First, he gave an unexpectedly dovish speech at the Jackson Hole conference, rather ungallantly upstaging the host, Ms Yellen, who was widely anticipated to be the most noteworthy speaker at the gathering (talking about the labor market, her favorite subject). Having thus single-handedly and without apparent provocation raised expectations for more “stimulus” at last week’s ECB meeting, he then even exceeded those expectations with another round of rate-cuts and confirmation of QE in form of central bank purchases of asset-backed securities.
These events are significant not because they are going to finally kick-start the Eurozone economy (they won’t) but because 1) they look rushed, and panicky, and 2) they must clearly alienate the Germans. The ideological rift that runs through the European Union is wide and deep, and increasingly rips the central bank apart. And the Germans are losing that battle.
As to 1), it was just three months ago that the ECB cut rates and made headlines by being the first major central bank to take a policy rate below zero. Whatever your view is on the unfolding new Eurozone recession and the apparent need for more action (more about this in a minute), the additional 0.1 percent rate reduction will hardly make a massive difference. Yet, implementing such minor rate cuts in fairly short succession looks nervous and anxious, or even headless. This hardly instils confidence.
And regarding the “unconventional” measures so vehemently requested by the economic commentariat, well, the “targeted liquidity injections” that are supposed to direct freshly printed ECB-money to cash-starved corporations, and that were announced in June as well, have not even been implemented yet. Apparently, and not entirely unreasonably, the ECB wanted to wait for the outcome of their “bank asset quality review”. So now, before these measures are even started, let alone their impact could even be assessed, additional measures are being announced. The asset purchases do not come as a complete surprise either. It was known that asset management giant BlackRock had already been hired to help the ECB prepare such a program. Maybe the process has now been accelerated.
This is Eurozone QE
This is, of course, quantitative easing (QE). Many commentators stated that the ECB shied away from full-fledged QE. This view implies that only buying sovereign debt can properly be called QE. This does not make sense. The Fed, as part of its first round of QE in 2008, also bought mortgage-backed securities only. There were no sovereign bonds in its first QE program, and everybody still called it QE. Mortgage-backed securities are, of course, a form of asset-backed security, and the ECB announced purchases of asset-backed securities at the meeting. This is QE, period. The simple fact is that the ECB expands its balance sheet by purchasing selected assets and creating additional bank reserves (for which banks will now pay the ECB a 0.2 percent p.a. “fee”).
As to 2), not only will the ECB decisions have upset the Germans (the Bundesbank’s Mr. Weidmann duly objected but was outvoted) but so will have Mr. Draghi’s new rhetoric. In Jackson Hole he used the F-word, as in “flexibility”, meaning fiscal flexibility, or more fiscal leeway for the big deficit countries. By doing so he adopted the language of the Italian and French governments, whenever they demand to be given more time for structural reform and fiscal consolidation. The German government does not like to hear this (apparently, Merkel and Schäuble both phoned Draghi after Jackson Hole and complained.)
The German strategy has been to keep the pressure on reform-resistant deficit-countries, and on France and Italy in particular, and to not allow them to shift the burden of adjustment to the ECB. Draghi has now undermined the German strategy.
The Germans fear, not quite unjustifiably, that some countries always want more time and will never implement reform. In contrast to those countries that had their backs to the wall in the crisis and had little choice but to change course in some respect, such as Greece, Ireland, and Spain, France and Italy have so far done zilch on the structural reform front. France’s competitiveness has declined ever since it adopted the 35-hour workweek in 2000 but the policy remains pretty much untouchable. In Italy, Renzi wants to loosen the country’s notoriously strict labour regulations but faces stiff opposition from the trade unions and the Left, not least in his own party. He now wants to give his government three years to implement reform, as he announced last week.
Draghi turns away from the Germans
German influence on the ECB is waning. It was this influence that kept alive the prospect of a somewhat different approach to economic challenges than the one adopted in the US, the UK and, interestingly, Japan. Of course, the differences should not be overstated. In the Eurozone, like elsewhere, we observed interest rate suppression, asset price manipulations, and massive liquidity-injections, and worse, even capital controls and arbitrary bans on short-selling. But we also saw a greater willingness to rely on restructuring, belt-tightening, liquidation, and, yes, even default, to rid the system of the deformations and imbalances that are the ultimate root causes of recessions and the impediments to healthy, sustainable growth. In the Eurozone it was not all about “stimulus” and “boosting aggregate demand”. But increasingly, the ECB looks like any other major central bank with a mandate to keep asset prices up, government borrowing costs down, and a generous stream of liquidity flowing to cover the cracks in the system, to sustain a mirage of solvency and sustainability, and to generate some artificial and short-lived headline growth. QE will not only come to the Eurozone, it will become a conventional tool, just like elsewhere.
I believe it is these two points, Draghi’s sudden hyperactivity (1) and his clear rift with the Germans and his departure from the German strategy (2) that may explain why the euro is finally weakening, and why the minor announcements of last Thursday had a more meaningful impact on markets than the similarly minor announcements in June. With German influence on the ECB waning, trashing your currency becomes official strategy more easily, and this is already official policy in Japan and in the US.
Is Draghi scared by the weak growth numbers and the prospect of deflation?
Maybe, but things should be put in perspective.
Europe has a structural growth problem as mentioned above. If the structural impediments to growth are not removed, Europe won’t grow, and no amount of central bank pump priming can fix it.
Nobody should be surprised if parts of Europe fall into technical recessions every now and then. If “no growth” is your default mode then experiencing “negative growth” occasionally, or even regularly, should not surprise anyone. Excited talk about Italy’s shocking “triple-dip” recession is hyperbole. It is simply what one should expect. Having said this, I do suspect that we are already in another broader cyclical downturn, not only in Europe but also in Asia (China, Japan) and the UK.
The deflation debate in the newspapers is bordering on the ridiculous. Here, the impression is conveyed that a drop in official inflation readings from 0.5 to 0.3 has substantial information content, and that if we drop below zero we would suddenly be caught in some dreadful deflation-death-trap, from which we may not escape for many years. This is complete hogwash. There is nothing in economic theory or in economic history that would support this. And, no, this is not what happened in Japan.
The margin of error around these numbers is substantial. For all we know, we may already have a -1 percent inflation rate in the Eurozone. Or still plus 1 percent. Either way, for any real-life economy this is broadly price-stability. To assume that modest reductions in any given price average suddenly mean economic disaster is simply a fairy tale. Many economies have experienced extended periods of deflation (moderately rising purchasing power of money on trend) in excess of what Japan has experienced over the past 20 years and have grown nicely, thank you very much.
As former Bank of Japan governor Masaaki Shirakawa has explained recently, Japan’s deflation has been “very mild” indeed, and may have had many positive effects as well. In a rapidly aging society with many savers and with slow headline growth it helped maintain consumer purchasing power and thus living standards. Japan has an official unemployment rate of below 4 percent. Japan has many problems but deflation may not be one of them.
Furthermore, the absence of inflation in the Eurozone is no surprise either. There has been no money and credit growth in aggregate in recent years as banks are still repairing their balance sheets, as the “asset quality review” is pending, and as other regulations kick in. Banks are reluctant to lend, and the private sector is careful to borrow, and neither are acting unreasonably.
Expecting Eurozone inflation to clock in at the arbitrarily chosen 2 percent is simply unrealistic.
Draghi’s new activism moves the ECB more in the direction of the US Fed and the Bank of Japan. This alienates the Germans and marginally strengthens the position of the Eurozone’s Southern periphery. This monetary policy will not reinvigorate European growth. Only proper structural reform can do this but much of Europe appears unable to reform, at least without another major crisis. Fiscal deficits will grow.
Monetary policy is not about “stimulus” but about maintaining the status quo. Super-low interest rates are meant to sustain structures that would otherwise be revealed to be obsolete, and that would, in a proper free market, be replaced. The European establishment is interested in maintaining the status quo at all cost, and ultra-easy monetary policy and QE are essentially doing just that.
Under the new scheme of buying asset-backed securities, the ECB’s balance sheet will become a dumping ground for unwanted bank assets (the Eurozone’s new “bad” bank). Like almost everything about the Euro-project, this is about shifting responsibility, obscuring accountability, and socializing the costs of bad decisions. Monetary socialism is coming. The market gets corrupted further.
Though he quotes F.A. Hayek a few times, the Austrian School gets only one mildly disparaging mention in the entire book. This seems odd for an author who devotes a whole chapter to the benefits of the gold standard. His first bestselling book, Currency Wars, argues that currency wars are not just an economic or monetary concern, but a national security concern for the USA.
Rickards relies on emerging Chaos theories of economics and markets (1) to buttress his arguments in favour of sound money and prudent – limited – government. He uses the same insights, twinned with years of Wall Street experience, to explain why the “coming collapse of the dollar and the international monetary system is entirely foreseeable.”
One of Rickards’ key arguments is that exponential increases in the total size of credit markets mean exponential increases in risk. The gross size of derivative markets is the problem, irrespective of false assurances about netting, he claims. Politicians and central bankers have by and large learnt nothing from recent crises, and are still “in thrall to bank political contributions.”
He makes the case for the US federal government to reinstate Depression-era restrictions on banking activities and for most derivatives to be banned. As a former Federal Reserve Chairman, Paul Volcker, said in 2009, “the only useful thing banks have invented in 20 years is the ATM” – a sentiment Rickards would probably be sympathetic to.
