Swiss National Bank Throws Banks, Self Under Bus

In 1985, Arnold Schwarzenegger played John Matrix in the action movie, Commando. One line stands out. While dangling a bad guy over the edge of a cliff Matrix said, “Remember, Sully, when I promised to kill you last?” The frantic man replied, and Matrix added, “I lied.” He let Sully go.

Thomas Jordan, Chairman of the Governing Board of the Swiss National Bank (SNB), must be channeling John Matrix. On December 18, 2014 Jordan said, “The SNB remains committed to purchasing unlimited quantities of foreign currency to enforce the minimum exchange rate with the utmost determination.” Last Thursday, not even a month later—he said, “The Swiss National Bank (SNB) has decided to discontinue the minimum exchange rate…”

Schwarzenegger said it better. Besides, Commando was just a work of fiction. Central bankers toy with people’s livelihoods. Several currency brokers have already failed, only one day after this reversal.

When a central bank attempts to peg its currency, it’s usually trying to stave off collapse. The bank must sell its foreign reserves—typically dollars—to buy its own currency. Recently, the Central Bank of Russia tried this with the ruble. It never lasts long. The market can see the dwindling dollar reserves, and pounces when the bank is vulnerable.

The SNB attempted the opposite, selling its own currency to buy euros. It faced no particular limit on how many francs it could sell. Despite that, the market kept testing its willpower. Here is a graph showing the price of the euro in Switzerland. The SNB’s former line in the sand, is drawn in red, a euro price of 1.2 francs.

Euro Priced in Swiss Francs


The price of the euro was falling the whole year. Jordan’s promise caused but a blip. The pressure must have been intense. So he tried one last trick, familiar to any gambler.

Thomas Jordan bluffed.

He said the SNB is committed and tossed around words like unlimited. The market saw his bet, and raised. That forced him to fold.

I wrote about why the SNB pegged the franc. It wasn’t about exporters, but commercial banks. They borrow francs from their depositors, but lend many euros outside Switzerland. This means they have franc liabilities mismatched with euro assets. When the euro falls, they take losses.

The SNB inflicted this same problem on itself with its intervention. It borrowed in francs, creating a franc liability. This borrowing funded its purchase of euros, which are its asset.

As of November, its balance sheet showed 462 billion francs worth of foreign currencies, and it has disclosed that euros represent just under 50% of that. This puts their euro assets around 230B francs (which probably increased after that). The euro has fallen from 1.2 francs to just under 1.0, or 17%.

On Thursday, the SNB lost at least 38B francs, or 6 percent of Swiss GDP.

Why on earth did it choose to take this loss? It threw the commercial banks under the bus, and got tire tracks on its own back too. Without being privy to its internal discussions, we can make an educated guess.

The SNB hit its stop loss.

As traders kept buying francs, the SNB was obliged to keep increasing its bet. Its exposure to euro losses was growing. To continue meant more euro exposure on the same capital base—rising leverage. It chose to realize a big loss now, rather than continue marching towards insolvency.

The market is much bigger than the Swiss National Bank. If the citizens of insolvent states like Greece want to sell their euros for francs to deposit in Swiss banks, and if hedge funds and currency traders want to bet on the franc then the SNB can’t stop that freight train.

Everyone who holds francs is happy, because the franc went up. However, the fallout has just begun. Franc holders will discover that they are creditors. They can’t rejoice for long at their debtors’ pain. Pain will one day morph into defaults. Soon enough the franc will abruptly reverse. Who will bid on a defaulted bond, or a currency backed by it?

The game of floating paper currencies is not zero-sum, but negative-sum. Every move destroys someone’s capital. On Thursday, the SNB admitted it lost 38B francs. How much did commercial banks, pension funds, and other debtors in Switzerland lose in addition?


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Carry Concern

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

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

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

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

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



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

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



EZ Contagion

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


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

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

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

The ECBs response

ECB Balance Sheet - Bloomberg

Source: Bloomberg

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

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

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

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

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

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

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

Source: ECB

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

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

Athens_vs_DAX_one_year bloomberg

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

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

Conclusion and investment opportunities

European Government Bonds

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

European Stocks

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

The Euro

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

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


Time Horizons And Time Preference

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

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

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

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

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

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

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

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

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

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

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


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

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


Core GDP

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


Household Leverage


Savings Rate

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

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


Corporate Profit Growth

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

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


Foreign capital

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


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

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

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

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

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

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


Dollar gains erased

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

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


Wiltshire total market cap


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

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

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

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


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

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

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

It is, in fact, an open question.

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

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

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

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

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

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Models, Damn Models and Statistics, or Math Gone Mad

Parliamentary committees are not especially noted for entertainment, but the November Treasury Select Committee hearing on the Bank of England’s Inflation Report is a refreshing exception. The fun starts on p. 30 of the transcript of the hearings with Steve Baker MP and Bank of England Governor Mark Carney light-heartedly jousting with each other.

