gold transfer business – a kind of private gold standard – run by Dr Doug Jackson out of Nevis in the Caribbean. By 2005, e-gold had risen to become second only to PayPal in the online payments industry. Jackson correctly argued that it was not covered by any existing US financial regulation, not just because of its offshore status but also because it was a payment system rather than a money transmitter or bank as then-defined, and not least because gold was not legally ‘money’. Yet despite its efforts to clarify its evolving regulatory and tax status, and despite helping them to catch some of the biggest cyber criminals then in operation, US law enforcement turned on the company: they trumped up charges of illegal money transmission and blackmailed its principals into a plea bargain.
Both these cases illustrate that there is a strong demand for private money and that the market can meet that demand and outcompete government monetary systems. Unfortunately, they also illustrate the perils of private money issuers operating out in the open where they are vulnerable to attack by the government. Perhaps they should operate undercover instead…
This takes us to the third case study: Bitcoin, a new type of currency known as crypto-currency, a self-regulating and highly anonymous computer currency based on the use of strong cryptography.
To quote its designer, Satoshi Nakamoto:
‘The root problem with conventional currency is all the trust that is required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust…
‘Bitcoin’s solution is to use a peer-to-peer network to check for double-spending…the result is a distributed system with no single point of failure.’
Bitcoin is produced in a kind of electronic ‘mining’ process, in which successful ‘miners’ are rewarded with Bitcoin. The process is designed to ensure that the amounts produced are almost exactly known in advance. Since its inception in 2009, the demand for Bitcoin has skyrocketed, albeit in a very volatile way, forcing its price from 3 cents to (currently) just under $600. Perhaps the best-known use of Bitcoin has been on the dark web drugs market Silk Road, the ‘Amazon.com of illegal drugs’, but Bitcoin is increasingly popular for all manner of mundane legal uses as well.
Bitcoin is a wonderful innovation, but the pioneers in any industry are rarely the ones who last. Despite Bitcoin’s success to date, it is doubtful whether being the first mover is an advantage in the longer term: design flaws in the Bitcoin model are set in concrete and competitors can learn from them. The crypto-currency market is also an open one and a considerable number of competitors have since entered the field. Most of these will soon fail, but no-one can predict which will be best suited to the market and achieve long-run success. Most likely, Bitcoin will eventually be displaced by even better crypto-currencies.
Crypto-currencies have momentous ramifications. As one blogger put it:
‘As long as my encrypted [Bitcoin] wallet exists somewhere in the world, such as on an email account, I can walk across national borders with nothing on me and retrieve my wealth from anywhere in the world with an internet connection.’
This gives Bitcoin great potential as an internationally mobile store of value that offers a high degree of security against predatory governments. Bitcoin now fulfils the role once met by bank secrecy – the ability to protect one’s financial privacy.
There is no easy way in which the government can prevent the use of Bitcoin to evade its control. The combination of anonymity and independence means that governments cannot bring Bitcoin down by taking out particular individuals or organisations because the system has no single point of failure. They could shut down whatever sites they like, but the Bitcoin community would carry on.
Strong cryptography therefore offers the potential to swing the balance of power back from the state toward the individual. Censorship, prohibition, oppressive taxes and repression are being undermined as people increasingly escape into the cyphersphere where they can operate free from government harassment.
We now face the prospect of a peaceful crypto-anarchic society in which there is no longer any government role in the monetary system and, hopefully, no government at all.
Welcome to crypto-anarchy.
New Private Monies: A Bit-Part Player can be downloaded here.
[Editor's note: This article also appears on Detlev Schlichter's blog here. It is reproduced with kind permission and should NOT be taken to be investment advice.]
Investors and speculators face some profound challenges today: How to deal with politicized markets, continuously “guided” by central bankers and regulators? To what extent do prices reflect support from policy, in particular super-easy monetary policy, and to what extent other, ‘fundamental’ factors? And how is all this market manipulation going to play out in the long run?
New York Stock Exchange 1963 (Photo: Wikimedia; US News and World Report; Library of Congress)
It is obvious that most markets would not be trading where they are trading today were it not for the longstanding combination of ultra-low policy rates and various programs of ‘quantitative easing’ around the world, some presently diminishing (US), others potentially increasing (Japan, eurozone). As major US equity indices closed last week at another record high and overall market volatility remains low, some observers may say that the central banks have won. Their interventions have now established a nirvana in which asset markets seem to rise almost continuously but calmly, with carefully contained volatility and with their downside apparently fully insured by central bankers who are ready to ease again at any moment. Those who believe in Schumpeter’s model of “bureaucratic socialism”, a system that he expected ultimately to replace capitalism altogether, may rejoice: Increasingly the capitalist “jungle” gets replaced with a well-ordered, centrally managed system guided by the enlightened bureaucracy. Reading the minds of Yellen, Kuroda, Draghi and Carney is now the number one game in town. Investors, traders and economists seem to care about little else.