The chapter dealing with the Fed’s hubris and what investment writer James Grant calls our “PhD Standard” of macroeconomic management will be familiar territory for readers of this site. The Fed is trapped between the rock of natural deflationary forces of excessive debt, an ageing population and cheap imports frustrating its efforts to generate a self-sustaining economic recovery and the hard place of annualised inflation of 2%. Rickards quotes extensively from eminent economist and Ben Bernanke mentor Frederic Mishkin, who noted in a 2013 paper titled Crunch Time: Fiscal Crises and the Role of Monetary Policy that “ultimately, the central bank is without power to avoid the consequences of an unsustainable fiscal policy.”
More interesting is the author’s attempt to map out what-happens-next scenarios. The chapter about the on-going transformation of the International Monetary Fund into the world’s central bank, and Special Drawing Rights (SDRs) into a global currency, is particularly insightful. Though Rickards doesn’t say it, Barack Obama’s former chief of staff (and current Mayor of Chicago) Rahm Emanuel’s dictum about never letting a crisis go to waste seems to apply here: hostile acts of financial warfare would lead to calls for more international regulation, and to more government intervention and monitoring of markets. Observers of the EU’s crab-like advance over the last half century will be familiar with the process.
Indeed, my only quibble with this book is Rickards’ starry-eyed take on the EU – soon to be “the world’s economic superpower” in his view. Though he makes a good argument – similar to Jesús Huerta de Soto’s – that relatively-tight European Central Bank monetary policy is forcing effective structural adjustments in the eurozone periphery, as well as in eastern states that wish to join the euro, his endorsement of other aspects of the EU seem too sweeping.
The author talks of the benefits of “efficiencies for the greater good” in supranational government, and how subsidiarity makes allowances for “local custom and practice”. But, as the regulatory débacle surrounding the Somerset floods has shown recently, EU rule frequently licenses bureaucratic idiocies that destroy effective, established national laws. Regulatory central planning for an entire continent is, I’d say, just as suspect as monetary central planning for one country.
The continent’s demographic problems are probably containable in the short-term, as Rickards says. But mass immigration is driving increasing numbers of white Europeans to far-right parties. And while there is consistently strong public support for the euro in the PIIGS (Portugal, Ireland, Italy, Greece and Spain), he’s silent on the broader question of the EU’s democratic legitimacy. No mention of those pesky ‘No’ votes in European Constitution, Maastricht and Lisbon Treaty referendums – or of the Commission’s own Eurobarometer polls, which show more and more Europeans losing faith in “the project”.
No matter I suppose: the eurocrats will rumble on regardless. But what was that quote about democracy being the worst form of government apart from all the others?
All in all though, this is a great book – even for someone like me who’s not exactly new to the economic doom ‘n’ gloom genre. As Rickards says at the end of his intro: “The system has spun out of control.”
(1) For example Juárez, Fernando (2011). “Applying the theory of chaos and a complex model of health to establish relations among financial indicators”. Procedia Computer Science 3: 982–986.
What the media calls a “currency war,” whereby nations engage in competitive currency devaluations in order to increase exports, is really “currency suicide.” National governments persist in the fallacious belief that weakening one’s own currency will improve domestically-produced products’ competitiveness in world markets and lead to an export driven recovery. As it intervenes to give more of its own currency in exchange for the currency of foreign buyers, a country expects that its export industries will benefit with increased sales, which will stimulate the rest of the economy. So we often read that a country is trying to “export its way to prosperity.”
Mainstream economists everywhere believe that this tactic also exports unemployment to its trading partners by showering them with cheap goods and destroying domestic production and jobs. Therefore, they call for their own countries to engage in reciprocal measures. Recently Martin Wolf in the Financial Times of London and Paul Krugman of the New York Times both accuse their countries’ trading partners of engaging in this “beggar-thy-neighbour” policy and recommend that England and the US respectively enter this so-called “currency war” with full monetary ammunition to further weaken the pound and the dollar.
I am struck by the similarity of this currency-war argument in favour of monetary inflation to that of the need for reciprocal trade agreements. This argument supposes that trade barriers against foreign goods are a boon to a country’s domestic manufacturers at the expense of foreign manufacturers. Therefore, reciprocal trade barrier reductions need to be negotiated, otherwise the country that refuses to lower them will benefit. It will increase exports to countries that do lower their trade barriers without accepting an increase in imports that could threaten domestic industries and jobs. This fallacious mercantilist theory never dies because there are always industries and workers who seek special favours from government at the expense of the rest of society. Economists call this “rent seeking.”
A Transfer of Wealth and a Subsidy to Foreigners
As I explained in Value in Devaluation?, inflating one’s currency simply transfers wealth within the country from non-export related sectors to export related sectors and gives subsidies to foreign purchasers.
It is impossible to make foreigners pay against their will for the economic recovery of another nation. On the contrary, devaluing one’s currency gives a windfall to foreigners who buy goods cheaper. Foreigners will get more of their trading partner’s money in exchange for their own currency, making previously expensive goods a real bargain, at least until prices rise.
Over time the nation which weakens its own currency will find that it has “imported inflation” rather than exported unemployment, the beggar-thy-neighbour claim of Wolf and Krugman. At the inception of monetary debasement the export sector will be able to purchase factors of production at existing prices, so expect its members to favour cheapening the currency. Eventually the increase in currency will work its way through the economy and cause prices to rise. At that point the export sector will be forced to raise its prices. Expect it to call for another round of monetary intervention in foreign currency markets to drive money to another new low against that of its trading partners.
Of course, if one country can intervene to lower its currency’s value, other countries can do the same. So the European Central Bank wants to drive the euro’s value lower against the dollar, since the US Fed has engaged in multiple programs of quantitative easing. The self-reliant Swiss succumbed to the monetary debasement Kool-Aid last summer when its sound currency was in great demand, driving its value higher and making exports more expensive. Lately the head of the Australian central bank hinted that the country’s mining sector needs a cheaper Aussie dollar to boost exports. Welcome to the modern version of currency wars, AKA currency suicide.
There is one country that is speaking out against this madness: Germany. But Germany does not have control of its own currency. It gave up its beloved Deutsche Mark for the euro, supposedly a condition demanded by the French to gain their approval for German reunification after the fall of the Berlin Wall. German concerns over the consequences of inflation are well justified. Germany’s great hyperinflation in the early 1920’s destroyed the middle class and is seen as a major contributor to the rise of fascism.
As a sovereign country Germany has every right to leave the European Monetary Union and reinstate the Deutsche Mark. I would prefer that it go one step further and tie the new DM to its very substantial gold reserves. Should it do so, the monetary world would change very rapidly for the better. Other EMU countries would likely adopt the Deutsche Mark as legal tender, rather than reinstating their own currencies, thus increasing the DM’s appeal as a reserve currency.
As demand for the Deutsche Mark increased, demand for the dollar and the euro as reserve currencies would decrease. The US Fed and the ECB would be forced to abandon their inflationist policies in order to prevent massive repatriation of the dollar and the euro, which would cause unacceptable price increases.
In other words, a sound Deutsche Mark would start a cascade of virtuous actions by all currency producers. This Golden Opportunity should not be squandered. It may be the only non-coercive means to prevent the total collapse of the world’s major currencies through competitive debasements called a currency war, but which is better and more accurately named currency suicide.
This article was previously published at Mises.org.
Professor Jesus Huerta De Soto sent me a copy of his new film called “In Defense of the Euro (An Austrian Perspective)”. You can watch it here.
For those truly interested in the Gold Standard as a potential solution to our monetary crises, whilst the Euro is a very weak imitation of it, it does force governments in the euro area, in the absence of any ability to mint up money out of nowhere, to confront their profligate over-expenditure and move towards being honest with their citizens over it.
We who sit in nations that can mint up new money from nowhere – the UK, USA, and Japan – can seemingly avoid the pain of confronting our profligacy, but we wither on the vine; the pain is required to and grow and prosper again. The eurozone area will be on a stronger footing, with governments living within their means, much quicker than in the nations where monetary nationalism rules the day.
To all those who trash the Euro and Euro-style solutions, you should listen to what the Professor has to say, reflect on this contrary view, and challenge your perspective. You may find that, surprisingly, the Euro could lead to smaller governments and more honest money.
“Toby Baxendale is an entrepreneur who built up, amongst other things, the UK's largest fresh fish supplier to the Food Service sector, see www.directseafoods.co.uk, and recently sold it. Toby is dedicated to furthering the teaching of the Austrian school of economics. He established and funded the 1st Distinguished Hayek Visiting Teaching Fellowship Program at the LSE in Honour of the Nobel Laureate F A Hayek. Toby is Chairman of The Cobden Centre. Richard Cobden's timeless principles of the abolition of legal privilege of the few at the expense of the many are worthy in this day and age to promote. | Contact us
15 August 13 | Tags: Euro, gold standard, Huerta de Soto | Category: Economics | 21 comments
Over a year ago, in the midst of an ongoing economic crisis, François Hollande celebrated his victory over Nicolas Sarkozy in France’s presidential elections. Hollande became the leader of a country in economic turmoil. In the past year, he has had relatively free rein to carry out his economic agenda, since the Socialist Party he leads has a majority in the French Parliament.
France has a history of grandiose government spending, even among European countries. Public spending accounts for 57 percent of national output, and public debt accounts for over 90 percent of GDP. While austerity has been the buzzword in the rest of Europe since 2009, resulting in a modest decline in government spending as a percentage of GDP, France is not part of that trend.