Steve begins by asking Dr. Carney if the Bank is all model-driven. To quote from the transcript:

Dr Carney: No. If we were all model driven, then you would not need an MPC.

Q81 Steve Baker: All right. But we do have plenty of models floating around.

Dr Carney: I presume you feel we do need an MPC, Mr Baker?

Steve Baker: I think you know I think we don’t.

Dr Carney: I just thought we would get that read into the record.

[KD: First goal to Dr. Carney, but looks to me like it went into the wrong net.]

Steve Baker: I want to turn to a criticism by Chris Giles in The Financial Times of the model for labour market slack, which called it a nonsense. If I may I will just share a couple of quotes with you. He said that, according to a chart in the inflation report, the average-hours gap hit a standard deviation of -6, and this is something we would expect to happen once in 254 million years. He also said that the Bank of England is again implying the recent recession, as far as labour market participation is concerned, was worse than any moment in 800 times the period in which homo sapiens have walked on the earth. How will the Bank reply to a criticism as strident as this one?

[KD: The article referred to is Chris Giles, “Money Supply: Why the BoE is talking nonsense”, Nov 17 2014:]

Dr Carney: Since you asked, let me reply objectively. Calculations such as that presume that there is a normal distribution around the equilibrium rate. Let me make it clear. First off, what is the point of the chart? The chart is to show a deviation relative to historic averages. It is an illustrative chart that serves the purpose of showing where the slack is relative to average equilibrium rates, just to give a sense of relative degrees of slack. That is the first point. The second point is that the calculation erroneously, perhaps on purpose to make the point but erroneously, assumes that there is a normal distribution around that equilibrium rate. So in other words to say that there is a normal distribution of unemployment outcomes around a medium-term equilibrium rate of 5.5%. So it is just as likely that something would be down in the twos as it would be up in the eights. Well, who really believes that? Certainly not the MPC and I suspect not the author of that article. It also ignores that the period of time was during the great moderation for all of these variables as well, so it is a relatively short period. These are not normal distributions. You would not expect them. You would expect a skew with quite a fat tail. So using normal calculations to extrapolate from a chart that is there for illustrative purposes is—I will not apply an adjective to it—misleading and I am not sure it is a productive use of our time.

Q82 Steve Baker: That is a fantastic answer. I am much encouraged by it, because it does seem to me it has been known for a long time that it is not reasonable to use normal distributions to model market events and yet so much mathematical economics is based on it.

[KD: Carney’s is an excellent answer: one should not “read in” a normal distribution to this chart, and the Bank explicitly rejects normality in this context.

Slight issue, however: didn’t the Bank’s economists use the normality assumption to represent the noise processes in the models they used to generate the chart? I am sure they did. One wonders how the charts would look if they used more suitable noise processes instead? And just how robust is the chart to the modelling assumptions on which it is based?]

Dr Carney: People do it because it is simple—it is the one thing they understand—and then they apply it without thinking, which is not what the MPC does.

Steve Baker: That is great. I can move on quickly. But I will just say congratulations to the Bank on deciding to commission anti-orthodox research because I think this is going to be critical to drilling into some of these problems.

Dr Carney: Thank you.

[KD: Incredulous chair then intervenes.]

Q83 Chair: To be clear, the conclusion that we should draw from this is that we should look at all economic models with a very high degree of scepticism indeed.

Dr Carney: Absolutely.

[KD: So you heard it from the horse’s mouth: don’t trust those any of those damn models. Still incredulous, the chair then intervenes again to seek confirmation of what he has just heard.]

Chair: Can I just add that it is an astonishing conclusion? I do not want to cut into Steve Baker’s questions, but is that the right conclusion?

Dr Carney: Absolutely. Models are tools. You should use multiple ones. You have to have judgment, you have to understand how the models work and particularly, if I may underscore, dynamic stochastic general equilibrium forecasting models, which are the workhorse models of central banks. What they are useful for is looking at the dynamics around shocks in the short term. What they are not useful for is the dynamics further out where—

[KD: Dr. Carney reiterates the point so there can be no confusion about it. So let me pull his points together: (1) He “absolutely” agrees that “we should look at all economic models with a very high degree of scepticism.” (2) He suggests “You should use multiple [models]”, presumably to safeguard against model risk, i.e., the risks that any individual model might be wrong. (3) He endorses one particular – and controversial – class of models, Dynamic Stochastic General Equilibrium (DSGE) models as the “workhorse models” of central banks, whilst acknowledging that they are of no use for longer-term forecasting or policy projections.

I certainly agree that none of the models is of any longer-term term use, but what I don’t understand is how (1), (2) and (3) fit together. In particular, if we are to be skeptical of all models, then why should we rely on one particular and highly controversial, if fashionable, class of models, never mind – and perhaps I should say, especially – when that class of models is regarded as the central banks’ workhorse. After all, the models’ forecast performance hasn’t been very good, has it?