“The problem is that we’re not there [in a low volatility environment] because markets have decided this, but because central banks have told us…” Sir Michael Hintze, founder of hedge fund CQS, observed in conversation with the Financial Times (FT, June 14/15 2014). “The beauty of capital markets is that they are voting systems, people vote every day with their wallets. Now voting is finished. We’re being told what to do by central bankers – and you lose money if you don’t follow their lead.”
That has certainly been the winning strategy in recent years. Just go with whatever the manipulators ordain and enjoy rising asset values and growing investment profits. Draghi wants lower yields on Spanish and Italian bonds? – He surely gets them. The US Fed wants higher equity prices and lower yields on corporate debt? – Just a moment, ladies and gentlemen, if you say so, I am sure we can arrange it. Who would ever dare to bet against the folks who are entrusted with the legal monopoly of unlimited money creation? “Never fight the Fed” has, of course, been an old adage in the investment community. But it gets a whole new meaning when central banks busy themselves with managing all sorts of financial variables directly, from the shape of the yield curve, the spreads on mortgages, to the proceedings in the reverse repo market.
Is this the “new normal”/”new neutral”? The End of History and the arrival of the Last Man, all over again?
The same FT article quoted Salman Ahmed, global bond strategist at Lombard Odier Investment Managers as follows: “Low volatility is the most important topic in markets right now. On the one side you have those who think this is the ‘new normal’, on the other are people like me who think it cannot last. This is a very divisive subject.”
PIMCO’s Bill Gross seems to be in the “new normal” camp. At the Barron’s mid-year roundtable 2014 (Barron’s, June 16, 2014) he said: “We don’t expect the party to end with a bang – the popping of a bubble. […] We have been talking about what we call the New Neutral – sluggish but stable global growth and continued low rates.”
In this debate I come down on the side of Mr. Ahmed (and I assume Sir Michael). This cannot last, in my view. It will end and end badly. Policy has greatly distorted markets, and financial risk seems to be mis-priced in many places. Market interventions by central banks, governments and various regulators will not lead to a stable economy but to renewed crises. Prepare for volatility!
Bill Gross’ expectation of a new neutral seems to be partly based on the notion that persistently high indebtedness contains both growth and inflation and makes a return to historic levels of policy rates near impossible. Gross: “…a highly levered economy can’t withstand historic rates of interest. […] We see rates rising to 2% in 2017, but the market expects 3% or 4%. […] If it is close to 2%, the markets will be supported, which means today’s prices and price/earnings are OK.”
Of course I can see the logic in this argument but I also believe that high debt levels and slow growth are tantamount to high degrees of risk and should be accompanied with considerable risk premiums. Additionally, slow growth and substantial leverage mean political pressure for ongoing central bank activism. This is incompatible with low volatility and tight risk premiums. Accidents are not only bound to happen, they are inevitable in a system of monetary central planning and artificial asset pricing.
Low inflation, low rates, and contained market volatility are what we should expect in a system of hard and apolitical money, such as a gold standard. But they are not to be expected – at least not systematically and consistently but only intermittently – in elastic money systems. I explain this in detail in my book Paper Money Collapse – The Folly of Elastic Money. Elastic money systems like our present global fiat money system with central banks that strive for constant (if purportedly moderate) inflation must lead to persistent distortions in market prices (in particular interest rates) and therefore capital misallocations. This leads to chronic instability and recurring crises. The notion that we might now have backed into a gold-standard-like system of monetary tranquility by chance and without really trying seems unrealistic to me, and the idea is even more of a stretch for the assumption that it should be excessive debt – one of elastic money’s most damaging consequences – that could, inadvertently and perversely, help ensure such stability. I suspect that this view is laden with wishful thinking. In the same Barron’s interview, Mr. Gross makes the statement that “stocks and bonds are artificially priced,” (of course they are, hardly anyone could deny it) but also that “today’s prices and price/earnings are OK.” This seems a contradiction to me. Here is why I believe the expectation of the new neutral is probably wrong, and why so many “mainstream” observers still sympathize with it.