The public sector now accounts for almost two-thirds of all direct economic activity, and more if indirect activity is counted. This large and growing dependence on government is disastrous because it is funded by ever higher taxes. These high taxes drain the private sector (while simultaneously giving the public sector an aura of impotence) and deficit spending obliges future generations of French citizens to pay off the largesse of today’s government.
Deep within the French psyche is the idea that cuts to the gargantuan public sector would cause undue harm to everyone. This inability to envision a French economy where the private sector picks up the slack when fewer public services are provided has reinforced the reluctance of politicians, and in particular, François Hollande, to use austerity measures to overcome the crisis. Instead, the current solution is to increase government spending and create more jobs in the public sector. For this reason, Hollande’s administration has pledged to increase the minimum wage for all employees, public and private, and create 60,000 new public teaching jobs.
In addition to the present increases in public expenditures, Hollande has committed to future increases in public spending. His decision to roll back Sarkozy’s initiative to raise the retirement age from 60 to 62 obliges taxpayers not only to support the burgeoning ranks of public employees “working” today, but the growing number of public retirees supported by generous social security payments.
In a bid to combat rising interest rates on its bonds, the French government has recently commenced a campaign to raise taxes to fund the country’s ballooning expenditures. Indeed, one of Hollande’s primary electoral promises was a top tax rate of 75 percent on the so-called riche (income earners above 1 million euros).
France has one of the highest corporate tax rates in the European Union, exceeding even the famous high rates of Sweden. While the European Union’s average tax rate has been decreasing (from about 50 percent in 2005 to about 44 percent in 2012), France’s tax rate has remained constantly high (over 65 percent from 2005 to 2012).
In addition to high tax rates, French businesses are faced with the highest social charges in the European Union, as well as oppressive government regulation. These factors make for an unattractive business environment. Recently several large companies closed their doors rather than deal with the difficult business conditions, resulting in thousands losing their jobs. New companies are slow to appear in such a climate.
In response to the threat of higher French taxes, British Prime Minister David Cameron, offered to “roll out the red carpet” for any high-income earning Frenchmen who wanted to avoid paying French taxes. Of course, we would be remiss to think that Cameron was motivated by anything other than to attract tax dollars into his own strained coffers. The result, however, was tax competition between states.
Before the advent of the European Monetary Union, highly indebted countries sought to cure their fiscal woes through inflationary policies. France removed this option from the table when it adopted the euro. Indeed, as Philipp Bagus demonstrates in his book The Tragedy of the Euro, it was the French who aggressively pushed for monetary integration within Europe. They must now adhere to the results of this decision.
The monetary union functions somewhat as a modern gold standard. Just as gold once kept states from running prolonged deficits, today the loss of an independent monetary policy constrains European member states in a similar way.
With no recourse to an inflationary monetary policy, the French government is at the mercy of the bond market. As lenders worry about the French government’s ability to repay their debts, now and in the future, interest rates will rise (as they have already). The French government will have to rein in its deficit spending either through spending cuts or tax increases as the cost of borrowing goes up. The private sector is already a heavily burdened minority, and given the current exodus of French companies and entrepreneurs to other countries, any further taxes would be coming from an already shrinking tax-paying base.
Like many of his counterparts, François Hollande realizes that the beleaguered French economy needs change. What he must do is focus on the areas that he can change. He must decrease public spending and lower taxes in order to increase employment. In addition, the private sector must be allowed to heal and recover, instead of treating it as a goose to be plucked. This is the only way the French government can continue to function, and more importantly, the only way to get France out of its economic cul-de-sac.
It’s official: global economic policy is now firmly in the hands of money cranks.
The lesson from the events of 2007-2008 should have been clear: boosting GDP with loose money – as the Greenspan Fed did repeatedly between 1987 and 2005 and most damagingly between 2001 and 2005 when in order to shorten a minor recession it inflated a massive housing bubble – can only lead to short term booms followed by severe busts. A policy of artificially cheapened credit cannot but cause mispricing of risk, misallocation of capital and a deeply dislocated financial infrastructure, all of which will ultimately conspire to bring the fake boom to a screeching halt. The ‘good times’ of the cheap money expansion, largely characterized by windfall profits for the financial industry and the faux prosperity of propped-up financial assets and real estate (largely to be enjoyed by the ‘1 percent’), necessarily end in an almighty hangover.
The crisis that commenced in 2007 was therefore a massive opportunity: an opportunity to allow the market to liquidate the accumulated dislocations and to bring the economy back into balance; an opportunity to reflect on the inherent instability that central bank activism and manipulation of interest rates must generate; an opportunity to cut off a bloated financial industry from the subsidy of cheap money; and an opportunity to return to sound money and, well, to capitalism. Because for all the thoughtless talk of this being a ‘crisis of capitalism’, a nonsense concocted on the facile assumption that anything that is noisily supported by bankers must be representative of free market ideology, the modern system of ‘bubble finance’, cheap fiat money and excessive debt has precious little to do with true free-market capitalism.
That opportunity was not taken and is now lost – maybe until the next crisis comes along, which won’t be long. It has become clear in recent years – and even more so in recent months and weeks – that we are moving with increasing speed in the opposite direction: ever more money, cheaper credit, and manipulated markets (there is one notable exception to which I come later). Policy makers have learned nothing. The same mistakes are being repeated and the consequences are going to make 2007/8 look like a picnic.
From ‘saving the world’ to blowing new bubbles
Of course, I was never very optimistic that the route back to the free market and sound money would be taken. At the time I left my job in finance in 2009 and began to write Paper Money Collapse, the authorities had already decided that to deal with the consequences of easy-money-induced bubbles we needed more easy money. ‘Quantitative easing’, massive bank bailouts, deficit spending and ultra-low policy rates had become the policy of choice globally. But at least the pretence was upheld for a while that these were temporary measures – ugly and unprincipled but required under the dreadful conditions of 2008 to save ‘the system’. The first round of debt monetization after the Lehman collapse – the exchange of $1 trillion of mortgage-backed securities on bloated bank balance sheets for freshly minted bank reserves from Bernanke’s printing press under ‘quantitative easing 1.0’ (QE1) – was presented as an emergency measure to avoid bank collapses and a systemic crisis.
I never thought that this was a convincing rationale as it was clear to me that whatever the accumulated dislocations were, there was ultimately no alternative to allowing the market to identify and liquidate them. Aborting, delaying and sabotaging this essential process of economic cleansing and rebalancing would only cause new problems. Even on the assumption that these were measures to deal with extreme ‘tail events’, I could not then and cannot now support them. But it is becoming abundantly clear that these measures are neither temporary nor restricted to avoiding bank runs or systemic chaos but that now, after the public has become sufficiently accustomed to them and a cheap-money-addicted financial industry has begun to incorporate them into their business models, they constitute the ‘new normal’, that they are now the accepted ‘modern’ tool kit of central bankers. Zero interest rates, trillion-dollar open-market operations to manipulate asset prices and to ‘manage’ the yield curve are now just another day in the modern fiat money economy. Nobody talks of restraining central bank activism. Rather, the temptation is growing to use these tools to kick-start another artificial boom.
In his excellent new book The Great Deformation – The Corruption of Capitalism in America, David Stockman provides a fascinating account of how the principles of sound money, balanced budgets and small government have progressively been weakened, betrayed, undermined and ultimately completely abandoned in American politics (often by Republican politicians and even some of the alleged ‘free market heroes’ of Republican folklore), and how today’s cocktail of bubble finance and trillion-dollar deficits represents the delayed but inevitable blossoming of destructive seeds that were sown with Roosevelt’s New Deal and Nixon’s default on the Bretton Woods gold exchange standard. In a chapter on the recent crisis, Stockman argues convincingly that the shameful bailout of Wall Street in 2008, in particular of Goldman Sachs, Morgan Stanley, and a few other highly leveraged entities via the bailout of ‘insurance’ giant AIG, were sold to Congress and the wider public with exaggerated claims that the nation’s real economy was at imminent risk of collapse. From my position as an economist and a market participant at the time of these events, Stockman’s analysis and interpretation strike me as entirely consistent and correct. But even if we were willing to give more credit to the claims of the ‘bailsters’ and interventionists that the fallout for Main Street would have been substantial, that would only further underline how far the Fed’s preceding easy money policies had destabilized the economy, and the question would still remain whether it could ever be a reasonable objective of policy to sustain these large-scale dislocations against market forces.
Be that as it may, the dislocations were largely sustained and plenty of new ones added. Talk of ‘exit strategies’ – that is, of a ‘normalization’ of interest rates and shrinking of central bank balance sheets – has now pretty much died down. Super-low interest rates are now a permanent tonic for the financial industry. In fact, the nature of the debate has shifted markedly over the past 15 months as the idea is progressively gaining adherents that the new hyper-interventionist tool-kit of the central bankers that was slipped in under the cloak of avoiding financial Armageddon in 2008 should now be used pro-actively to start a new easy-money-induced credit boom, that aggressive money printing and debt monetization should be employed to generate a new growth cycle. Many economists are de facto demanding a new bubble.
In America, QE2 was already targeted at boosting the prices of government debt and thereby lowering interest rates and encouraging more lending – which naturally means more borrowing and more debt, the opposite of deleveraging and rebalancing. And QE3 – which is an open-ended $85-billion-a-month price-fixing exercise for selected mortgage- and government- securities – is even targeted officially at lowering the unemployment rate, meaning Fed officials seriously claim that they can create (profitable and lasting?) jobs by cleverly manipulating asset prices.