The discussion then goes from the ridiculous to the sublime:]

Chair: I am just thinking about all those economists out there whose jobs have been put at risk.

Dr Carney: No, we have enhanced their jobs to further improve DSG models.

Steve Baker: We are all Austrians now.


[A little later, Steve asks Sir Jon Cunliffe about the risk models used by banks.]

Q84 Steve Baker: Sir Jon, before I move too much further down this path, can I ask you what would be the implications for financial stability and bank capital if risk modelling moved away from using normal distributions?

Sir Jon Cunliffe: Maybe I will answer the question another way. It is because of some of the risks around modelling, the risk-weighted approach within bank capital, that we brought forward our proposals on the leverage ratio. So you have to look at bank capital through a number of lenses. One way of doing is to have a standardised risk model for everyone and there is a standardised approach and it works on, if you like, data for everybody that does not suit any particular institution and the bigger institutions run their own models, which tend to have these risks in them. Then you have a leverage ratio that is not risk-weighted, and therefore takes no account of these models, and that forms a check. So with banks, the best way to look at their capital is through a number of different lenses.

[KD: Sir Humphrey is clearly a very good civil servant: he responds to the question by offering to answer it in a different way, but does not actually answer it. The answer is that we do not use a non-normal distribution because doing so would lead to higher capital requirements but that would never do as the banks would not be happy with it: they would then lobby like crazy and we can’t have that. Instead, he evades the question and says that there are different approaches with pros and cons etc. etc. – straight out of “Yes, Minister”.

However, notwithstanding that Sir Jon didn’t answer the question on the dangers of the normal distribution, I would also ask him a number of other (im)pertinent questions relating to bad practices in bank risk management and bank risk regulation:

1. Why does the Bank continue to allow banks to use the discredited Value-at-Risk (or VaR) risk measure to help determine their regulatory capital requirements, a measure which is known to grossly under-estimate banks true risk exposures?

The answer, of course, is obvious: the banks are allowed to use the VaR risk measure because it grossly under-estimates their exposures and no-one in the regulatory system is willing to stand up to the banks on this issue.

2. Given the abundant evidence – much of it published by the Bank itself – that complex risk-models have much worse forecast performance than simple models (such as those based on leverage ratios), then why does the Bank continue to allow banks to use complex and effectively useless risk models to determine their regulatory capital requirements?

I would put it to him that the answer is the same as the answer to the previous question.

3. Why does the Bank continue to rely on regulatory stress tests in view of their record of repeated failure to identify the build-up of subsequently important stress events? Or, put it differently, can the Bank identify even a single instance where a regulatory stress test correctly identified a subsequent major problem?

Answer: The Northern Rock ‘war game’. But even that stress test turned out to be of no use at all, because none of the UK regulatory authorities did anything to act on it.

In the meantime, perhaps I can interest readers in my Cato Institute Policy Analysis “Math Gone Mad”, which provides a deeper – if not exactly exhaustive but certainly exhausting – analysis of these issues:



The Truth Behind The Swiss Gold Referendum

A recent column in US News & World Report, The Swiss Gold Rush by Pat Garofalo, its assistant managing editor for opinion, is subtitled “A push for the gold standard in Switzerland is symbolic of Europe’s rising right wing.” US News & World Report hereby descends from commentary to propaganda. Who edits its editors?

To begin with, the Swiss referendum, decisively and sensibly rejected by the Swiss electorate, was not about “the gold standard.” It was a vote on a proposition requiring its central bank to increase its gold reserves from around 8% to 20% — implying the acquisition, over five years, of 1,500 tons (“costing at about $56.3 billion at current prices,” reports Bloomberg), never to sell gold, and to hold that federation’s gold within Switzerland.  That had nothing to do with the gold standard.

The Swiss voted 77% – 23% to reject this proposition. The Swiss National Council had rejected the initiative by 156 votes to 20 with 22 abstentions, and the Council of States by 43 votes to 2 abstentions. And the referendum may well have been a bad, or at least silly, idea.

With a Swiss GDP of around $650 billion (USD) per year the requirement to acquire $10B/year of this iconic shiny-and-ductile commodity while not insignificant, at less than 2% of annual GDP, hardly would have been crippling.  That said, the gold standard was not on the ballot.

As for the gold markets themselves, according to a 2011 report by the FT, reporting on a study by the London Bullion Market Association, there was a $240bn average daily turnover in the London bullion market. The annual mandated Swiss acquisition, then, apparently would have amounted to about … half an hour’s trading volume on one of the world’s major gold marketplaces.  Commodity investment, however, has nothing to do with the gold standard.

Demonetized (as at present), gold merely is a commodity. The gold standard is a quality standard, not a quantity standard, and is about maintaining the integrity of the currency, not limiting its supply. This Swiss referendum substantively was irrelevant to monetary policy. As’s own Nathan Lewis perceptively has pointed out the amount of gold held, under the gold standard, as reserves by banks of issue fluctuated dramatically and immaterially.