- Imbalances have accumulated over time. Not all were eradicated in the recent crisis. We are not starting from a clean base. Central banks are now all powerful and their massive interventions are tolerated and even welcome by many because they get “credited” with having averted an even worse crisis. But to the extent that that this is indeed the case and that their rate cuts, liquidity injections and ‘quantitative easing’ did indeed come just in time to arrest the market’s liquidation process, chances are these interventions have sustained many imbalances that should also have been unwound. These imbalances are probably as unsustainable in the long run as the ones that did get unwound, and even those were often unwound only partially. We simply do not know what these dislocations are or how big they might be. However, I suspect that a dangerous pattern has been established: Since the 1980s, money and credit expansion have mainly fed asset rallies, and central banks have increasingly adopted the role of an essential backstop for financial markets. Recently observers have called this phenomenon cynically the “Greenspan put” or the “Bernanke put” after whoever happens to lead the US central bank at the time but the pattern has a long tradition by now: the 1987 stock market crash, the 1994 peso crisis, the 1998 LTCM-crisis, the 2002 Worldcom and Enron crisis, and the 2007/2008 subprime and subsequent banking crisis. I think it is not unfair to suggest that almost each of these crises was bigger and seemed more dangerous than the preceding one, and each required more forceful and extended policy intervention. One of the reasons for this is that while some dislocations get liquidated in each crisis (otherwise we would not speak of a crisis), policy interventions – not least those of the monetary kind – always saved some of the then accumulated imbalances from a similar fate. Thus, imbalances accumulate over time, the system gets more leveraged, more debt is accumulated, and bad habits are being further entrenched. I have no reason to believe that this has changed after 2008.
- Six years of super-low rates and ‘quantitative easing’ have planted new imbalances and the seeds of another crisis. Where are these imbalances? How big are they? – I don’t know. But I do know one thing: You do not manipulate capital markets for years on end with impunity. It is simply a fact that capital allocation has been distorted for political reasons for years. Many assets look mispriced to me, from European peripheral bond markets to US corporate and “high yield” debt, to many stocks. There is tremendous scope for a painful shake-out, and my prime candidate would again be credit markets, although it may still be too early.
- “Macro-prudential” policies create an illusion of safety but will destabilize the system further. – Macro-prudential policies are the new craze, and the fact that nobody laughs out loud at the suggestion of such nonsense is a further indication of the rise in statist convictions. These policies are meant to work like this: One arm of the state (the central bank) pumps lots of new money into the system to “stimulate” the economy, and another arm of the state (although often the same arm, namely the central bank in its role as regulator and overseer) makes sure that the public does not do anything stupid with it. The money will thus be “directed” to where it can do no harm. Simple. Example: The Swiss National Bank floods the market with money but stops the banks from giving too many mortgage loans, and this avoids a real estate bubble. “Macro-prudential” is of course a euphemism for state-controlled capital markets, and you have to be a thorough statist with an iron belief in central planning and the boundless wisdom of officers of the state to think that this will make for a safer economy. (But then again, a general belief in all-round state-planning is certainly on the rise.) The whole concept is, of course, quite ridiculous. We just had a crisis courtesy of state-directed capital flows. For decades almost every arm of the US state was involved in directing capital into the US housing market, whether via preferential tax treatment, government-sponsored mortgage insurers, or endless easy money from the Fed. We know how that turned out. And now we are to believe that the state will direct capital more sensibly? — New macro-“prudential” policies will not mean the end of bubbles but only different bubbles. For example, eurozone banks shy away from giving loans to businesses, partly because those are costly under new bank capital requirements. But under those same regulations sovereign bonds are deemed risk-free and thus impose no cost on capital. Zero-cost liquidity from the ECB and Draghi’s promise to “do whatever it takes” to keep the eurozone together, do the rest. The resulting rally in Spanish and Italian bonds to new record low yields may be seen by some as an indication of a healing Europe and a decline in systemic risk but it may equally be another bubble, another policy-induced distortion and another ticking time bomb on the balance sheets of Europe’s banks.
- Inflation is not dead. Many market participants seem to believe that inflation will never come back. Regardless of how easy monetary policy gets and regardless for how long, the only inflation we will ever see is asset price inflation. Land prices may rise to the moon but the goods that are produced on the land never get more expensive. – I do not believe that is possible. We will see spill-over effects, and to the extent that monetary policy gets traction, i.e. leads to the expansion of broader monetary aggregates, we will see prices rise more broadly. Also, please remember that central bankers now want inflation. I find it somewhat strange to see markets obediently play to the tune of the central bankers when it comes to risk premiums and equity prices but at the same time see economists and strategists cynically disregard central bankers’ wish for higher inflation. Does that mean the power of money printing applies to asset markets but will stop at consumer goods markets? I don’t think so. – Once prices rise more broadly, this will change the dynamic in markets. Many investors will discount points 1 to 3 above with the assertion that any trouble in the new investment paradise will simply be stomped out quickly by renewed policy easing. However, higher and rising inflation (and potentially rising inflation expectations) makes that a less straightforward bet. Inflation that is tolerated by the central banks must also lead to a re-pricing of bonds and once that gets under way, many other assets will be affected. I believe that markets now grossly underestimate the risk of inflation.