The resurgence of the money cranks
Rising real wealth is always and everywhere the result of the accumulation of productive capital, which means real resources saved through the non-consumption of real income, and its employment by entrepreneurs in competitive markets under the guidance of uninhibited price formation. This process requires apolitical, hard and international money. Monetary debasement always hinders real wealth creation; it does not aid it. Easy money leads to boom and bust, never to lasting prosperity. Easy money is not a positive-sum game and not even a zero-sum game. It is always and everywhere a negative-sum game.
To claim, instead, that an economy’s performance and society’s wealth is lastingly enhanced by pumping more fiat money through its financial system requires a considerable degree of economic illiteracy and, in the wake of the recent crisis, selective amnesia. Not too long ago, such assertions as to the benefit of inflation and money printing would have clearly marked its proponent as a money crank. But the cranks are now manning the monetary policy ships everywhere, and the international commentariat is either willingly complicit in spreading economic nonsense or intellectually challenged when it comes to exposing the naivete and recklessness of these policies.
Nothing confirms the renewed dominance of money crankism more than the present sad spectacle of Japan, a country that became a post-WWII economic powerhouse in no small measure thanks to the old capitalist virtues of hard work, high savings rates, strong capital accumulation, and innovative and international-minded entrepreneurship, now taking a leaf out of the policy book of Argentina and embarking on a mission of aggressive money printing, currency debasement, asset price manipulation and inflationism. Japanese savers are already losing international purchasing power by the bucket load as the Yen keeps plummeting in international markets.
The idea that currency debasement will result in lasting, self-sustained growth and rising prosperity is positively laughable. I do not doubt that Japan’s new initiative of aggressive monetization has the potential to improve the headline numbers on a number of corporate earning reports and to even give a near-term boost to GDP. Like most drugs, easy money tempts its users with the promise of an immediate but short-lived high. What is, however, absolutely certain is that whatever ‘stimulus’ is generated in the short term is bought at the price of more imbalances (most certainly higher indebtedness) that will weigh down severely on the Japanese population in the future. What is even more worrying is that Japan’s gigantic pool of government debt – held to a large extent by an aging population as a ‘pension nest egg’ and by domestic banks on highly levered balance sheets – is a veritable powder keg, and the Bank of Japan’s new inflation strategy is tantamount to playing with fire.
The deflation myth
It has become commonplace to justify Japan’s monetary ‘experimentation’ with reference to the country’s long suffering under supposedly ‘crippling’ deflation. Even otherwise respectable financial newspapers and journals lazily repeat this standard refrain. It is complete and utter nonsense. Whatever Japan’s problems are, and I am sure they are numerous and sizable, deflation is not one of them.
Firstly, there is no economic rationale for assuming that the type of moderate and ongoing deflation (secular deflation) that analysts suspect in Japan and that is the result of stable money and marginal improvements in productivity could constitute a problem for the economy’s performance. Why such deflation is harmless (and even preferable to moderate inflation) I explain in detail in chapter 5 ofPaper Money Collapse. I make no claim to originality here, as this insight was widely accepted among most serious mainstream economists up to and including the first third of the twentieth century when it became sadly ‘forgotten’ rather than refuted. But if you don’t want to take my word for it or go through the argument in my book, or if you want to have ‘empirical evidence’, then you might want to listen to Milton Friedman, hardly an advocate of the gold standard, who (together with Anna Schwartz) analyzed the late 19th century economy of the United States which had both stronger growth and much more deflation (in particular after the fiat money episode of the Civil War had ended) than Japan had over the past 20-odd years, and who concluded that U.S. data “casts serious doubts on the validity of the now (1963) widely held view that secular price deflation and rapid economic growth are incompatible.”
Secondly, there is not even any deflation in Japan that deserves the name. The data (which is here) does not support it. I am sure the economists at the Bank of Japan employ massive magnifying glasses to detect deflation in their data series. What Japan has is, by any rational standard, price stability.
In February 2013, the consumer price index (CPI) stood at 99.3. Ten years earlier, in February 2003, it stood at 100.3, and ten years before that, in February 1993, at 99.6. Apart from the fact that, as with any price-index data, the methodology, accuracy and relevance of these statistics is always highly debatable, it is clear that if we do take the data at face value we see an economy that has roughly enjoyed stable prices for two decades. In fact, prices rose marginally in the late 1990s, remained stable for a few years, and have recently declined marginally.
In February of this year, the inflation rate was -0.6 percent year over year. Would any of the commentators who lament Japan’s ‘crippling deflation’ claim that an inflation rate of +0.6 percent year over year would constitute worrying inflation, or even deserve the label ‘inflation’ at all? Would it not simply be called a rounding error? – By comparison, official UK inflation stood at +2.8 percent year over year in February 2013 and has fluctuated between +1.1 percent and +5 percent over the past 4 years alone. What monetary system is more conducive to rational economic calculation and planning – Japan’s or Britain’s? (It should be worth noting that over those 4 years the British economy has NOT outperformed Japan, despite its ‘wonderful’ inflation.)
Those commentators who tell us that this ‘crippling deflation’ is hurting the economy because people postpone spending decisions in anticipation of lower prices, want us to believe that Mr. and Mrs. Watanabe don’t buy a new popup toaster for ¥3,930 this year because – at a 0.6 percent p.a. deflation rate – they can reasonably assume that it will only cost ¥3,906 to buy the same toaster next year. And they won’t even buy it next year at ¥3,906 because the year after that it will only cost ¥3,883. The Watanabes would thus be able to save ¥47 over two years by not eating any toast (and it goes without saying that they may save considerably more by never eating toast!). This is a saving of – wait for it! – $0.47 or £0.31 (at present exchange rates) for postponing the purchase of a standard consumption item for two years – 730 mornings without toast! The notion that this ‘crippling’ deflation is holding back Japanese growth is simply beyond ridiculous, yet you can hardly open a newspaper these days without seeing such nonsense presented as economic analysis. (I would recommend that these experts on consumer psychology call the people at Apple, Samsung and other providers of tablets, smartphones and various consumer technology items and tell them that they are missing a trick: it is evidently rising prices that get people buying, not falling prices!)
Funding the state
The deflation argument is so flimsy that one can only assume it is a convenient scapegoat for a different agenda: securing printing-press funding for the state. Under Japan’s new monetary debasement plan, the Bank of Japan will practically buy the entire annual issuance of new government debt and thus fund excessive public sector spending directly via the printing press. Japan is famously the world’s most highly indebted state at 230% of GDP and runs an annual budget deficit of around 10% of GDP. Even the most troubled members of EMU enjoy better funding stats.
The often-heard argument that such profligacy has evidently not been punished by markets for years and decades, so why should the day of reckoning be any nearer now, is unconvincing. For years, the Japanese public has in fact saved and has faithfully handed its private savings over to the state, which immediately wasted them on Keynesian ‘stimulus’ projects that will never bring a meaningful return (bridges and roads to nowhere, public pools, agricultural subsidies). For a long time it was to a considerable degree private frugality that funded public excess. But now the savings rate has collapsed to 2 percent and given the shrinking workforce and aging population is unlikely to ever recover. Private savings are thus no longer sufficient to fund the state’s recklessness, so now it is up to the Bank of Japan to keep the state in business and maintain a mirage of solvency. The inflationary implications of funding massive government waste through money-printing rather than voluntary savings are, of course, considerable.
The risk here is not that the policy of monetary debasement will again amount to ‘pushing on a string’ and fail to raise inflation and inflation expectations. The much riskier and likelier outcome is that this policy will ultimately ‘succeed’. The aging Japanese population sits on a massive pile of government debt that is not backed by productive capital but that the population still considers its ‘pension assets’. Debasing the purchasing power of fixed income streams that Japanese pensioners draw from this pool will ultimately dampen domestic consumption – the very component of GDP that the inflationists claim to boost with their monetary debasement. If inflation only rises from -0.6 percent to +1 percent, the entire Japanese yield curve is ‘under water’. Only very long maturity bonds will still provide a positive real yield. This will also hurt the banks which are massive (leveraged) owners of government debt. And of course, a meaningful sell-off in the bond market would quickly wipe out bank capital.
Such a sell-off may still not occur anytime soon. At the present UK inflation-rate of +2.8 percent, most of the UK’s government bonds are also trading at negative real yields. In fact, in recent months many bond investors around the world have exhibited a remarkable willingness to hold bonds at negative real returns. It appears as if many of these securities have become, in the eyes of their holders, ‘cash equivalents’, i.e. instruments that are held for reasons of safety and liquidity, not for reasons of income generation. How far the central banks can exploit this phenomenon is uncertain. Central banks cannot turn water into wine but almost any asset into (fiat) money by ‘monetizing’ them. The only limit to this operation is the willingness of the public to hold these new ‘monetized’ assets, and frankly I doubt that there is money demand in Japan to the tune of 230 percent of GDP. – We shall find out.