The Swiss referendum generated a modicum of international attention and considerable criticism. The referendum presented, in fact, as misguided. It did not, however, even imply a restoration of the gold standard much less prove itself, as Garofalo presented it, as a symptom of “Europe’s rising right wing.”

Garofalo stated that “the gold standard is the idea that a nation’s money supply should be tied to gold, rather than being fully controlled by its central bank.”  This is not even a crude approximation of the gold standard. The gold standard simply holds that the value of a currency shall be defined by, and legally convertible into, a fixed weight of gold.

Garofalo implies, and cites other writers who claim, that the gold standard constrains the money supply.  Not so.  As Nathan Lewis has pointed out, for instance, from 1775 to 1900 the amount of gold in the U.S. monetary system increased by 3.4x while the currency increased by 163x without causing a depreciation in value of the currency.

The gold standard is a qualitative, not quantitative, standard. It does not constrain growth of the money supply, merely calibrating it reasonably well (albeit imperfectly, perfection having never been attained by any monetary system) to the real economy’s money demand. Lewis:

between 1880 and 1900, the monetary base in Italy actually shrank by 4.8%.  However, the monetary base in the U.S. grew by 81% over those same years. Both used gold standard systems. So, the “money supply” not only has no relation to gold mining production, but two countries can have wildly different outcomes during the same time period.

As for whether the gold standard is superior to fiduciary management there is abundant evidence that the organic nature of the gold standard consistently outperforms the synthetic nature of central bank discretion.  Garofalo references a poll of 40 academic economists who dismiss the (admittedly unfashionable) gold standard.

In criticizing the performance of the gold standard Garofalo relies on The Atlantic’s Matt O’Brien.

Indeed, when it was in force, the gold standard brought with it a whole host of negative effects, and as Matt O’Brien wrote in The Atlantic, “was a devilish device for turning recessions into depressions.” It ensures that a central bank can’t respond to a crisis by putting more money into the financial system, greasing the wheels of the economy, since the money supply is restricted by an outside factor.

As for another celebrity on whom Garofalo relies, Nouriel Roubini, his ill-founded hysteria on the gold standard has been critiqued here and here. O’Brien and Roubini are entitled to their own opinions but not to their own facts.

As economic historian Professor Brian Domitrovic, also at, relates, The Gold Standard Had Nothing To Do With Panics and Busts,

Looking at the 19th century, before the gold standard became a ghost, a dead-letter in the early era of the Federal Reserve from 1913-33, there is no evidence that the good old thing was implicated in any panic or bust.

Rather than relying on commentators and academics, pro or anti gold, it might be pertinent to turn to the thoughts of central bankers. Herr Dr. Jens Weidmann, president of the Bundesbank, in a 2012 speech referred to gold as “in a sense, a timeless classic.”

And Garofalo makes no reference to the 2011 Bank of England Financial Stability Paper No. 13, summarized and hyperlinked by contributor Charles Kadlec here. This study by the prudential Bank of England — not for nothing called “the Old Lady of Threadneedle Street” — provides an empirical assessment of the fiduciary management approach ushered in by Presidents Johnson and Nixon and, at the time of the study, in effect for 40 years.

Financial Stability Paper No. 13 contrasts the world economy’s real performance under the Johnson/Nixon protocols relative to the Bretton Woods gold-exchange standard and the classical gold standard. The Bank of England analysis, based on the empirical data, concludes that fiduciary management greatly underperformed (for economic growth, financial stability, inflation, recession, and all other categories assessed) its predecessor systems.

Garofalo legitimately cites the weight of elite academic economic opinion against the out-of-fashion gold standard. That said, this august collection of economists, few if any of whom foresaw the panic of 2007 and ensuing Great Recession, seem to be guided by former U.S. Treasurer Ivy Baker Priest’s motto, “Often wrong, never in doubt.” Readers deserve to be provided with the weight of the evidence to, at least, supplement the weight of elite opinion.

More troubling are Garofalo’s innuendos tying gold standard proponents to sinister “right-wing” politics. There is no meaningful correlation between advocacy for the gold standard and, for example, anti-immigrant sentiment. I, a gold standard proponent, am very much on record for a generous, inclusive, immigration policy (including a path to citizenship for undocumented aliens). So is American Principles In Action, the gold standard’s most prominent advocacy group in Washington, DC (which I professionally advise).

The figure most synonymous with right-wing totalitarianism, Adolf Hitler, virulently opposed the gold standard.  The gold standard then was, as it now is, intrinsic to a liberal republican order. Hitler is recorded as saying:

I had no interest in gold— either natural or synthetic.Our opponents have not yet understood our system. We can be easy in our minds on that subject; they’ll have terrible crises once the war is over. During that time, we’ll be building a solid State, proof against crises, and without an ounce of gold behind it. Anyone who sells above the set prices, let him be marched off into a concentration camp ! That’s the bastion of money. There’s no other way.