Some potential dislocations
Money and credit expansion are usually an excellent source of trouble. Just give it some time and imbalances will have formed. Since March 2011, the year-over-year growth in commercial and industrial loans in the US has been not only positive but on average clocked in at an impressive 9.2 percent. Monetary aggregate M1 has been growing at double digit or close to double-digit rates for some time. It presently stands at slightly above 10 percent year over year. M2 is growing at around 6 percent.
U.S. Commercial & Industrial Loans (St. Louis Fed – Research)
None of this must mean trouble right away but none of these numbers indicate economic correction or even deflation but point instead to re-leveraging in parts of the US economy. Yields on below-investment grade securities are at record lows and so are default rates. The latter is maybe no surprise. With rates super-low and liquidity ample, nobody goes bust. But not everybody considers this to be the ‘new normal’: “We are surprised at how ebullient credit markets have been in 2014,” said William Conway, co-founder and co-chief executive of Carlyle Group LP, the US alternative asset manager (as quoted in the Wall Street Journal Europe, May 2-4 2014, page 20). “The world continues to be awash in liquidity, and investors are chasing yield seemingly regardless of credit quality and risk.”
“We continually ask ourselves if the fundamentals of the global credit business are healthy and sustainable. Frankly, we don’t think so.”
1 trillion is a nice round number
Since 2009 investors appear to have allocated an additional $1trn to bond funds. In 2013, the Fed created a bit more than $1trn in new base money, and issuance in the investment grade corporate bond market was also around $1trn in 2013, give and take a few billion. A considerable chunk of new corporate borrowing seems to find its way into share buybacks and thus pumps up the equity market. Andrew Smithers in the Financial Times of June 13 2014 estimates that buybacks in the US continue at about $400bn per year. He also observes that non-financial corporate debt (i.e. debt of companies outside the finance sector) “expanded by 9.2 per cent over the past 12 months. US non-financial companies’ leverage is now at a record high relative to output.”
Most investors try to buy cheap assets but the better strategy is often to sell expensive ones. Such a moment in time may be soon approaching. Timing is everything, and it may still be too early. “The trend is my friend” is another longstanding adage on Wall Street. The present bull market may be artificial and already getting long in the tooth but maybe the central planners will have their way a bit longer, and this new “long-only” investment nirvana will continue. I have often been surprised at how far and for how long policy makers can push markets out of kilter. But there will be opportunities for patient, clever and nimble speculators at some stage, when markets inevitably snap back. This is not a ‘new normal’ in my view. It is just a prelude to another crisis. In fact, all this talk of a “new normal” of low volatility and stable markets as far as the eye can see is probably already a bearish indicator and a precursor of pending doom. (Anyone remember the “death of business cycles” in the 1990s, or the “Great Moderation” of the 2000s?)
Investors are susceptible to the shenanigans of the manipulators. They constantly strive for income, and as the central banks suppress the returns on many mainstream asset classes ever further, they feel compelled to go out into riskier markets and buy ever more risk at lower yields. From government bonds they move to corporate debt, from corporate debt to “high yield bonds”, from “high yield” to emerging markets – until another credit disaster awaits them. Investors thus happily do the bidding for the interventionists for as long as the party lasts. That includes many professional asset managers who naturally charge their clients ongoing management fees and thus feel obliged to join the hunt for steady income, often apparently regardless of what the ultimate odds are. In this environment of systematically manipulated markets, the paramount risk is to get sucked into expensive and illiquid assets at precisely the wrong time.
In this environment it may ultimately pay to be a speculator rather than an investor. Speculators wait for opportunities to make money on price moves. They do not look for “income” or “yield” but for changes in prices, and some of the more interesting price swings may soon potentially come on the downside, I believe. As they are not beholden to the need for steady income, speculators should also find it easier to be patient. They should know that their capital cannot be employed profitably at all times. They are happy (or should be happy) to sit on cash for a long while, and maybe let even some of the suckers’ rally pass them by. But when the right opportunities come along they hope to be nimble and astute enough to capture them. This is what macro hedge funds, prop traders and commodity trading advisers traditionally try to do. Their moment may come again.
As Sir Michael at CQS said: “Maybe they [the central bankers] can keep control, but if people stop believing in them, all hell will break loose.”
I couldn’t agree more.
Seth Lipsky, the editor of the storied New York Sun
(a brand distinguished by the long residency of Henry Hazlitt), recently, in the Wall Street Journal
, brought to wider attention certain remarkable recent comments by Paul Volcker. Volcker spoke before the May 21st annual meeting of the Bretton Woods Committee at the World Bank Headquarters in Washington, DC. Volcker’s remarks did not present a departure in substance from his long-standing pro-rule position. They nonetheless were striking, newly emphatic both by tone and context.