Money crankism will spread
‘Abenomics’ will not solve Japan’s problems; it will make the Japanese worse off and it has the potential to trigger a mighty financial crisis. Yet, what is surely inevitable might not be imminent. During the early honeymoon between ‘Abenomics’ and financial reality, the idea of printing yourself to prosperity is likely to have imitators, with the UK being a prime candidate. In terms of total indebtedness, the UK is the one industrialized country that can compete with Japan, meaning it is in the same supersized debt-pickle. Even the timid attempts by Chancellor Osborne to lower the speed at which Her Majesty’s government goes further into debt are being attacked as savage ‘austerity’ by the opposition and large parts of the media. In his latest budget he put the remaining taxpayer-chips on another housing bubble and gave the Bank of England more room to ignore inflation. Over at Thredneedle Street, the Deputy Governor of the Bank of England, Paul Tucker, openly fantasized about negative interest rates recently, outgoing Governor Mervyn King voted for more QE (overruled), and Governor-elect Mark Carney promises to be, well, – flexible. Bottom line: desperation is spreading. Watch this place! Chances are the Old Lady is the next to throw any remaining caution and remaining vestiges of monetary sanity to the wind and – go ‘all in’.
This will end badly.
P.S.: As to ‘the exception’, the only place where money crankism is not the order of the day yet is – the Euro Zone!– Yes, I am serious. – I know, I know. This is an amalgamation of semi-socialist, semi-bankrupt welfare states that share the same politicized paper currency issued by a central bank that has already bailed out too many banks, has manipulated various government bond markets and whose balance sheet as a percent of GDP is larger than the Fed’s. However: in a global sea of monetary madness there are at least a few remaining signs of sanity and orthodox monetary discipline on display in the much derided EMU. Greece was allowed or encouraged to default on part of its debt, which meant that bond-holders had to eat losses. Cyprus’ biggest bank is being wound down, which means depositors are going to eat losses, too. There is a persistent push towards ‘austerity’. On the fiscal front, the Euro Zone easily outperforms the US, the UK and, of course, Japan. While the Fed has increased its balance sheet girth by almost $300 billion in the first three months of 2013 alone, the ECB has reduced its own by almost €400 billion over the same time. My rule is this: the more Professor Krugman is foaming at the mouth and the more apoplectic the commentary from the strategists, analysts and economists in the bailout-addicted financial industry get, the more it seems that Mrs Merkel & Co are getting a few things right.
Episode 87: GoldMoney’s Andy Duncan talks to Nigel Farage MEP, leader of the United Kingdom Independence Party, and co-chair of the Europe of Freedom and Democracy Group within the European Parliament.
They talk about the ongoing euro currency situation and the recent speeches from Mr Barroso, the President of the European Commission. They also discuss the recent news of the German Bundesbank’s decision to repatriate some of its physical gold reserves from the USA and France, and what the chances are of the UK leaving the EU – “Brexit” – in the next few years, and the likely fate of the euro and the EU itself.
This podcast was recorded on 15 January 2013 and previously published at GoldMoney.com.
Not your typical Cobden Centre interview, but hopefully thought-provoking …
John Llewellyn is one of the most highly regarded economists in Europe, having worked in the private sector, academia, and national and supranational policy institutions. He now runs his own consultancy, advising governments, multinational corporations, and institutional and private investors. He was educated in the neo-Keynesian tradition but, on becoming an applied economist, he became what he terms “an evidence-based eclectic”. As such John recognises the potential explanatory limitations of the Keynesian paradigm for a world of excessive debt and unprecedented policy activism. At present, he is concerned about what appears to be an unfolding, synchronised global cyclical downturn amidst what remains a structurally weak growth environment. The consensus is in his view too complacent in believing that recent policy stimulus actions will either lift growth rates or reduce debt burdens meaningfully over the coming 1-2 years.
BY WAY OF BACKGROUND…
Born in England, but raised in New Zealand, John Llewellyn attended The Victoria University of Wellington for his BA (Hons) degree and then Oxford University, where he obtained his DPhil. He then researched and taught at Cambridge University for nearly ten years, and was a Fellow of St John’s College. Thereafter, he moved to Paris to the Organisation for Economic Cooperation and Development (OECD), the supranational economic policy analysis and forecasting organisation, where he rose from Head of Economic Forecasting to Deputy Director for Employment, and finally Chef de Cabinet to the Secretary General. In 1995 he moved to London, where he was Global Chief Economist for Lehman Brothers until 2005, when he became the firm’s Senior Economic Policy Adviser. Following the bankruptcy of Lehman Brothers he set up his own firm in 2009, Llewellyn Consulting, which specialises in thematic macro research (e.g. demographics, technological innovation, climate change) and economic risk assessment.
I came to know John during my time at Lehman Brothers in the mid-2000s, where I was the European Head of Interest Rate Strategy. We worked closely together to link economic forecasts and risks with practical, implementable strategies for the global interest rate and currency markets.
We both became deeply concerned by developments in global housing and credit markets in the mid-2000s, in particular in the US, agreeing that a dangerous bubble was forming in association with global trade and capital flow imbalances. On numerous occasions we presented our counterparts and other colleagues in New York with this view. It was not well received.
When the crisis began to unfold in 2007, and then intensified in 2008, neither of us was particularly
surprised. We did not, however, predict that not only Lehman Brothers but also a number of major financial institutions would fail. The intensity of the crisis and the aftermath of tepid growth, together with lingering structural problems and global imbalances, have caused both of us, each in our own way, to change the way we think about the world, and question some core assumptions. In general, this process has led us to become decidedly less optimistic in how we see the economic future.
John and I continue to speak on a weekly basis, and get together at least once a month to review global economic developments and assess the risks, as we see them. Recently, John identified an associated set of economic risks that could well result in a much sharper downturn in global growth over the coming year than the consensus expects. What follows below is a rough amalgamation of several informal, recent conversations between us about how John came to this view; about the risks associated with excessive debts and so-called ‘financial repression’; the future of the euro and possible alternatives to the current set of national economic policy choices. The conversation then turns to the financial markets.
THE GATHERING STORM
JB: John, in your most recent economic risks publication, you write that, in 2013, economic activity in nearly every part of the world is likely to slow. That is highly unusual. Normally there are at least a few pockets of strength that support demand for weaker economies. If that is not going to be the case, does this raise the risk of a generally sharper downturn across the world?
JL: It does. Conventional, single-economy, economic models assume stable and reasonably large fiscal ￼and monetary multipliers. These are derived from historical observation. But there is little evidence about synchronised global downturns, so most of the data are irrelevant, or at least potentially misleading: policymakers are therefore likely to underestimate the size of the coming slowdown. This analytic point used to be one of the major reasons for, and messages from, the OECD; but the message is heard less these days. Were the US, the EU, or China to get traction with new stimulus in the near-term, then the slowdown would be less likely to be synchronised, and the consensus, as best I can tell, would be more likely to be correct that 2013 growth will be similar to 2012. On the other hand, if there is a further move toward outright tightening of policy, say due to the fiscal cliff in the US, or enhanced austerity in Europe, things could get worse.
JB: Let’s step back for a moment. Neither the fiscal cliff nor austerity would be an issue if debt burdens were lower, or growth higher, or both. Manageable debts are a nonissue. How did the developed world get into this mess? Is it purely a result of the financial crisis, or were there longer-term, structural forces at work, largely unseen by the policy mainstream?
JL: To some extent the answer differs from country to country. Some, like Greece and Portugal, were simply consuming beyond their means, and had to rein in total expenditure. Others, like Spain and Ireland, as well as the UK and the US, let leverage in their financial systems build up to such an extent that, when assets prices collapsed, the authorities had little option but, in effect, to nationalise the resulting private sector debt in order to keep the financial system functioning. But overlaying this in virtually all economies was, and is, a set of promises made by generations of politicians that they will be unable to meet, not least given the ageing of populations.
JB: Doesn’t this bring a central tenet of Keynesian economics into doubt, that you can borrow your way to prosperity? While countercyclical government borrowing and spending seems reasonable on paper, we now have quite a bit of empirical evidence that these debt burdens accumulate over time, that governments embrace deficit spending but eschew the offsetting surpluses required to keep finances in balance. Going forward, should we have faith that policy can be more responsible?
JL: The central tenet of Keynesianism is subtler than the bastardised version that came to be taught later. I was taught what I would term ‘classical Keynesianism’ in New Zealand, and had it reinforced at Cambridge by former colleagues of Keynes, such as Joan Robinson, Austin Robinson, Richard Kahn, Nicholas Kaldor, as well as more recent luminaries, such as Geoff Harcourt and John Eatwell. This central tenet is that borrowing works if it takes GDP back towards full employment, and fairly quickly, and if it kindles, or re-kindles, Keynes’ ‘animal spirits’ – the entrepreneur’s intrinsic faith such that he or she is willing to incur the certain cost of borrowing now in the expectation that he or she will earn a return in an unavoidably uncertain future. In other words, as Robin Matthews pointed out in the 1960s, Keynesianism works only if people believe it will work. Or, as Keynes observed, economies are held up by their own bootstraps.
FINANCIAL REPRESSION PAST, PRESENT AND FUTURE
JB: Returning to the fix we appear to be in, I know you have thought extensively about policies that limit financial freedom in order to subsidise government debt service and reduction, collectively termed in the jargon as ‘financial repression’. Could you elaborate on this and how you see it developing going forward?
JL: Basically in such circumstances, governments do four things: they encourage inflation; they instruct the central bank to keep short rates and bond yields along the curve low; they oblige savers (including pension companies and insurance companies) to hold an increased proportion of their assets in government bonds; and they impose capital controls to prevent savers from taking their capital abroad in search of higher real yields.