Garofalo states that “In 2012, Republicans kowtowed to their more extreme members by including a call to return to the gold standard in their party platform.”   This, flatly, is wrong.  The 2012 GOP platform did not call to return to the gold standard.  It simply called for a ““commission to investigate possible ways to set a fixed value for the dollar.”  (Nor did it represent a “kowtow” to “more extreme members.”)

Instead of reciting the platform language Garofalo relied on a distorted description of it by commentator Bruce Bartlett, to which he links.  (Bartlett’s reference, in his New York Times Economix blog, to a “metallic basis” was to platform language referencing a commission established by Reagan, not the call to action in the 2012 platform.)

Garofalo states that “Kentucky Sen. Rand Paul – has mentioned the possibility of a return to the gold standard.”  The source to which he links states shows the Senator entirely noncommittal:  “Paul wouldn’t comment on whether a gold standard is needed or not….”  Sen. Paul, pressed by a questioner, simply called for a commission to study the matter, which has a subtle yet materially different connotation from having “mentioned the possibility.”

Garofalo’s misrepresentations are, at best, sloppy, giving readers good cause to wonder about the integrity of this writer’s work. His collected writings are a compilation of progressive nostrums: complaining that gas prices are too low, opposing corporate tax reform, criticizing President Obama for refusing to propose a gas tax, supporting the mandated minimum wage, throwing bouquets to the IRS, and so forth.

Garofalo is a propagandist rather than a commentator. Good on him: the discourse is made spicier by propaganda.

That said, the readers of US News & World Report deserve much better quality propaganda than this. The Swiss referendum may have been silly but it was not about the gold standard. The gold standard neither is “ugly” nor evidence of a “rightward lurch.” And, in the words of its foremost living proponent, Lewis E. Lehrman (whose eponymous Institute I professionally advise), “By the test of centuries, the true gold standard, without reserve currencies, is the least imperfect monetary system of history.”

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The Gold Standard Did Not Cause The Great Depression, Part 1

AEI’s James Pethokoukis and National Review’s Ramesh Ponnuru — among many others — appear to have fallen victim to what I have called “the Eichengreen Fallacy,” the demonstrably incorrect proposition that the gold standard caused the Great Depression.  This fallacy is at the root of much confusion in the discourse.

Both these conservatives find themselves, most incongruously, in the company of Professors Paul Krugman, Brad Delong, and Charles Postel; Nouriel Roubini; Thomas Frank; Think Progress’s Marie Diamond; the Roosevelt Institute’s Mike Konczal and other leading thinkers of the left pouring ridicule on the gold standard.  Most recently, Matt O’Brien, of the Washington Post, hyperbolically described the gold standard as “the worst possible case for the worst possible idea,” echoing a previous headline of a blog by Pethokoukis “The case for the gold standard is really pretty awful.”

Mssrs. Pethokoukis and Ponnuru appear to have been misled by an ambient fallacy (reprised recently by Bloomberg View‘s Barry Ritholtz) that there is an inherent deflationary/recessionary propensity of the gold standard. Thus they are being lured into opposition to such respected center-right thought leaders as Lewis E. Lehrman (whose Institute’s monetary policy website I professionally edit); Steve Forbes, Chairman of Forbes Media; Sean Fieler, chairman of American Principles in Action (for which I serve as senior advisor, economics) and the Honorable Steve Lonegan, APIA’s monetary policy director.

They also put themselves sideways with Cato Institute president John Allison; Professors Richard Timberlake, Lawrence White, George Selgin and Brian Domitrovic; Atlas Economic Research Foundation’s Dr. Judy Shelton; Ethics and Public Policy Center’s John Mueller; public figures such as Dr. Ben Carson and, perhaps, Peter Thiel; journalists such as George Melloan and James Grant; and commentators John Tamny, Nathan Lewis, Peter Ferrara, and Jerry Bowyer, among others.

At odds, too, with such esteemed international figures as former Indian RBI deputy governor S.S. Tarapore; former El Salvadoran finance minister Manuel Hinds; and Mexican business titan Hugo Salinas Price. And, at least by way of open-mindedness and perhaps even outright sympathy, The Weekly Standard editor-in-chief William Kristol; Cato’s Dr. James Dorn; Heritage Foundation’s Dr. Norbert Michel; the UK’s Honorable Kwasi Kwarteng and Steve Baker … among many other respected contemporary figures.   Not to mention libertarian lions such as the Honorable Ron Paul.

Gold advocates and sympathizers from the deep past include Copernicus and Newton, George Washington, Alexander Hamilton, Thomas Jefferson, John Witherspoon, John Marshall and Tom Paine, among many other American founders; and, from the less distant past, such important thinkers as Carl Menger, Ludwig von Mises and Jacques Rueff, as well as revered political leaders such as Ronald Reagan and Jack Kemp.