Volcker, asked by the conference organizer for his preferred topic, declared that he had said:
“What About a New Bretton Woods???” – with three question marks. The two words, “Bretton Woods”, still seem to invoke a certain nostalgia – memories of a more orderly, rule-based world of financial stability, and close cooperation among nations. Following the two disasters of the Great Depression and World War II that at least was the hope for the new International Monetary Fund, and the related World Bank, the GATT and the OECD.
No one here was actually present at Bretton Woods, but that was the world that I entered as a junior official in the U.S. Treasury more than 50 years ago. Intellectually and operationally, the Bretton Woods ideals absolutely dominated Treasury thinking and policies. The recovery of trade, the opening of financial markets, and the lifting of controls on current accounts led in the 1950’s and 60’s to sustained growth and stability.
The importance, especially from a speaker of Volcker’s stature presenting among the current heads of the two leading Bretton Woods institutions, the IMF’s Christine Lagarde, and the World Bank Group’s Jim Yong Kim, among other luminaries, potentially has radical implications. Volcker provided a quick and precise summary of the monetary and financial anarchy which succeeded his dutiful dismantling of Bretton Woods:
Efforts to reconstruct the Bretton Woods system, either partially at the Smithsonian or more completely in the subsequent negotiations of the Committee of 20, ultimately failed. The practical consequence, and to many the ideological victory, was a regime of floating exchange rates. Somehow, the intellectual and convenient political argument went, differences among national financial and economic policies, shifts in competitiveness and in inflation rates, all could be and would be smoothly accommodated by orderly movements in exchange rates.
How’s that working out for us? Volcker played an instrumental role in dutifully midwifing, as Treasury undersecretary for monetary affairs under the direction of Treasury Secretary John Connally the “temporary” closing of the gold window announced to the world on August 15, 1971 by President Nixon. Volcker now unequivocally indicts the monetary regime he played a key role in helping to foster.
By now I think we can agree that the absence of an official, rules-based cooperatively managed, monetary system has not been a great success. In fact, international financial crises seem at least as frequent and more destructive in impeding economic stability and growth.
The United States, in particular, had in the 1970’s an unhappy decade of inflation ending in stagflation. The major Latin American debt crisis followed in the 1980’s. There was a serious banking crisis late in that decade, followed by a new Mexican crisis, and then the really big and damaging Asian crisis. Less than a decade later, it was capped by the financial crisis of the 2007-2009 period and the great Recession. Not a pretty picture.
Volcker fully recognizes the difficulties in restoring a rule-based well functioning system both in his speech and in this private comment to Lipsky made thereafter. Lipsky: “It’s easy to say what’s wrong,” Mr. Volcker told me over the weekend, “but sensible reforms are a pretty tough thing.”
The devil, of course, is in the details. What rule should prevail? There is an almost superstitious truculence on the part of world monetary elites to consider the restoration of the gold standard. And yet, the Bank of England published a rigorous and influential study in December 2011, Financial Stability Paper No. 13, Reform of the International Monetary and Financial System. This paper contrasts the empirical track record of the fiduciary dollar standard directed by Secretary Connally and brought into being (and then later administered by) Volcker. It determines that the fiduciary dollar standard has significantly underperformed both the Bretton Woods gold exchange standard and the classical gold standard in every major category.
As summarized by Forbes.com
contributor Charles Kadlec, the Bank of England found
When compared to the Bretton Woods system, in which countries defined their currencies by a fixed rate of exchange to the dollar, and the U.S. in turn defined the dollar as 1/35 th of an ounce of gold:
- Economic growth is a full percentage point slower, with an average annual increase in real per-capita GDP of only 1.8%
- World inflation of 4.8% a year is 1.5 percentage point higher;
- Downturns for the median countries have more than tripled to 13% of the total period;
- The number of banking crises per year has soared to 2.6 per year, compared to only one every ten years under Bretton Woods;
That said, the Bank of England paper resolves by calling for a rules-based system, without specifying which rule. Volcker himself presents as oddly reticent about considering the restoration of the “golden rule.” Yet, as recently referenced in this column, in his Foreword to Marjorie Deane and Robert Pringle’s The Central Banks (Hamish Hamilton, 1994) he wrote:
It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less. By and large, if the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with ‘free banking.’ The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy.
There is an active dispute in Washington between Republicans, who predominantly favor a rule-based monetary policy, and Democrats, who predominantly favor a discretion-based monetary policy. The Republicans have not specified the rule they wish to be implemented. The specifics matter.