JB: But does it work? Recall that Carmen Reinhart made explicit that ‘financial repression’ is historically associated with failing third-world governments desperate for public revenue. What does this imply about the developed world today? Are you troubled by this? Does it not seem, potentially, to be a road to ‘financial tyranny’? A road to Argentina, to name an obvious case in point?
JL: It does work; but of course it is troubling. The West has used these policies before. The UK, the US, and France amongst others did exactly what I have summarised to reduce public debt as a proportion of GDP after WWII. But there was a difference then: As various people of that generation have told me, they were completely aware at the time that the war bonds that they were buying would not be worth much, if anything, after the War. But they bought them nevertheless, because that was the price for having a chance to defeat tyranny. I am not sure that the younger generation will be so tolerant today with politicians and political parties who made promises only to get elected, and which they knew they could not fulfil.
PRESENT AT THE CREATION
JB: You were, to use a colloquial term, present at the creation of the euro. You knew some of the architects. You observed, indeed contributed to, some of the planning, as well as the implementation. And now you have observed the crisis unfolding. You have always held that the euro is a political project, and remains so. You are also on record as having more confidence than most that the euro will not only survive but that it will in time prove its detractors wrong, that it will enhance European economic performance through greater stability and integration.
￼Given recent developments, this seems a bold view to some. Would you care to elaborate?
JL: All economists involved in the creation of the euro knew that its initial institutional arrangements contained a number of important flaws. But those ‘present at the creation’ also knew that Chancellor Kohl and President Mitterrand knew this too. The Kohl / Mitterrand calculation was that they were the last generation fully able to appreciate the enormity of war in Europe; that they would bind their two economies together by ‘a thousand silken threads’; and that they would hope that when, in the future, the project ran into problems, their successors would choose to fix them rather than allow the union to break up. So far, the gamble has paid off. Of course, the British do not see it that way. They were told by Edward Heath that this was an economic union, and they believed him. And British economists in turn analyse the union purely in economic terms. That is a generalisation: but you get the point.
JB: You also hold, and rightly so I believe, that there is far too much focus on the troubles of the euro-area and not enough on those elsewhere. As a case in point, consider Japan, which has comparatively larger demographic issues with which to deal and which is, following a multi-decade period of sub-par growth, slipping out of trade surplus and into deficit. In my opinion, this is an issue not only for Japan but for the entire world. How do you feel about Japan?
JL: Under US guidance, Japan did a brilliant job after WWII in adapting its manufacturing sector to the Western (initially US) market which the US opened to it, and then widened further by admitting Japan to the OECD. But Japan’s policymakers drew a wrong conclusion: That the only way to grow was to sell goods to foreigners. As a result they never allowed any real competition, nor any structural reform, to take place in the service sector: They did not realise that they could get rich also by selling to themselves. To this day, they have not learned that lesson.
JB: It is so easy to forget that no single economy is a closed system. Especially today, given how globalised the world has become. Even the US, which has a comparatively small external sector, is today far more widely integrated into the global economy that it has ever been. There is also the non-trivial matter of the US providing the world’s reserve currency. Some argue that this ‘exorbitant privilege’, to use a term coined by former French President Valery Giscard d’Estaing, is not at risk. I know you disagree that the US is a ‘safe-haven’ in the way normally portrayed in the financial press. Could you please elaborate?
JL: A country is a safe haven right up until the moment when investors decide that it is not. The US economy produces a vast array of goods and services. If since WWII one had to hold monetary assets denominated in any currency, that currency would be the US dollar. Dollars can be converted into anything that one might conceivably want. But alternatives are emerging: The euro. The renminbi. At the least, investors will want to diversify; and indeed they are so doing. And if the US does not deal with its fiscal problem, the move away from the dollar will likely accelerate.
JB: But that is precisely the point: The US is not a safe haven. A safe haven cannot be a country that is at risk of devaluation, default, or some combination of the two. But that does leave a rather small list of countries, and I would suggest that none of them is realistically the provider of a dominant reserve currency, or the provider of sufficient additional aggregate demand to provide for Keynesian stimulus to bail the world out of its excessive debts. If this is the road we’re on, where does it lead? Can the economics profession continue to act as if the policy tools and actions that got us into this mess can get us out? Or does the solution lie elsewhere?
JL: Just as reflating one’s own economy requires that entrepreneurs and investors have faith in the future, so does reflating the world economy require that entrepreneurs and investors have faith in the currency or currencies that are attempting the reflating. I shudder to think what the world economy will look like of investors’ faith in the dollar declines, rather than revives.
FROM DEBT CRISES TO CURRENCY CRISES
JB: When a debt crisis becomes a currency crisis you have a problem that is an order of magnitude greater, because at that point you are not only distorting macro price signals via ‘financial repression’ but as there is now so little confidence in the stability of the currency, and households and businesses no longer have confidence in their ability to manage their time preferences effectively. Austrian economists would argue that this is so damaging that, if sustained, it will destroy an economy’s capital stock through severe resource misallocation. Do you have some sympathy with this view or is it too pessimistic?
JL: I have some sympathy, but also some humility. When economies are so far away from where they have even been in modern economic history; when the structure of our economies, with their much, much larger government sectors, is so unprecedented; and when we have been told so confidently what will happen by economists who engage in a priori theorising only to be proved wrong later, I am, I confess, rather more humble.
JB: The alternative to printing your way out of a debt burden is to allow for bankruptcy, restructuring and reorganisation of the capital stock to take place instead. Josef Schumpeter called this ‘creative destruction’, and he believed that it was not only helpful but in fact essential for economic progress. Might a severe recession be exactly the bitter medicine required at this point to save the patient, rather than more of the palliative to date that appears not to be working, or perhaps even making the problems worse? Would you argue that Britain’s ￼basket case economy of the 1970s could only have been turned around in this way? Or could there have been a more mainstream, Keynesian way to go about it, such as an even larger currency devaluation?
JL: I have never liked ‘severe recession’ as the cure for anything. The spectre of all that lost output always appalls me. It smacks of the same mentality that advocated bloodletting and leeches. It has always seemed to me that more useful things could be done with potential output than just letting it flow out to sea. The state could build toll roads, harbours, airports, even certain types of housing, and sell them off later to the private sector when confidence returned. Surely that ought to be possible.
JB: Let’s move a bit closer to your current home. What about the UK of today? Does the UK need to undergo another Thatcher-like experience, something beyond timid ‘austerity’, including more meaningful structural reforms to make it more competitive internationally in exports? If so, would that be easier to accomplish were the UK to leave the EU? You have said that there is a distinct possibility of that in the coming few years.
JL: I think that leaving the EU is a distraction from the real issue, which is that UK companies are sitting on a pile of cash and are so uncertain about the future that they will not invest. Meanwhile households are trying to reduce their borrowing; and so is the government. The only thing to be done, in my view, would have been for the government to have undertaken the type of investment that companies otherwise would have done, and sell it on later. But that idea ran straight up against political dogma.
JB: But if the UK economy needs to rebalance, doesn’t the US need to as well? And on the other side of these trade deficits are trade surpluses elsewhere. Can the world continue to grow without first correcting these imbalances to at least some degree? And doesn’t history suggest that imbalances this large are ultimately corrected only in periods of unusually weak growth?
JL: Here you are putting your finger on a problem that Keynes highlighted at the end of WWII, but which Harry Dexter White, the senior US Treasury official at the 1944 Bretton Woods conference, refused to acknowledge. Surpluses and deficits are mirror images of one another. Two sides of the same coin. There cannot be one without the other. Hence being in surplus is just as contributory to imbalances as being in deficit. In a properly run global world, policies would bear down on surplus economies and deficit economies equally. But they never do.
ON FINANCIAL MARKET VALUATIONS AND THE MONETARY FUTURE
JB: Taking into account our discussion so far, I think there are ample reasons why the stock market should appear ‘undervalued’ to many. P/E ratios may not be particularly high, even if profit margins are. The fact is, however, revenues simply cannot grow rapidly in this environment, at least not in real terms. And record profit margins cannot survive a proper global rebalancing as the cheap labour of emerging markets converges on the developed world. In my opinion, given the structural macroeconomic headwinds we have discussed, stock market valuations should, in fact, be at generational lows, perhaps below where they were in the early 1980s or early 1960s. Your thoughts?
JL: I think that that argument is correct as far as it goes. But given that investors are starting to lose confidence in paper assets, and particularly government paper, they want to hold something real: and that includes shares in companies. And it is not as if there is a stock market bubble – so far at least. PEs in the US and the UK are not far from their historical averages.
JB: But if stock market valuations need to adjust even lower from here, perhaps much lower if policymakers don’t embrace more meaningful structural reforms, and if bond markets are overvalued due to the risks of currency devaluations, where, exactly, is an investor to hide? I lean toward a diversified exposure to real assets, including raw commodities. Could you perhaps share your thoughts on that?
JL: Clearly, commodities, industrial, food, and of course gold, are obvious contenders.
JB: Speaking of gold, you are aware that I believe that there has now been so much global economic confidence lost that it will not be properly restored absent a return to some form of gold standard, if only for international rather than domestic commerce. While I know you are sceptical, you don’t disregard the idea entirely. You have mentioned before the possibility of an international pricing convention based on a ‘bancor’, a currency based on a fixed basket price of globally traded commodities. How might that work? And are you confident that there would be sufficient support for such a regime, given that global economic cooperation is endangered by the threat of competitive devaluation, trade wars and the rise of economic nationalism generally?