Alan Greenspan recently, in Foreign Affairs, while not discerning gold on the horizon, recently celebrated the “universal acceptability of gold” while raising a quizzical avuncular eyebrow, or two, at what he describes as “fiat” currency.

Let not pass unnoticed the recent statement by Herr Jens Wiedmann, president of the Bundesbank,

Concrete objects have served as money for most of human history; we may therefore speak of commodity money. A great deal of trust was placed in particular in precious and rare metals – gold first and foremost – due to their assumed intrinsic value. In its function as a medium of exchange, medium of payment and store of value, gold is thus, in a sense, a timeless classic.

Nor let pass unnoticed the Bank of England’s 2011 Financial Stability Paper No. 13 assessing the long term performance of the Federal Reserve Note standard and assessing its real outcomes — in every category reviewed, including job creation, economic growth, and inflation — to have proven itself, over 40 years, as deeply inferior in practice to the gold and even gold-exchange standards.

Seems a puzzling mésalliance on the part of Mssrs. Pethokoukis and Ponnuru.The Eichengreen Fallacy — that the gold standard caused and protracted the Great Depression — has led the discourse severely astray. It is imperative to set matters straight.  As I previously have written:

Prof. Eichengreen, author of Golden Fetters, was and remains non-cognizant of a subtle but crucial aspect of world monetary history — and, apparently, of the works of Profs. Jacques Rueff and Robert Triffin elucidating the implications.  Eichengreen blundered by attributing the Great Depression to the gold standard.  This, demonstrably, is untrue.

As Lehrman puts it, the true gold standard repeatedly has proven, in practice, the least imperfect of monetary regimes tried. Robust data actually recommend the gold standard as a powerful force for equitable prosperity.

Just perhaps it can be bettered.  So let the games begin. That said, proposing alternatives to the gold standard is very different from denigrating it.

Pethokoukis (whose writings I regularly follow and with appreciation) recently presented, at AEIdeas, The gold standard is fool’s gold for Republicans. This was a riposte to my here calling him to task for insinuating a connection between the gold standard and the rise of the Nazis and Hitler.  And to task for making statements in another of his AEIdea blogs taking Professors Beckworth and Tyler Cowen out of context.  He also therein conflated the “weight of the evidence” with “weight of opinion.”  It appears that he has fallen prey to the Eichengreen Fallacy.

In self-defense Pethokoukis cites scholarly materials which tend to prove the innocence of the gold standard rather than his insinuation.  For example: he cites Prof. Beckworth’s statement that “the flawed interwar gold standard … probably … led to the Great Depression which, in turn, guaranteed the rise of the Nazis….”

Prof. Beckworth’s characterization “flawed” is entirely consistent with the characterization by the great French monetary official and savant Jacques Rueff, whose work informs my own, of the gold-exchange standard as “a grotesque caricature” of the gold standard.

Similarly, his reference to Prof. Sumner overlooks the obvious fact that Prof. Sumner would appear fully to grasp the key distinction.  Sumner, as quoted by Pethokoukis:

The gold standard got a bad reputation after the Great Depression, when it was seen as contributing to worldwide deflation.  Kurt Schuler points out that the interwar gold standard didn’t follow the rules of the game, which is true.

Pethokoukis speculates,

Perhaps advocates are so sensitive to charges that the gold standard played a key role in the Great Depression, that nuance gets lost in their knee-jerk counterattacks. After all, many gold bugs think their moment is approaching once again. As Ron Paul wrote in his 2009 book “End the Fed”: ” … we should be prepared for hyperinflation and a great deal of poverty with a depression and possibly street violence as well.”  And when the stuff hits the fan, nations will again return to the gold standard for stability. Or so goes the theory over at Forbes.

Notwithstanding my high regard for Dr. Ron Paul I have not shared in prognostications of hyperinflation, poverty, and possible street violence.  If such sentiments have occurred at, whose columnists trend to the classical liberal rather than Austrian model preferred by Dr. Paul, they are vanishingly rare.  To indict by imputing Dr. Paul’s views here suggests a lack of familiarity with these publications.  There are some crucial distinctions to which his attention hereby is invited.

There are some civil disputes amongst various camps of gold standard proponents.  They are far less material than the demonstrably incorrect fallacy that the authentic gold standard has deflationary tendencies which precipitated the Great Depression.  Once this fallacy is dispelled, James Pethokoukis and Ramesh Ponnuru may find it congenial to adopt a different posture in the — steadily rising — debate over the gold standard.  They, as do Profs. Beckworth and Sumner, might find themselves arguing for their version of a better policy rather than denigrating the case for gold standard as, in Pethokoukis’s words, “pretty awful.”

To be continued.