There is an abundance of purely empirical evidence for the gold standard’s effectiveness in creating a climate of equitable prosperity. The monetary elites still flinch at discussion the gold option. That said, the slow but sure rehabilitation of the legitimacy of the gold standard as a policy option was put into play by one of their own, no less than the then World Bank Group president Robert Zoellick, in an FT
op-ed, The G20 must look beyond Bretton Woods.
There he observed, in part, that “Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today.”
There are many eminent and respectable elite proponents of the gold standard. Foremost among these Reagan Gold Commissioners Lewis E. Lehrman (with whose Institute this writer has a professional association) and Ron Paul, and Forbes Media CEO Steve Forbes, coauthor of a formidable new book, Money
, among them. There are many more, too many to list here.
In the penultimate paragraph of his remarks to the Bretton Woods Committee Volcker observes:
Walter Bagehot long ago set out succinctly a lesson from experience: “Money will not manage itself”. He then spoke from the platform of the Economist to the Bank of England. Today it is our mutual interdependence that requires a degree of cooperation and coordination that too often has been lacking on an international scale.
As the great Walter Layton, editor of the Economist, wrote in 1925, “the choice which presents itself is not one between a theoretical standard on the one hand and gold with all its imperfections on the other, but between the gold standard … and no control at all.” “No control at all” anticipates Volcker’s own critique.
If Chairman Volcker overcame his aversion to considering the gold standard as a respectable option for consideration he just might find that his his stated concern “We are long ways from (a new Bretton Woods conference)” may be exaggerated. A golden age of equitable prosperity and financial stability is closer than Mr. Volcker believes.
The corollary to Volcker’s dictum, “ultimately the power to create is the power to destroy” is that the power to destroy is the power to create. It is time, and past time, Mr. Volcker, to give full and respectful consideration to the gold standard which served the world very well indeed and would serve well again.
This article was previously published at Forbes.com
Editor’s Note: This article was previously published in The Amphora Report, Vol 5, 09 May 2014.
“Capitalism is not chiefly an incentive system but an information system.” -George Gilder
“Don’t shoot the messenger” is an old aphorism taken primarily to mean that it is unjust to take out the frustrations of bad news on he who provides it. But there is another reason not to shoot the messenger: News, good or bad, is information, and in a complex economy information, in particular prices, has tremendous value. To suppress or distort the information industry by impeding the ability of messengers to do their jobs would severely damage the economy. As it happens, messengers in the price signals industry are normally referred to as ‘speculators’ and the importance of their economic role increases exponentially with complexity. So don’t shoot the speculator. Embrace them. And if you feel up to it, consider becoming one yourself. How? Read on.
IN ADMIRATION OF SPECULATION
Back in high school my sister had a boyfriend who was quite practical by nature and, by working odd jobs, saved up enough money for the down payment on a 4WD pickup truck before his 18th birthday. It was a powerful truck and as a result he was able to generate additional business doing landscaping and other work requiring off-road equipment transport.
His truck also had a winch, which was of particular use one night in 1982. A severe storm hit, flooding the primary commuting routes north of San Francisco. Hundreds of motorists got stranded in water on roads stretching all the way to the Sonoma County borders. The emergency services did their best but the gridlock severely curtailed their ability to reach many commuters, who ended up spending the night in the cars. Fortunately, it was not particularly cold, and the conditions, while unpleasant, were hardly life-threatening.
As word got round just how bad the situation was, among others, my sister’s boyfriend headed out in his truck and sought out stranded commuters to winch out of the water. Sure, he wanted to help. But he also had payments to make on his truck. And he needed money generally, not being from a wealthy family. So naturally he expected to get paid for his services. What he didn’t expect, at least not at first, was just how much he could get paid.
As he told the story the next day, at first he was charging $10 to winch a car to safety. But as it dawned on him just how much demand there was and how few motorists he could assist-attaching a winch to a car and pulling it to safety could take as long as 20mins-he began to raise his prices in response. $10 became $20. $20 became $50. By midnight, stranded drivers were willing to pay as much as $100 for his assistance (Marin County is a wealthy county so some drivers were not just willing but also able to pay this amount.)
I forget exactly, but I believe he earned nearly $3,000 that night, enough money to pay off the lease on the truck! He was thrilled, my sister was thrilled and my parents were duly impressed. Yet the next day the local papers contained stories disparaging of ‘price-gouging’ by those helping to rescue the stranded commuters, who also noted and complained about the lack of official emergency services.
This struck me as a bit odd. The way my sister’s boyfriend told the story, he thought he was providing a valuable service. At first he was charging very little but as people were obviously willing to pay more, he raised his prices in return. The price discovery went on into the wee hours and reached $100 in the end. Did he plan things that way? Of course he had no idea he would be in the right place, at the right time, to make nearly $3,000 and pay off the lease in one go. But to hear some of the stranded commuters talk as if he was a borderline criminal just didn’t fit.