JL: It would work by governments setting fixed rates for converting currencies into a basket of commodities. I think that it makes logical sense; and it could help in spurring the production of commodities that would later be in demand as activity picked up. Kaldor thought a lot about this, and we discussed it when I worked under him. But equally, I am sure that it is a non-starter. Two decades of life in the OECD has shown me just how hard it is for countries to agree about anything so fundamental.
JB: Some economists simply dismiss the idea of a gold standard as archaic and unworkable. I don’t think you hold that strong an opinion. But what would you see as the primary disadvantages of a gold standard, or relative advantages of the current dollar reserve standard. Does it come down to how much confidence you have in policymakers?
￼JL: It is possible to have confidence in individual policymakers at the national level, while nevertheless having little confidence about their ability to agree to reforms to the international system as a whole. And that is where I come from. In any international negotiation of this sort, two types of country have disproportionate influence: the biggest; and those in current account surplus. Today, that would mean the US and China: and I doubt that they would agree on any reform that proved to be in the global interest.
IF JOHN WERE IN CHARGE
JB: Now I’m really going to put you on the spot. An economist of your stature must always be considered a potential candidate for a senior policy role, say as a senior advisor to a finance minister, or a member of a central bank policy committee. Were you to be appointed to a role in which you had a broad mandate to design and implement fiscal and monetary policy, say for the euro-area or the UK, what would you do? If hard choices need to be made and if you had the mandate to make them, what would these be?
JL: In the UK, about which I thought particularly as an adviser to the Treasury from 2009 to 2012, I would have “thrown everything at the 2008 crisis, including the kitchen sink” as my friend William Keegan put it and as, in fact, Alistair Darling did. And I would thereafter have set out on much the same course of fiscal consolidation as Darling did, and Osborne continued. I think that Paul Krugman and Ed Balls understate the risk that would attach to the government borrowing substantially more. But, as I indicated above, I would also have embarked on finding ways to support private-sector-like investment. My proposition throughout has been that the government should have been willing to underwrite, or undertake, investment that produces marketable output – ports; airports; toll roads; certain types of housing, etc. These could be valued and entered as an explicit, verifiable, line in the National Accounts, and could later be sold to the private sector. The ratings agencies would, on my understanding, have been open to such a plan being explained to them.
JB: I’m pleased to hear that there are things that might yet be done within the existing policy framework to help, at least if people listen to you a bit more! Thanks so much for your time; I’m certain that Amphora Report readers will appreciate it.
JL: Thank you John.
JB: Perhaps we can do this again in a year or so to see how things are panning out?
JL: It would be my pleasure. Perhaps you will even eventually win our bet that Greece withdraws from the euro-area.
JB: Well as you recall that bet expires on 31 December. It appears I will need to treat you to dinner in the New Year.
JL: Ah yes. Well as you strategists sometimes say, all views are potentially correct; the timing, however, is always uncertain.
JB: Indeed. Well Happy Holidays!
JL: To you too John.
POST-SCRIPT: FROM RISK TO UNCERTAINTY
My many conversations with John, including those recent ones merged into the transcript above, were an important input into my 2012 Amphora Reports. While the primary purpose of these reports is to interpret contemporary economic and financial market developments through the lens of Austrian economics (and occasional, plain common sense), it is essential to continuously check assumptions, however strongly held. As I’m certain is clear from the conversation(s) above, John has provided an invaluable source of such checking.
This is not to say that we agree on most things. Far from it. For example, as alluded to briefly in closing, I am of the opinion that the euro-area cannot survive in its current form. John believes that it is indeed salvageable, although he does doubt the willingness of policymakers to do what is necessary.
This brings us, I believe, to the crux of the risks the lie ahead. Policymaker activism continues to escalate across economies. This is not going to change in the near-term, nor absent another crisis that clearly and plainly discredits economic central planning generally, be it in fiscal or monetary matters. As has increasingly been the case in recent years, future risks are going to originate primarily from policy decisions. They will, in other words, be qualitative rather than quantitative in nature.
Currently serving as the Chief Investment Officer of a commodities
fund, John was previously Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, systematic quantitative strategies for global interest rate markets.
A cum laude graduate of Occidental College in California, John holds a Masters Degree in International Finance and Economics from the Fletcher School of Law and Diplomacy, associated with Harvard and Tufts Universities.
Follow John Butler on twitter! @ButlerGoldRevo | Contact us
10 January 13 | Tags: Euro, Gold, Japan, Keynesianism | Category: Economics | 7 comments
Every Monday morning the readers of the UK’s Daily Telegraph are treated to a sermon on the benefits of Keynesian stimulus economics, the dangers of belt-tightening and the unnecessary cruelty of ‘austerity’ imposed on Europe by the evil Hun. To this effect, the newspaper gives a whole page in its ‘Business’ section to Roger Bootle and Ambrose Evans-Pritchard, who explain that growth comes from government deficits and from the central bank printing money, and why can’t those stupid Europeans get it? The reader is left with the impression that, if only the European states could each have their little currencies back and merrily devalue and run some proper deficits again, Greece could be the economic powerhouse it was before the Germans took over.
Ambrose Evans-Pritchard (AEP) increasingly faces the risk of running out of hyperbolic war-analogies sooner than the euro collapses. For months he has been numbing his readership with references to the Second World War or the First World War, or to ‘1930s-style policies’ so that not even the most casual reader on his way to the sports pages can be left in any doubt as to how bad this whole thing in Europe is, and how bad it will get, and importantly, who is responsible. From declining car sales in France to high youth-unemployment in Spain, everything is, according to AEP, the fault of Germany, a ‘foolish’ Germany. Apparently these nations had previously well-managed and dynamic economies but have now sadly fallen under the spell of Angela Merkel’s Thatcherite belief in balancing the books and her particularly Teutonic brand of fiscal sadism.
Blame it on ze Germans
The pending bankruptcy of France’s already semi-nationalized car industry is, of course, not to be blamed on high French taxes, strangling French labour market regulation, increasingly uncompetitive French wages, and grave business errors – French car companies have been falling behind their German rivals for years – but the result of French ‘austerity’, which hasn’t even started yet and will culminate in – quote AEP, and drum roll please! – a ‘shock therapy’ next year of 2 percent. Mind you, France’s state has a 57% share in GDP, and the economy deserves the label socialist more than capitalist. Does France really need more state spending, or even unchanged state spending? Another government stimulus? I bet you could cut the French state by 10 percent instantly, and in a year or two you’d have faster growth, not slower growth!
However, Monsieur Hollande is eager to live up to his socialist promises, all the egalité he was voted for, and does not shrink the state but instead raises taxes further, lowers the pension age and raises minimum wages, none of this a demand from Rosa Klebb in Berlin, as far as I know, but AEP doesn’t quibble over such detail. It is all ‘austerity’ to him and ‘austerity’ is always imposed by Germany, and to make really sure that you get that this is a bad idea, and a bad idea coming from Germany, he now calls it the ‘contractionary holocaust’.
Nice touch. There is no place for subtlety, I guess.
Bootle does not stoop quite so low but his pieces are equally filled with the Keynesian myth that there is no economic problem that cannot be solved by more debt and easy money and the occasional devaluation. The fallacy here is the standard Keynesian one: there is no limit to debt, the market doesn’t matter, people can be fooled forever.
The real issue
The reality is different: the markets are slowly waking up to the fact that the social-democratic welfare-state that dominated the West since the First World War is going bust. Everywhere. Faster in some places (Greece, the UK), more slowly in others (Germany), but the direction and the endpoint are the same. This is not a specifically European problem, or even one that is particularly linked to the single currency project; it is pretty much a global phenomenon, and it will shape politics for years to come. It is naïve, dangerous and even irresponsible to dress this up as a design-fault of the euro and thus imply that the problem would be smaller or more easily manageable, or even non-existent, if countries could only issue their own currencies, print money, keep running deficits and devalue to their hearts’ content. The false impression that is being conveyed by Bootle and AEP is that Spain, Greece, Portugal and Italy could somehow simply turn back the clock and, in the more open, more competitive world of the 21st century still run the cosy big state, high inflation, frequent debasement policies of the 1970s.
Bootle and AEP represent the naïve Keynesianism that still believes deficits just pop up in recessions as a ‘natural corrective’ – in fact, AEP exactly describes it that way. The truth is, countries like Greece have been running big deficits in good times and now run bigger deficits in bad times, and they are far from being alone in this. Since the introduction of unconstrained fiat money, most states see no need to balance the books but operate blissfully under the assumption that they can keep accumulating debt forever. Since Greece joined the euro and thereby benefitted from lower borrowing costs, the country’s average wage bill went up 60%, compared to 15% in Germany over the same period. Present Greek structures are simply unsustainable. An economy that has been stifled for decades by the persistent political rent-seeking of its powerful, connected and self-serving interest groups, by an overgrown public sector and uncompetitive wages, simply will not be reinvigorated by yet more debt. And in any case, the bond market has now had enough and won’t fund the Greek state any more anyway. Letting deficits rise, as AEP suggests, is no longer even an option. Not now in Greece, and soon elsewhere. Austerity is, increasingly, not a policy choice but an unavoidable necessity.
So what about devaluation? — It is a bad idea. It must mean inflation, the confiscation of wealth from savers – and savers are the backbone of any functioning economy, even though Bootle and AEP apparently believe it is the state and the central bank that make the economy tick – it must lead to persistent capital flight and hinder the build-up of a productive capital stock. And once you have accumulated a certain level of debt, devaluing the currency could undermine confidence completely and end in hyperinflation, default and total economic destruction.