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Markets and reality disconnected

The behaviour of financial markets these days is frankly divorced from reality, with value-investing banished.

Markets have become distorted by Rumsfeld-knowns such as interest rate policy and “market guidance”, and Rumsfeld-unknowns such as undeclared market intervention by the authorities. On top of these distortions there is remote investing by computers programmed with algorithms and high-frequency traders, unable to make human value-assessments.

Take just one instance of possible “market guidance” that occurred this week. On Thursday 16th October, James Dullard of the St Louis Fed hinted that QE might be extended. In the ensuing four trading sessions the Dow rallied over 5%. Was this comment sparked by signs of slowing economic growth, or by a desire to buoy up sliding equity markets? Then there is the vested interest of keeping government funding costs low, which raises the question whether or not exceptionally low bond yields, particularly in the Eurozone, are by design or accidental.

Those who support the theory that it is all an evil plot will also note that governments and their central banks through exchange stability funds (set up with the explicit purpose of market intervention), wealth funds and state pension funds have some $30 trillion to direct as they see fit. The reality is that there is intervention across a range of markets; but most of the mispricing is in the hands of private, not government investors. For evidence look no further than the record level of brokers’ loans to buyers of equities, who with greed worthy of a latter-day South-Sea Bubble seek to gear up their speculative profits.

These are not markets with widespread public participation, buying dot-coms and the like. Instead ordinary people have given their savings and pension funds to professionals who speculate on their behalf. It is the professionals who talk about the Yellen put, meaning the Fed simply won’t let prices fall significantly. We can fret about who is actually responsible for market distortions, instead we should ask who benefits.

Governments: in the past they have covered their debts through a process dubbed financial repression, when artificially low interest rates and bond yields were the principal mechanism whereby wealth is transferred from savers to the government. This process still goes on today. Forget government inflation figures: when did a bank deposit net of taxes last give a positive return after your cost of living increases?

Zero interest rate policy lays the process bare, and turns savers into borrowers. Mr Average has replaced savings with mortgages and car loans. And while the elderly and other passive savers are still defenceless against financial repression, the process has taken on a new twist. The transfer of wealth to governments now targets investment managers.

Investment and hedge funds we invest with together with the banks which take our deposits speculate on our behalf. They think that with a Yellen or Draghi put underwriting markets a ten-year government bond with a two per cent yield is an attractive investment. In doing so they are transferring financial resources to governments in a variation on old-fashioned financial repression.

Our dysfunctional markets have become little more than the essential prerequisite, as Louis XIV’s finance minister Colbert might have said, to plucking the goose for the largest amount of feathers with the minimum of hissing.


A market reset due

Recent evidence points increasingly towards global economic contraction.

Parts of the Eurozone are in great difficulty, and only last weekend S&P the rating agency warned that Greece will default on its debts “at some point in the next fifteen months”. Japan is collapsing under the wealth-destruction of Abenomics. China is juggling with a debt bubble that threatens to implode. The US tells us through government statistics that their outlook is promising, but the reality is very different with one-third of employable adults not working; furthermore the GDP deflator is significantly greater than officially admitted. And the UK is financially over-geared and over-dependent on a failing Eurozone.

This is hardly surprising, because the monetary inflation of recent years has transferred wealth from the majority of the saving and working population to a financial minority. A stealth tax through monetary inflation has been imposed on the majority of people trying to earn an honest living on a fixed salary. It has been under-recorded in consumer price statistics but has occurred nonetheless. Six years of this wealth transfer may have enriched Wall Street, but it has also impoverished Main Street.

The developed world is now in deep financial trouble. This is a situation which may be coming to a debt-laden conclusion. Those in charge of our money know that monetary expansion has failed to stimulate recovery. They also know that their management of financial markets, always with the objective of fostering confidence, has left them with market distortions that now threaten to derail bonds, equities and derivatives.

Today, central banking’s greatest worry is falling prices. The early signs are now upon us, reflected in dollar strength, as well as falling commodity and energy prices. In an economic contraction exposure to foreign currencies is the primary risk faced by international businesses and investors. The world’s financial system is based on the dollar as reserve currency for all the others: it is the back-to-base option for international exposure. The trouble is that leverage between foreign currencies and the US dollar has grown to highly dangerous levels, as shown below.

Total World Money 2013

Plainly, there is great potential for currency instability, compounded by over-priced bond markets. Greece, facing another default, borrows ten-year money in euros at about 6.5%, while Spain and Italy at 2.1% and 2.3% respectively. Investors accepting these low returns should be asking themselves what will be the marginal cost of financing a large increase in government deficits brought on by an economic slump.

A slump will obviously escalate risk for owners of government bonds. The principal holders are banks whose asset-to-equity ratios can be as much as 40-50 times excluding goodwill, particularly when derivative exposure is taken into account. The stark reality is that banks risk failure not because of Irving Fisher’s debt-deflation theory, but because they are exposed to a government debt bubble that will inevitably burst: only a two per cent rise in Eurozone bond yields may be sufficient to trigger a global banking crisis. Fisher’s nightmare of bad debts from failing businesses and falling loan collateral values will merely be an additional burden.