I didn’t think of it at the time, but as I began the study of economics some years later and learned of the role that speculators play in a market-based economy, I recalled this episode as one that fit the definition rather well. Speculators provide essential price information. Yet their most important role, where they really provide economic value, is not when market conditions are simply ‘normal’-when supply and demand are in line with history-but rather when they help to determine prices for contingent or extreme events, such as capacity constraints. Without sufficient capacity for a rainy day-or a VERY rainy day such as that in 1982-consumers will find at critical times that they can’t get access to essential services at ANY price.
In that rare moment, when prices soar, it might be tempting to shoot the messenger-blame the speculator-but this is unfair. Sometimes they take big risks. Sometimes they take huge losses or reap huge rewards. But regardless, they provide essential price discovery signals that allow capacity to be built that otherwise might not exist.
Consider those who speculate in electricity prices as another example. Electricity demand naturally fluctuates. But electricity providers are normally contractually required to meet even unusually large surges in peak demand. Occasionally, due to weather or other factors, there are extreme spikes in demand and capacity approaches its limit. If there is a tradable market, the price then soars. At the limit of capacity, the last kw/hr goes to the highest bidder, much as at the end of an auction for a unique painting. Such is the process of price discovery.
Absent the unattractive option of inefficient and possibly corrupt central planning, how best to determine how much capacity should be made available? Who is going to finance the infrastructure? Who will assume the risks? Well, as long as there is a speculative market in the future price of electricity, the implied forward price curve provides a reference for determining whether or not it is economically attractive to add to available capacity or not, with capacity being an option, rather than the obligation, to produce power at a given price and point in time.
My sister’s boyfriend’s truck thus represented an undervalued ‘option’ with which to winch cars to safety. Under normal conditions this option had little perceived value. But on the occasion of the flood, it had tremendous value and the option was ‘exercised’ at great profit. Valuing the truck without speculating on the possibility of such a windfall would thus be incorrect. And failing to appreciate the essential role that speculators play in building and maintaining economic capacity generally, for all goods and services, can result in a temptation to shoot the messenger, rather than to get the message.(1)
HOW DO SPECULATORS SURVIVE?
If speculators are the ‘messengers’ of market economies, how are they compensated? Obviously, those who are consistently right generate trading profits. But what of those on the other side who are consistently wrong? How can speculators as a group, right and wrong, make money? And if they can’t, how can they exist at all? (Of course, if they are too big to fail, they can count on getting bailed out. But I’ve already flogged that dead horse in many a report.)
This was once one of the great mysteries of economics, but David Ricardo, Ludwig von Mises and others eventually figured it out. Speculators do more than just speculate, although from their perspective that is what they see. Speculators also provide liquidity for hedgers, that is, those who wish NOT to speculate. And they charge a small implied fee for doing so, in the form of a ‘risk premium’. This risk premium is what keeps them going through the inevitable ups and downs of markets. They assume risks others don’t want to take and are compensated for doing so. In practice, it is impossible to determine precisely what this implied fee is, although economists do have ways to approximate the ‘liquidity risk premium’ that exists in a market.
Hedgers can be those who have a natural exposure to the underlying economic good. Take wheat for example. A highly competent farmer running an efficient farm might want to concentrate full-time on his operations and leave the price risk of wheat to someone else. He can do so by selling his estimated production forward in the futures markets. On the other side, a baked goods business might prefer to focus on their operations too. In principle, the farmer and the baker could deal directly with one another, but this arrangement would give them little flexibility to dynamically adjust hedging positions as estimated wheat production or the demand for bread shifted, for example. With speculators sitting in the middle, the farmer and the baker needn’t waste valuable time seeking out the best counterparty and can easily hedge their risk dynamically. Yes, they will pay a small liquidity risk premium to the speculators by doing so, but advanced economies require a high degree of specialisation and thus the professional speculator is an essential component.
While it is nice to receive a small risk premium in exchange for providing essential price information and liquidity, what speculators most want is to be right. Sadly, pure speculation (ie between speculators themselves, not vis-à-vis hedgers) is a zero sum game. For every ‘right’ speculator there is a ‘wrong’ speculator. While there is an extensive literature regarding why some traders are more successful than others, I will offer a few thoughts.
THE UNWRITTEN ‘RULES’ OF SUCCESSFUL SPECULATION
There are several unwritten rules in speculation, and I would confirm these through my own experience. The first is that it is the rare trader who is right more than 60% of the time, so most successful traders are right within the narrow range of 51-60%. Then there is the second rule, that 20% of traders capture 80% of the available profits. Combining these two rules, what you have is that 20% of traders are correct 51-60% of the time: So 0.2 * 0.5 or 0.6 = 0.10 to 0.12 or 10-12% of all trades initiated are winning trades for winning traders. The remaining 88% are either losing trades or they are winning trades spread thinly amongst the less successful traders.