No country has ever become prosperous by having a soft currency and devaluing repeatedly, yet many have become poor. A hundred years ago, Argentina was among the 8 richest nations in the world and has since managed to decline from first world status to third world status through persistent currency debasement. Since the end of Bretton Woods, Britain has consistently debased its currency, more rapidly than Germany or even the United States, a policy that has undoubtedly contributed to the country’s de-industrialization over this period, its high debt-load, low savings rate and its dependence on cheap money that lasts to this day.
True and lasting prosperity – as opposed to make-believe bubble wealth – has the same sources everywhere and at all times: true savings, proper capital accumulation, and as a result, rising labour productivity. Hard money is the best foundation for these powerful drivers of wealth creation to do their work.
Default instead of devaluation
It is not my goal to defend the policy of the German government or of Chancellor Merkel here. The present policy is wrong in many ways and will fail. But the reasons and my conclusions are different from those advanced by AEP and Bootle. Merkel is desperately trying to pretend that these governments are not bankrupt, that the debt will be repaid, and in so doing she throws good money – that of the German taxpayer – after bad. Most of the governments in Europe, plus the US, the UK and Japan, are unlikely to ever repay their debt, and the big risk is that, once the 40-year fiat money boom that facilitated this bizarre debt extravaganza has ended for good, and the illusion of living forever beyond your means has evaporated, a lot of that debt will have to be restructured, which means it will be defaulted on. That is not the end of the world, albeit the end of the type of government largesse that has defined politics in the West for generations, and it will be the end of the modern welfare state, and herald an era of proper austerity, imposed by the reality of the market and not the Germans. The question is only if policymakers will desperately try and postpone the inevitable and in the process also destroy their fiat monies.
In the case of Greece and Portugal and other countries, default should simply be allowed to occur, a proper default, not the type of managed default that Greece went through and that left the country with more debt as a result of more official aid – all in the vain attempt to pretend the country is somehow still solvent and creditworthy. Whether any issuer is solvent or not, is not decided by a bunch of Eurocrats in Brussels but by the market. The market is not lending to Greece, ergo Greece is bankrupt. Period. It would be better for everybody to admit it.
Germany is far from healthy. It, too, is travelling on the road to fiscal Armageddon, just at a slower speed. Merkel’s policy of bailing out her ‘European partners’ – a policy for which she gets little credit from AEP, Bootle and the rest of Europe – will only hasten that process.
Proper defaults on government debt would also teach bond investors a lesson, namely that they should not engage in the socially destructive practice of channelling scarce savings through the government bond market into the hands of politicians and bureaucrats with the aim of obtaining a ‘safe’ income stream out of the state’s future tax receipts (i.e. stolen goods) but to instead invest savings in capitalist enterprise and thus fund the creation and maintenance of a productive, wealth-enhancing capital stock. Losing their money in allegedly ‘safe’ government bonds is, quite frankly, what they deserve.
In defence of a common currency
None of this means that defaulting nations should be forced to leave the single currency. There is, in most cases, simply no need for leaving, and staying in a widely shared common currency does indeed have many benefits.
The idea that numerous countries – even countries with very diverse economic characteristics – should share the same money is entirely sensible and highly recommendable. Money is a medium of exchange that helps people interact on markets and cooperate via trade, and this cooperation does not stop at political borders. Money is valuable because it connects people via trade, and the more people money can connect (the more widely accepted and widely used any form of money is), the more valuable it is, and the more beneficial its services are to society overall. Yes, the best money would be universal money, global money, such as a global gold standard. It is nonsense to have money tied to the nation state. This type of thinking is a relic of the 19th century when the myth could still be maintained that a ‘national economy’ – somehow magically congruous with the political nation state – existed, and that the national government should manipulate the national money according to national objectives. That is the type of thinking that Bootle and AEP epitomize. Although, already by the late 19th century, this myth of the national economy was dying, as the Classical Gold Standard began to provide a stable global monetary framework that allowed peaceful cooperation across borders by vastly different states, and heralded a period of unprecedented globalization, harmonious economic relations and relative economic stability.
Every form of money is more valuable the wider its use. Currency competition is deceptively appealing to many free marketeers, and as an advocate of pure capitalism, I would never stop anybody from introducing a new form of money. But the economic good ‘money’ conveys enormous network benefits. Because of its very nature as a facilitator of trade, there will always be an extremely powerful tendency for the trading public to adopt a uniform medium of exchange, that is, for everybody to adopt the same money.
There is a persistent fallacy out there, and Bootle and AVP are among its numerous victims: the fallacy is that countries can do better economically by cleverly manipulating their own domestic monies. This is erroneous on a very fundamental level. Any easing of financial conditions through extra money creation, through an extra bit of inflation or a bit of devaluation, can never bestow lasting benefits. Such manipulations of money can only ever result in short-lived growth blips, at the most, and these growth blips always come at the price of severe economic costs in the medium to long run. Monetary manipulation is never a free lunch. It is always damaging in the final analysis.
Being part of a currency-union means the end of national monetary policy, and that is, on principle, to be welcome. The main problem with monetary policy today is that there is such a thing as monetary policy. Money should be hard, inflexible, apolitical and universally accepted to best deliver whatever services money can deliver to society. The problem with the euro is not that it encapsulates so many diverse countries but that it is not hard, not inflexible, and not apolitical. The euro is a paper currency, and like any state fiat money it is a political tool, constantly manipulated to achieve certain ends, and over which ends to pursue there is, quite naturally, almost constant conflict.
If only the euro was golden!
Some people say that the euro is like a gold standard and that its failure demonstrates the undesirability of a return to gold. This is nonsense. To the contrary, the euro would work better if it operated more like the gold standard and if it was as hard, as inflexible and as non-political as gold. Then, interest rates could not have been kept artificially low back in the early 2000s, for the benefit of Germany and France, a policy that laid the foundation for the real estate and debt bubbles in the EMU-periphery. Then banks could not have ballooned their balance sheets quite as much as they did with the help of the ECB and not have dragged us all into a major banking crisis, and once the banks had self-destructed, they could not have been bailed out with unlimited ECB loans and artificially low and even lower rates so that they might continue in their merry reckless ways. Today’s major imbalances, from over-extended and weak banks to excessive levels of debt, are inconceivable in a hard money system. But even now that these imbalances have been allowed to accumulate, it would still be preferable to go back to hard and inflexible money. Under a hard money system politicians and bureaucrats cannot lie and cheat and pretend, at least not as much as they can today. Hard money has a tendency to expose illusions.
This is not a defence of the EU, which is a wretched project, and increasingly morphs into a meddling, arrogant super-state, an ever more potent threat to our liberty and our prosperity. I am not particularly keen on the fiat-euro either. But still, the idea of many countries sharing the same currency is a good one. No question.
If Bootle and AEP were right that weaker nations should opt for weaker currencies, for the monetary quick-fixes of devaluation and inflation, what would that mean for so-called national currencies? By that logic, shouldn’t Italy not only exit the euro and return to the lira, but instead adopt a number of different local liras? Should Italy’s Mezzogiorno not issue its own super-soft currency and devalue against the hard lira of the north? Why should these two diverse regions be tied together under the same currency? Should Scotland have its own currency and happily devalue versus more prosperous South East England? And wouldn’t Liverpool and Manchester not benefit from their own monies, conveniently manipulated to stimulate and reinvigorate their local economies? The absurdity of the whole idea becomes quickly apparent.
But AEP is quite happy with his little island nation state. The extent to which he hopelessly underestimates the challenges facing his home nation – and by extension, the world – becomes apparent when he assures the reader that he, AEP, too, supports modest austerity, namely the present coalitions’ pathetic and entirely insufficient attempt of trimming spending by ‘1 pc of GDP each year’, ‘thankfully’ (AEP) flanked by generous debt monetization from the Bank of England and constantly checked by the Labour Party’s opportunistic clamouring for more deficit spending. Well, last I checked, the UK was running 8 pc deficits per annum. Next to Japan, Britain is the most highly geared society on the planet (private and public debt combined), and when the markets pull the plug on this island nation, the fallout might make Greece look like a walk in the park.
But then, AEP won’t be able to blame it on the Germans.
In the meantime, the debasement of paper money continues.
Episode 73: GoldMoney’s Andy Duncan talks to Godfrey Bloom, who represents Yorkshire and North Lincolnshire in the European Parliament, and who is a member of the parliament’s Committee on Economic and Monetary Affairs. They talk about the possibility of Germany instituting a gold-backed Deutschmark, and broader issues to do with European monetary and fiscal policy.
In a recent Mises.org daily article co-authored with Patrick Barron, Mr Bloom states that Germany now has a “Golden Opportunity” to get back to sound money by pulling out of the euro and introducing a gold-backed Deutschmark. However, given the lack of a comprehensive audit, suspicions about the integrity of the German gold reserves remain. Bloom therefore advocates that Germany should repatriate its physical gold from the storage locations abroad.
They also talk about monetary policies of the European Union, the errors of European politicians and whether or not the eurozone can be sustained. In addition, they also discuss Britain’s relationship with the EU and Britain’s own precarious financial position, particularly in relation to its welfare state and deficit spending.
This podcast was recorded on 21 November 2012 and previously published at GoldMoney.com.