Macro-economists refer to a slump as deflation, but we face something far more complex worth taking the trouble to understand.

The weakness of modern macro-economics is it is not based on a credible theory of prices. Instead of a mechanical relationship between changes in the quantity of money and prices, the purchasing power of a fiat currency is mainly dependent on the confidence its users have in it. This is expressed in preferences for money compared with goods, and these preferences can change for any number of reasons.

When an indebted individual is unable to access further credit, he may be forced to raise cash by selling marketable assets and by reducing consumption. In a normal economy, there are always some people doing this, but when they are outnumbered by others in a happier position, overall the economy progresses. A slump occurs when those that need or want to reduce their financial commitments outnumber those that don’t. There arises an overall shift in preferences in favour of cash, so all other things being equal prices fall.

Shifts in these preferences are almost always the result of past and anticipated state intervention, which replaces the randomness of a free market with a behavioural bias. But this is just one factor that sets price relationships: confidence in the purchasing power of government-issued currency must also be considered and will be uppermost in the minds of those not facing financial difficulties. This is reflected by markets reacting, among other things, to the changing outlook for the issuing government’s finances. If it appears to enough people that the issuing government’s finances are likely to deteriorate significantly, there will be a run against the currency, usually in favour of the dollar upon which all currencies are based. And those holding dollars and aware of the increasing risk to the dollar’s own future purchasing power can only turn to gold and subsequently those goods that represent the necessities of life. And when that happens we have a crack-up boom and the final destruction of the dollar as money.

So the idea that the outlook is for either deflation or inflation is incorrect, and betrays a superficial analysis founded on the misconceptions of macro-economics. Nor does one lead to the other: what really happens is the overall preference between money and goods shifts, influenced not only by current events but by anticipated ones as well.


Recently a rising dollar has led to a falling gold price. This raises the question as to whether further dollar strength against other currencies will continue to undermine the gold price.

Let us assume that the central banks will at some time in the future try to prevent a financial crisis triggered by an economic slump. Their natural response is to expand money and credit. However, this policy-route will be closed off for non-dollar currencies already weakened by a flight into the dollar, leaving us with the bulk of the world’s monetary reflation the responsibility of the Fed.

With this background to the gold price, Asians in their domestic markets are likely to continue to accumulate physical gold, perhaps accelerating their purchases to reflect a renewed bout of scepticism over the local currency. Wealthy investors in Europe will also buy gold, partly through bullion banks, but on the margin demand for delivered physical seems likely to increase. Investment managers and hedge funds in North America will likely close their paper-gold shorts and go long when their computers (which do most of the trading) detect a change in trend.

It seems likely that a change in trend for the gold price in western capital markets will be a component part of a wider reset for all financial markets, because it will signal a change in perceptions of risk for bonds and currencies. With a growing realisation that the great welfare economies are all sliding into a slump, the moment for this reset has moved an important step closer.


Math Gone Mad: Regulatory Risk Modeling by the Federal Reserve

The U.S. financial system faces a major, growing, and much under-appreciated threat from the Federal Reserve’s risk modeling agenda—the “Fed stress tests.” These were intended to make the financial system safe but instead create the potential for a new systemic financial crisis.

The principal purpose of these models is to determine banks’ regulatory capital requirements—the capital “buffers” to be set aside so banks can withstand adverse events and remain solvent.

Risk models are subject to a number of major weaknesses. They are usually based on poor assumptions and inadequate data, are vulnerable to gaming and often blind to major risks. They have difficulty handling market instability and tend to generate risk forecasts that fall as true risks build up. Most of all, they are based on the naïve belief that markets are mathematizable. The Fed’s regulatory stress tests are subject to all these problems and more. They:

  • ignore well-established weaknesses in risk modeling and violate the core principles of good stress testing;
  • are overly prescriptive and suppress innovation and diversity in bank risk management; in so doing, they expose the whole financial system to the weaknesses in the Fed’s models and greatly increase systemic risk;
  • impose a huge and growing regulatory burden;
  • are undermined by political factors;
  • fail to address major risks identified by independent experts; and
  • fail to embody lessons to be learned from the failures of other regulatory stress tests.

The solution to these problems is legislation to prohibit risk modeling by financial regulators and establish a simple, conservative capital standard for banks based on reliable capital ratios instead of unreliable models. The idea that the Fed, with no credible track record at forecasting, can be entrusted with the task of telling banks how to forecast their own financial risks, displacing banks’ own risk systems in the process, is the ultimate in fatal conceits. Unless Congress intervenes, the United States is heading for a new systemic banking crisis.

[Editor’s Note: the full document published by the Cato Institute can be found here]