These numbers should make it clear that successful traders are largely just risk managers: Yes, they succeed in identifying the 10-12% of trades that really matter for profits but they are also wrong 40%+ of the time so they must know how to manage their losses as well as when to prudently take profits on the 10-12% of winning trades.
Internalising this negative skew in trading returns is an essential first step toward becoming a good trader. Just accept that something on the order of 50% of trades are going to go against you, possibly even more. Accept also that only 10-12% of your trades are going to drive your profits. Focus on finding these but keep equal focus on minimising exposure to the other 88-90% of trades that either don’t matter, or that could overwhelm the 10-12%.
At Amphora, we have an investment process that we believe is particularly good at identifying and isolating the most attractive trades in the commodities markets. Sure, we make mistakes, but our investment and risk management processes are designed to keep these mistakes to a minimum. Indeed, we miss out on many potentially winning trades because we are highly selective. So while speculation may have a cavalier reputation of bravado trading, day in and day out, the Amphora process is more patient; an opportunistic tortoise rather than a greedy, rushed hare.
CURRENT OPPORTUNITIES IN THE EQUITIES AND COMMODITIES MARKETS
In my last Report discussing the financial and commodities markets outlook, 2014: A YEAR OF INVESTING DANGEROUSLY, I took the view that the equity market correction (or crash) that I anticipated from spring 2013 was highly likely to occur in 2014, for a variety of reasons (2). While I did not anticipate that the Ukraine crisis would escalate as much as it did, as quickly as it did, thereby causing some concern, I did expect that corporate revenues and profits would increasingly disappoint, as they most certainly have done year to date. This is due in part to weaker-than-expected economic growth, with the drag from excessive inventory growth plainly visible in the Q1 US GDP data. But the news is in fact much worse than that, because labour productivity growth has gone sharply negative due to soaring costs. These costs may or may not be specifically associated with the ‘(Un?)Affordable Care Act’ depending on who you ask, but the fact that productivity has plunged is terrible news for business fixed investment, which is the single most important driver of economic growth over the long-term. While a recession may or may not be getting underway, the outlook is for poor growth regardless, far below what would be required to justify current corporate earnings expectations, as implied by P/Es, CAPEs and other standard valuation measures. For those who must hold an exposure to equities, my key recommendation from that previous Report holds:
[I]t is time to rotate into defensive, deep-value, income-generating shares. These could include, for example, infrastructure, consumer non-discretionary and well-capitalised mining shares, including gold miners. That may seem an odd combination, but it so happens that even well-capitalised miners are trading at distressed levels at present, offering unusually good value.
Turning to the commodities markets, I expressed a preference for ‘defensive’ commodities in the Report (Although I did recommend taking initial profits in coffee). Indeed, basic foodstuffs, in particular grains, have outperformed strongly of late, continuing their rise from the depressed levels reached last year. However, the large degree of such outperformance now warrants some rotation out of grains and into industrial metals, including copper, aluminium, iron and nickel. Yes, these are exposed to the business cycle, which does appear to be rolling over in the US, China, Japan, Australia and most of Asia, but the extreme speculative short positioning and relative cheapness of industrial metals at present makes them an attractive contrarian play.
Precious metals have not underperformed to the same degree and they are normally less volatile in any case, but given the nearly three-year bear market, attractive relative valuations and the potential for a surge in risk-aversion, I would add to precious metals. Silver in particular looks cheap, although gold is highly likely to be the better performer in a risk-off environment. My recommendation would be to favour gold until the equity markets suffer at least a 15-20% correction. At that point, incremental rotation into silver would be sensible, with a more aggressive response should equity markets suffer a substantial 30%+ decline.
Turning to the platinum group metals, palladium is unusually expensive due to Russian supply concerns. While this is entirely reasonable due to the Ukraine crisis, the fact is that near-substitute platinum is much cheaper. And the on-again, off-again strikes at the large platinum mines in South Africa could escalate in a heartbeat, providing ample justification for platinum prices to catch up to palladium. Alternatively, should the Ukraine crisis de-escalate meaningfully, palladium is highly exposed to a sharp downward correction, and I would recommend a strong underweight/short position at present.
(1) Perhaps one reason why many fail to appreciate the essential role that speculators play in a market economy is that mainstream, neo-Keynesian economics treats speculation as mere ‘animal spirits’, to borrow their classic depiction by Keynes himself.
(2) This report can be accessed here.